Risk Expectations of a Growth Capital Lender

Posted on: January 24th, 2023

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Growth capital lenders are valuable resources in the middle market ecosystem, providing scale up financing for acquisitions, product growth and organizational expansion. The uses for growth capital funding are varied and bespoke to each specific company scale-up plan. It can be used to buy a business, hire more people, expand capacity and for customer acquisition. Intrinsic to the value proposition of growth capital funding is its elasticity to accommodate various types of growth investments simultaneously.

Key to Unlocking Growth Capital

As long as a strong economic case can be made that an investment will result in a larger and more profitable business, it will qualify as an acceptable use of funds. The key to unlocking growth capital is in understanding how the riskiness of your growth path aligns with the lender’s appetite for risk. There are certain types of risk that lenders are perfectly willing to consider and other types of risk they shun. Growth capital lenders are keenly interested in providing capital to augment historical like-kind growth, where additional financing will scale the enterprise within the existing product and customer framework.

They will also fund growth into an adjacent or complementary market, where the business can leverage an existing strength of its model to facilitate entry. The more continuous the growth strategy is, the more likely it is to qualify for funding. Business investment that smacks of start up risk or represents a completely new area for a company is generally a bridge too far for a growth capital lender. Start up risk has an enormous number of unknown factors and lacks proof of concept for a lender. Start up risk is not something most growth capital lenders know how to deal with as most start ups are funded with equity. Business investment that leads to greater customer concentration is another challenging area.

Growth capital lenders require customer diversification, not concentration. Investments that are difficult to explain or appear completely unrelated to the core business are another non-starter. The best way to gauge whether your growth path aligns with the lender is to ensure that the growth is relatable to your core business or a variation on a major theme of your core business. The more future growth can be explained through the core strengths of the business, the greater your case for growth capital.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.