Written by Jimmy Becker

Alphabet Soup: PE vs. VC

A correspondent asked:

What’s the difference between venture capital and private equity?

Curious in Kansas

Hi Curious-

Venture capital (VC) and private equity (PE) investments have much in common but also important differences.

First, how are they similar?

1. Funders
VC and PE firms raise investment capital from pension funds, college endowments, and wealthy individuals. 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’ funds are committed for many years and not redeemable on demand.

3. Compensation
VC and PE firms are compensated in a structure colloquially known as “2 and 20.” They receive a 2% management fee each year as well as 20% of the investment returns that are generated by the fund. Even if the returns are low, the firms still receive their 2 and 20. It’s nice work for them, but it’s a mystery why the LPs pay such high fees.

4. Deal structure
The financial engineering is complex and sometimes not fully understood by anyone other than the PE or VC firms. The deal terms are designed to protect their interests to the detriment of other parties involved in these transactions such as employees, creditors, and the LPs.

5. End game
The ideal outcome is either a sale of the business to another company or an IPO (initial public offering). At that point, these investments are “cashed out” and the proceeds are ultimately returned to the LPs. In the industry patois, this is a liquidity event.

How do PE and VC firms differ?

1. Target companies
VC firms invest in small, high-growth, and unprofitable companies that are in need of investment capital. PE firms invest in mature, low-growth, and profitable companies that are perceived to be under-performing and may require re-engineering to improve their rates of growth and profitability.

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 that a few will generate huge returns. 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 most of the time; PEs want lots of singles and doubles while trying to avoid strike outs.

For investors, how have these asset classes performed?

It is hard to know. Certainly some VC and PE funds have generated very high returns, but it is unclear whether they consistently do so as a group as there’s no comprehensive and publicly available database of investment performance. 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 is a better place to work?

A VC-funded company can be a great professional experience when things are working as planned. Revenues are growing fast, capital is available for new investment opportunities, and career development opportunities abound.

However, if the business isn’t going well, 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 VC-funded success stories — free lunches, stock option millionaires, etc. — but the reality is different as most VC-funded companies ultimately fail. You don’t hear as much about them.

PE-funded companies face slower growth and pressure to cut expenses. Layoffs are often part of the turnaround strategy and this can get tiresome and demoralizing. However, the company should have significant value — otherwise the PE firm would not have made the acquisition — so it is unlikely that it would go out of business. For the surviving employees, there would be more job security than with a VC-funded company that was doing poorly.

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