The Differences and Similarities Between Private Equity and Venture Capital
Venture capital (VC) and private equity (PE) investments have much in common but also important differences.
First, how are they similar?
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.
These investments are not liquid. The LPs’ funds are committed for many years and are not redeemable on demand. Investors must be prepared to be unable to get immediate access to their investment funds. These investments have a time horizon of many years before the investment capital may be returned.
VC and PE firms are typically 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 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 the interests of the general partners, sometimes to the detriment of other parties involved in these transactions such as employees, creditors, LPs, and sometimes other shareholders.
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 they 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 operational re-engineering to improve their rates of growth and profitability. Generally, 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. 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 avoid strike outs. As in baseball, either approach can be a winning strategy.
4. Deal Structure
VC portfolio companies have little or no debt. This is sensible because they are not generating profits or positive cash flow and thus would have no ability to sustain debt repayments. PE portfolio 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.”
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. 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 have languished 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 is a better place to work?
A VC-funded company can be a great professional experience when things are going well. Revenues are growing 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 VC-funded success stories — free lunches, stock option millionaires, etc. — but the reality is different as most VC-funded companies ultimately fail and the stock options are worthless. You don’t hear as much about them.
PE-funded companies face slower growth and pressure to cut expenses. This is partly because they have taken on so much debt to fund the acquisition. Layoffs 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 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.