The Masters of the Universe

The big tech companies that now run our lives were all initially funded with venture capital — Amazon, Apple, Facebook, Google, Microsoft, Netflix, and many others. And, many of the best known bankruptcies of recent years were all owned by private equity firms — Bed, Bath, and Beyond, Serta, Toys R Us, Sears, Hertz, J Crew, Friendly’s Restaurants, and Neiman Marcus, to name a few.

Do you ever wonder what these venture capital (VC) and private equity (PE) masters of the universe do, how they are different, similar? If so, read on.

How do VC and PE firms invest and how do they differ?

1. Target companies

VC firms invest in smaller, high-growth, and unprofitable companies that are in need of investment (so-called “growth capital”). PE firms invest in mature,  low-growth, and usually profitable companies that are perceived to be under-performing and require operational re-engineering to improve their growth rates and profitability. VC firms want their portfolio companies to maximize growth; PE firms want their companies to maximize profitability and cash flow.

2. Investment size

VCs make minority investments. They don’t fully control these companies but have influence through seats on the board of directors. PEs buy complete ownership in their companies and fully control the company’s strategy and operations.

3. Success rate

VCs expect most of their investments to ultimately fail, but a few will generate huge returns (the so-called “power law” in the patois). PEs expect most of their investments to succeed, but with smaller profits on each of these turnarounds.

To use a baseball metaphor, VCs swing for home runs, knowing they’ll strike out much of the time; PEs want lots of singles and doubles while trying to minimize strike outs. As in baseball, either approach can be a winning strategy.

4. Deal structure

VC-funded companies have little or no debt. This is sensible because they are not generating positive cash flow and thus would have no ability to sustain debt repayments. PE-owned companies typically take on as much debt as they believe the company’s cash flow and profitability can handle. In this manner, they are leveraging the equity investments they’ve made. In an earlier era, these deals were known as “leveraged buy-outs.” That term became declasse and they were rebranded as the more respectable-sounding private equity. But, it’s the same thing.

How are they similar?

1. Funders

VC and PE firms raise investment capital from institutional investors such as pension funds, college endowments, and wealthy families. These investors are the limited partners (LPs) and the VC and PE firms act as the general partners.

2. Liquidity

These investments are not liquid. The LPs have to commit funds for many years and, unlike mutual fund investments, are not redeemable on demand. LPs must be prepared to be unable to get immediate access to their invested funds. These investments have a time horizon of many years before the investment gains or losses may be distributed.

3. Compensation

They are compensated in a structure known as “2 and 20.”  They receive a management fee of 2% of the invested funds each year as well as 20% of the investment profits that are generated by the fund. Even if the returns are low or the funds are not immediately invested, the firms still receive their 2 and 20. If you’re thinking it’s a “heads we win; tails we don’t lose” structure for them, you would be astute. Nice work if you can get it, but it’s a mystery why the LPs pay such high fees. In addition, this compensation is what’s known as the infamous carried interest that is taxed more favorably than ordinary income. It’s this compensation and tax structure that has created this billionaire class.

4. Deal structure

The financial engineering is complex and sometimes not fully understood by anyone other than these firms and their lawyers. The deal terms are designed to protect the interests of the general partner firms, sometimes to the detriment of other parties involved in these transactions such as employees, creditors, LPs, and, perhaps, other shareholders.

5. End game

The ideal outcome is either a sale of the business or an initial public offering. At that point, these investments may be “cashed out” and the proceeds are ultimately returned to the LPs. In the industry patois, this is a liquidity event.

Dunkin’ (née Dunkin Donuts) is a good example having been acquired by PE firms for the second time. The Boston Globe tells their story of a previous acquisition by other PE firms in 2006, followed by going public in 2011, and now followed by going private again.

For investors, how do these asset classes perform, net of fees?

It’s hard to know. Certainly some VC and PE funds generate very high returns, and the firms are sure to brag about those, but it is unclear whether, over time, they consistently do so as a group as there’s no comprehensive and publicly available database of investment performance.

It is likely that, as in most things in life, there is a wide range of performance where some firms have generated enormous investment returns, while others languish in the land of mediocrity. Because the fees are so high, much of the profits accrue to the investment firms themselves, rather than the LPs who have provided the investment capital.

For employees, which target company is a better place to work?

A VC-funded company can be a great professional experience when things are going well. Revenues grow fast, capital is available for new investment opportunities, career development opportunities abound, and employees often receive stock option grants that can be valuable.

However, if the business is struggling, the company may be unable to raise more capital. In that scenario, it can face a death spiral and be forced to shut down with little warning. We hear about the success stories — espresso machines, on-site massages, stock option millionaires, etc. — but the reality is different as most VC-funded companies ultimately fail with the stock options worthless and the espresso machine ending up in someone’s kitchen. You don’t hear as much about those stories.

PE-funded companies face slower growth and pressure to cut expenses. This is partly because they have taken on so much debt to generate cash distributions for the investors. Layoffs and benefit cuts are often part of the turnaround strategy and this is demoralizing. However, the company should have significant value — otherwise the PE firm would not have made the acquisition — so it is unlikely to go out of business. For the surviving employees, there is more job security than with a VC-funded company that was doing poorly.

The biggest risk with PE-owned companies is the enormous debt burden that they typically carry. If the economy sours or business tanks for any reason — e.g., a pandemic — the company has little financial wiggle room and bankruptcy can follow.

PE and VC firms are high risk and return opportunities for investors. For employees, they’re also high risk, but few experience the high returns.