A Closer Look at the Differences between Private Equity and Venture Capital
In the world of start-ups and early stage companies, few labels or terms are as confused and improperly assigned as Private Equity (PE) and Venture Capital (VC). Many business owners and entrepreneurs treat them interchangeably as though they are identical forms of investment. And while there are instances where the two overlap, the truth is they could not be further apart in their core objectives and target markets.
Many pundits offer a rather elementary perspective that VC is merely a subset of PE. Alternatively, they refer to VC (or growth capital) as a separate investment strategy within PE. This assessment is a bit narrow in scope and, therefore, we devote the remainder of this narrative to a more critical analysis of these two important investment avenues.
We view PE and VC investments as separate assets classes owing to the numerous differences in their underlying characteristics:
- companies and industries targeted,
- lifecycle stage of the investment,
- capital hurdles,
- relative risk-return profiles,
- deal structures (equity, debt, hybrid),
- liquidity time horizon,
- control vs. minority interest and the associated tax implications, and
- investor/firm expertise.
A venture capitalist, or VC fund, earns a rate of return by acquiring an equity stake – typically a minority position – in a company. Given the relatively low capital hurdle ($2 million to $50 million), VC funds consist of a portfolio of start-up, early-stage companies; 20 or more is common.
VCs expect that many of the companies they invest in will ultimately fail and generate no investment return. Portfolio risk is largely managed through diversification and having multiple investments within high-growth, emerging industries. In doing so, the intent is for one or more ventures to generate exceptional returns, making the underlying fund profitable. The hope for most VC funds is that one of their start-up investments will blossom into a dominant, game-changing organization like eBay, Sun, Google, and Apple (all of which were VC-funded).
The general tendency is for VC funds to be more intimately involved in the operations of a target company. This advisory function is unique to VCs (as well as some Angel investors), and is usually tied to industry-related expertise as opposed to the core investment banking knowledge commonly evident at PE firms.
Due to the early-stage nature of the investments, as well as the more eclectic nature of the companies, valuations are generally less defined within the VC environment. In fact, many companies may be unprofitable. The financial and business focus is on cash conservation (reducing cash burn), revenue growth, operating leverage, brand evolution, and capturing mind/market share.
PE firms invest in target companies to cultivate expansion, provide working capital, advance product development, or restructure the capital composition. In most instances, particularly in the case of mature, value-oriented entities, PE deals are treated as outright acquisitions or purchases. The form of investment can either be cash, equity, debt [leveraged buyout (LBO)], or some hybrid structure. In some instances, a PE acquisition may entail more than one firm.
Valuations within the PE landscape are relatively more defined than their VC counterparts. Target companies are frequently known quantities within established industries and are evaluated based on public market multiples such as price-to-sales, earnings, cash flow, and enterprise value-to-EBITDA. Owing to the similar backdrop to traditional investment banking, it is little surprise that a vast majority of PE firms’ headcount comes from those ranks.
Outside of replacing the management of a target company, most PE firms prefer to keep out of the way as long as tangible progress towards stated objectives can be readily observed. As such, PE investors have less involvement with daily operations.
Due to the relative maturity of the businesses, failures are far less common in PE (severely distressed turnarounds being the exception). Investments have a more linear growth trajectory that is stimulated by the infusion of a new product line, an altered marketing or distribution strategy, targeted operational cost savings, or some combination thereof.
Exit strategies typically involve an initial public offering (IPO) in which investors realize some return on invested capital (ROIC). Due to the larger scope of the businesses (some of which are multinational conglomerates), it is not uncommon for the investment horizon to extend anywhere from 6 to 12 years, or longer, depending on risk appetite and the underlying conditions of the public markets.
Investing through traditional PE and VC organizations is not all about their differences. There are a few areas in which there are distinct similarities. For instance, both types of organizations make money by exiting their investments – handing their portfolio companies over to the next funding round. In the case of PE firms, this is typically done through an initial public offering (IPO). With VCs this can be accomplished either through an IPO or a secondary funding round, which could be another VC round or Series A funding from a PE firm.
While both VC and PE firms target healthy 20% to 30% returns, they typically see returns in the high single-digit to low-teens on a percentage basis. The manner in which they arrive at these returns is quite different, however. PE firms usually are invested in fewer, larger deals that carry more stable revenue, earnings, and cash flow streams. VCs have a broader portfolio of companies – 20 or more is commonplace. Due to the embryonic stage of development, many of these companies will ultimately fail or produce low returns. A small handful will go on to be significant contributors.
As noted earlier, the personnel composition of PE and VC firms is very polarized. PE firms employ a more traditional investment banking workforce as the work streams parallel those in a bank environment. VC backgrounds tend to be more varied, but are generally skewed toward individuals with experience in specific industries in which a VC fund is focused.
Although PE and VC firms cater to much different clientele, a convergence has been observed over the course of the past decade (the Great Recession notwithstanding). A lack of quality deals at the low-end of PE and the high-end of VC has given way to more competitive middle market (deals in the $50 million to $100 million range). We ascribe this to the proliferation of capital firms over that same timeframe, as well as the comparative low-cost environment and the availability of funds. Said differently, competition within the middle-market has expanded as many well-capitalized firms are chasing relatively few high-quality deals.
Tale of the Tape