Private equity and venture capital firms invest in different companies and for different reasons.
Private Equity and Venture Capital 101
But for the purpose of making investment decisions, their individual characteristics are sufficiently distinctive that we should treat them as separate asset classes.
Those characteristics include:
- target companies
- risk-reward profiles
- minimum capital contributions
- deal structures
- tax benefits
- control vs. minority share acquired
- investor expertise
(There are others, too. See comparison chart below.)
*By private companies, I mean companies whose ownership shares or units are not traded publicly, because the owners want to restrict the number and/or kinds of people who can invest in them.
PE and VC - Different Investment Targets
Private equity investors tend to target relatively mature companies, which may be under-performing or under-valued, with the goal of improving their profitability and selling them for a return on their investment (capital gain) — or in some cases, splitting them apart and selling their assets at a profit.
Venture investors, on the other hand, target early-stage and expanding companies (often pre-revenue) with fast-growth potential, with the objective of nurturing and growing them quickly, then selling them in M&A deals or taking them public.
Comparison Chart for Investors: PE and VC
|Private Equity||Venture Capital|
|Target companies||Mature companies, often under-performing or under-valued||Startups, early-stage companies, usually pre-revenue|
|Target industries||All industries, usually with established marketplace for the product or service||High-growth industries like high-tech, biomedical, alternative energy|
|ROI expectation*||Depends on the inherent risk of particular firm and industry. Target can be 20%/yr over five years, more likely 10%/yr or less||Many failures, some solid returns, a few spectacular successes. Expectations must reflect the risks.|
|Investment size ($)||100 million to 10′s of billions for big PE funds; 10+ million for small funds & indiv.||Less than 10 million|
|Liquidity horizon||6 to 10 years||4 to 7 years|
|Share acquired by investor/fund||Control (often 100%) of company||Usually minority stake in company|
|Funding structure||Equity and debt||Often equity only, but can be structured to fit needs of both parties**|
|Investor active?||Investors may be passive concerning management, unless purpose of acquisition is to improve company performance||Investors provide advice, connections, distribution; monitor cash burn; etc.|
* ROI = return on investment ** Often a convertible instrument is used and triggered by pre-defined milestones. [All entries in the comparison chart are estimates and generalizations.]
In Europe, PE professionals further categorize the field into growth capital and mezzanine capital, also called convertible debt.
Both of these fall in-between PE and VC regarding the life stage of the target companies — growth being more established than venture startups, and mezzanine being not quite as “mature” as buyout targets.
In the past eight years or so, private equity and venture capital, as asset classes, have been converging in some respects.
“With the robust, if not frothy state of the capital markets today, there is far too much capital chasing too few quality deals,” said Mike Myatt, chief strategy officer at N2growth (a venture consultancy), writing in 2006.
“The increased pressure on the part of money managers, investment advisers, fund managers, and capital providers to place funds is at an all-time high. This excess money supply has created more competition between investors, driving valuations up for entrepreneurs and yields down for investors. “This increased competition among investors has forced both venture capital and private equity firms to expand their respective horizons in order to continue to capture new opportunities. Over the last 12 months I have seen an increase in private equity firms willing to consider earlier-stage companies and venture capital firms lowering yield requirements to be more competitive in securing later-stage opportunities.”
Below is a list of what I think are the most authoritative and concise articles and other materials on the differences between PE and VC.
- “The Differences between Venture Capital and Private Equity,” a segment of On the Media, aired by NPR on August 3, 2012. Hosted by Brooke Gladstone. Listen to it here.
- “Why Private Equity and Entrepreneurship Don’t Mix,” by Suren Dutia (Forbes, October 4, 2012), argues that PE does not play a “legitimate” role in fostering entrepreneurial ventures, and neatly sets out significant differences between PE and VC.
Dave Freedman has worked as a financial and legal journalist since 1978. For his help with the article, the author thanks Richard R. Conn, CMA, MBA, CPA/ABV, CFFA, ERP, principal of Conn Valuation Services, in Calgary, Alberta, Canada.