Meeting the capital challenge within impact growth equity

5 min read 2 Jul 24

Private equity investors increasingly are seeking to make a positive impact with their investments. However, for the businesses involved, the reduction in availability of late-stage funding is proving a serious obstacle.

Impact growth equity investing continues to advance with ever growing investor interest. Overall, the impact investing market globally is estimated to grow from $3 trillion in 2023 to almost $8 trillion within the next 10 years, according to market research firm The Brainy Insights1. This represents a compound annual growth rate (CAGR) of 10%, expected to be driven by factors such as government policy, more robust impact measurement tools and increased allocations from institutional investors.

Within private equity (PE), specifically, the attraction for investors is clear – alignment of financial objectives and values, together with support for businesses with high-growth potential seeking to make a positive social and/or environmental impact. For institutional clients, particularly pension plans, allocating towards impact growth equity within private equity can play an important role in endgame planning given extended investment horizons and potentially superior long-term return profiles. 

“Impact growth equity provides essential capital during a business’s build and scale-up phase.”
 

Additionally, investors can often secure portfolio diversification benefits. Impact growth equity investing typically has a focus on small and mid-cap stocks. Within a larger overall equity portfolio with a heavy large-cap weighting, this can prove an important diversifier. Further, the typically longer holding periods within impact growth equity, relative to traditional equity portfolios, can be a further source of portfolio diversification.  

However, challenges have emerged which are acting to hamper the continued growth of this crucial investment area. Prime among these is a funding gap, particularly the growth or scale-up phase of equity funding.

Traditionally, venture capital (VC) would have been an important source of funding at this stage. However, high interest rates and the general macroeconomic environment have proven a deterrent. Add in a steep fall in initial public offering (IPO) volumes limiting their primary exit route, together with the ‘private-for-longer’ trend being problematic for VC funds with a normal 5- to10-year fund life, and their absence makes sense.

Another potential funding source might have been infrastructure equity investors. The issue here has been the high sensitivity of infrastructure to elevated interest rates given the importance of cash-flow. Higher interest rates impact valuations discouraging infrastructure equity fund participation. The step-back by both VC and infrastructure equity investors matters as businesses require the main attributes of these investors – scale, capital availability, and with VC, an appetite for risk.

Mind the gap

For investors and society, this funding gap matters. Impact growth equity provides essential capital during a business’s build and scale-up phase. It finances operational build-out, marketing activity, geographic expansion and M&A, and the right strategic investors can help open doors previously closed. It is at this point in a company’s development that investor value is accelerated and any impediment to this cycle hampers prospective investor returns and stifles vital innovation.

“Normally the less risky part of a company’s development journey is at the later stages of its development.”
 

Particularly concerning to impact investors, this funding gap has a direct impact on capital intensive businesses such as those involved in energy transition. With sizeable funding requirements, these companies often depend on late-stage funding support to innovate and bring to market much needed infrastructure and energy solutions. The failure to support such businesses has environmental and societal implications. Lack of funding for enterprises seeking to deliver reliable, renewable energy solutions to populations in remote areas of the world would seem at odds with the primary investment goals of many impact equity funds.

Several factors have exacerbated the funding gap, in our view:

  • Decline in late-stage activity mirrors decline in IPO market. Globally, the number of IPOs fell 45% from 2021 to 2022 (source: EY, 2022). The subsequent impact on late-stage investment is obvious, in our view, with investors looking for exit pathways, and IPOs being a primary route.
  • Valuation reset. Whilst the ‘exuberance’ within PE markets ended in 2022, the inevitable retrenchment has not finished with valuations taking longer to reset. Business owners are choosing to stay private for longer, perhaps reluctant to accept valuations lower than those they would have achieved two years ago. This reluctance may be limiting both demand for, and provision of, late-stage financing.
  • Venture capital contraction. Mirroring the decline in IPO activity, there has been a similar collapse in VC funding activity. Analysis by S&P Global Market Intelligence (Nov 2023) highlights the number of VC rounds has fallen by 46% over the last 2-years, declining 26% in 2023 alone.  Lacking exit opportunities, VC funds are reluctant to invest. Compounding this has been a more general issue of VC firms struggling, both in terms of capital availability and professional bandwidth to further commit following the VC boom in 2021. 
  • Limited institutional allocations. Globally, but particularly within the European market, institutional investors have focused primarily on private equity buy-out opportunities, rather than growth PE. In addition, whilst data provider Preqin believes global institutional investors plan to increase their PE allocations over the next few years, target allocations by institutions remain limited. Public sector pension plans have an average target allocation to PE of only 7.1% with private sector funds only slightly higher at 8.5% (Preqin, July 2022).  

Restricting return and impact potential

From an impact investor’s perspective, we believe addressing these challenges is paramount. Normally the less risky part of a company’s development journey is at the later stages of its development. It has already survived proof-of-concept and likely has a revenue base and perhaps already generates profit. Arguably the less risky but potentially higher return stage comes with scale and build-out – precisely where the current funding gap exists. Having accepted high levels of initial risk, investors may potentially be denied the rewards of their patience and risk tolerance.

Looking to address these issues and provide investors with a route to support and capitalise from these dynamics, M&G Catalyst was launched. This growth equity impact strategy provides equity to private, mission-driven companies operating in the climate, health and inclusive growth sectors. Its aim is to directly confront the funding gap purposeful businesses struggle with and secure late-stage funding enabling them to push forwards and make the transformational changes required.

But crucially, beyond pure capital provision, these businesses are looking for an investment partner with both the scale, network and level of experience to help them accelerate at a crucial point in their growth journey. M&G Catalyst has a team of over 40 investment professionals worldwide, providing local insight with global reach to identify opportunities and map out risk-mitigated pathways to future growth. 

Addressing the problem

The three impact themes targeted by M&G Catalyst are:

Impact theme Potential investment opportunity
Climate & Environment Climate-positive enterprises, carbon-capture technology 
Health AI-led discovery eg, medical diagnostics and screening
Inclusive growth Democratisation of basic needs eg, off-grid solar

These themes are where we believe the greatest impact investment opportunities lie. Catalyst’s investment mission is aligned with these themes and, in our opinion, is now, poised to deliver incremental value to private companies within this space. Specifically:

  • Leveraging an integrated asset management model. The breadth of M&G’s asset class capabilities allows Catalyst to leverage in-house expertise. For example, the M&G private credit team can provide loans to Catalyst companies. Due to existing relationships, these loans can often be provided in a shorter time frame than would be the case with a third-party lender. Curtailing the due diligence to loan advancement timeframe could prove critical for the success of a business.

Another example of cross-asset class collaboration would include a £500 million co-development funding by the M&G Real Estate team together with Catalyst in a UK-based sustainable housebuilder.

  • Flexible funding pathways. With a ‘patient capital’ approach, Catalyst addresses the ‘private-for-longer’ trend within the corporate sector. It is flexible and offers both IPO and private-for-longer funding pathways supporting future funding requirements. Further, benefiting from a stable and long-term internal investor, capital can be accessed when required allowing Catalyst to be genuinely innovative in terms of funding its portfolio businesses.
  • Scale, reach, expertise. Maximising potential returns for investors depends on manager expertise and resource. M&G Investments, as an integrated asset manager, has in-house expertise across both private and public markets, together with specific research specialisms across the climate, health and social inclusion sectors.

Purposeful partnership

Despite the challenges facing private companies seeking support and funding for the growth stage of their development, established partners exist with the expertise and investment approach required. We believe these partners will be vital in order to effectively address some of the most pressing challenges the world is confronting.

Within the area of energy transition substantial long-term capital is required to develop emergent and transformative alternative energy sources (source: International Renewable Energy Agency, 2023). Meeting UN Sustainable Development Goals (SDGs) alone requires addressing a near $4 trillion annual funding gap in developing countries, according to UN Trade and Development (UNCTAD)2.

A willingness to remain a partner and seeking to make a positive impact for the duration of a company’s development are central to M&G Catalyst’s mission. With interests aligned with investee companies, we believe Catalyst continues to add investor value during a period of unprecedented global disruption and transition.

1Source: The Brainy Insights, Impact Investing Market Size by Sector, Investor, Regions, Global Industry Analysis, Share, Growth, Trends, and Forecast 2024 to 2033, January 2024.
2Source: UNCTAD, SDG investment is growing, but too slowly: The investment gap is now $4 trillion, up from $2.5 in 2015, SDG Investment Trends Monitor (Issue 4), September 2023. While we support the UN SDGs, we are not associated with the UN and our funds are not endorsed by them.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.  While we support the UN SDGs, we are not associated with the UN and our funds are not endorsed by them.

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