Welcome to the first installment of this column. Other columns on Financial Poise (check them out – they are excellent) are more subject-specific than this will be. My guiding principle will be to write about things I want my children and my parents to understand about the world of business, investing, finance and law. I’ll do it in a way that doesn’t require you to have read any past installments. And I will jump around a lot, based on whatever my undiagnosed ADD causes me to have an interest in at the time I am writing.
For this first installment, I explain the difference between “VC” and “PE.”
There is no universally accepted definition of “venture capital” but the U.S. Small Business Administration’s definition works well:[A] type of equity financing that addresses the funding needs of entrepreneurial companies that for reasons of size, assets, and stage of development cannot seek capital from more traditional sources, such as public markets and banks. Venture capital investments are generally made as cash in exchange for shares and an active role in the invested company.
One challenge with the definition above, however, is that it also describes “angel investing.” An angel investor, however, is different from a VC investor in that an angel investor is an individual (i.e. a human being) who does not consider angel investing to be her occupation. VCs, on the other hand, are typically investment firms (though the professionals who work at such firms are also commonly referred to as “VCs”) whose business it is to invest in entrepreneurial companies. There are many other important distinctions between VCs and Angel Investors. For example, Angel Investors tend to invest in startup companies earlier than do VCs and typically demand less in terms of governance rights. You can read more about angel investing here.
The term “private equity,” in its broadest sense, could encompass everything from angel investments to venture capital, and a lot more. More common definitions, however, distinguish between venture capital and private equity. Financial Poise defines “private equity” to mean:
Purchasing control positions in established privately held companies, typically by borrowing a high percentage of the cash used for the purchase, for the purpose of making improvements to such companies and then selling them within about seven years.
An individual investor can make a private equity investment along the lines described above and, such investment would meet the definition. However, most private equity investments historically have been made by private equity funds and when financial literature refers to private equity, it usually means private equity investments conducted by private equity funds. You can read a lot more about private equity here.
My prior paragraph needs elaboration: a person (call her Sophie) can invest money in a PE fund (or a VC Fund, as well as other private investment funds). And if Sophie does so, the PE fund in which she invested will pool Sophie’s money with the money of others who invest in the fund and use it to invest, in turn, to purchase control positions in established privately held companies.
Is Sophie a PE investor? Sure. Has she made a PE investment? Sure. But there is a distinction to be made between Sophie’s investment in the fund and the fund’s investment in its companies (called portfolio companies). Some very wealthy people skip the fund and make direct control investments into established privately held companies. These people (often working though their family offices) are thus “direct” PE investors. You can read more about investing in PE deals “directly” in this great article by Cyril Demaria.
A PE fund (or, any PE investor, for that matter) differs from a VC fund (or, again, any VC investor) principally in terms of when in the life cycle of a company the investor seeks to invest. Said really plainly, VCs invest in younger companies, which may not even have profits yet – or revenue for that matter. PE investors look to more established companies. Most of the other differences stem from this difference. For example, VCs look for much higher returns than do PE investors, to compensate them for the risk they take in investing in less mature businesses. That’s it, really. You can read about the differences in greater detail, however, here.
PE and VC funds actually have more in common than one might assume. To be clear, I am referring to the funds now – meaning the way they are set up. Each can be viewed as generally having four basic periods in its lifecycle:
The traditional fund model seeks commitments from potential investors, to invest in the fund. Once committed, the investors are “limited partners” of the fund. Some PE “funds” are not really funds, in that their investors are not committed. They are called fundless sponsors. But let’s stay focused on traditional funds.
By example, Sophie might agree to invest $50,000. Sophie won’t typically write a $50,000 check the day she commits. Rather, she commits to write checks, up to a total of $50,000, when instructed. Thus, Sophie makes a “binding capital commitment.”
Later, when Sophie receives such an instruction, it is called a “capital call.” Once a fund has secured a sufficient level of binding capital commitments, it moves from the capital raise period to the investment period.
During the investment period, with the assistance of an investment management firm or investment adviser (who typically is an affiliate of the fund’s sponsor), the fund seeks out companies to invest in (in the case of a VC fund) or companies to purchase (in the case of a PE fund). This is a good overview of how PE funds go about selecting the companies they buy. As the fund executes investments, the sponsor makes capital calls on its investors. The investment period typically spans the first three to five years of a fund’s life.
Following the investment period, and during the holding period, a fund will maintain the investments in its portfolio for a period of time (five to seven years is not uncommon) while they develop and appreciate in value. It is also common for a PE fund to support its portfolio companies in making “followon” investments during the holding period or in making them themselves. By this I mean that once a PE fund owns a company is an industry, it may seek to make additional acquisitions in the same industry or may invest more money into the portfolio company so that it can purchase others in the industry.
By example, if PE firm X buys an eyeglass frame manufacturer during the investment period, it may end up buying a second eyeglass frame manufacturer or, perhaps, a contact lens manufacturer, or a chain of optometry shops later, even if it’s during the holding period. Or it may help its original portfolio company to buy it by providing the funds to do so.
Lastly, during the harvesting period, a fund will liquidate its portfolio of investments and distribute proceeds to its investors. To be clear, these four periods do not have rigid lines and, in fact, overlap a great deal.
You might find it helpful to refer to this chart in order to better understand the differences between private equity and venture capital:
|Characteristic||Venture Capital||Private Equity|
|Target companies||Startups, earlystage companies, often prerevenue||Mature companies, often underperforming or undervalued, but always with real revenue|
|Target industries||Highgrowth industries like hightech, biomedical, alternative energy||All industries, usually with established marketplace for the product or service|
|ROI expectation||Many failures, some solid returns, a few spectacular successes. Expectations must reflect the risks||Similar to VC but less dramatic failures and successes|
|Investment size ($)||Smaller||Larger|
|Liquidity horizon||Five to 10 year but generally slightly shorter than PE||Five to ten years but generally slightly longer than VC|
|Desired ownership percentage of targets||Usually minority stake in company||Control (often 100%) of company|
|Funding structure||Often equity only, but highly flexible||Equity and debt|
|Investor active?||Investors provide advice, connections, distribution; monitor cash burn; etc.||Similar to VC|
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Jonathan Friedland is a partner with Sugar Felsenthal Grais & Hammer, a law firm with offices in Chicago and New York City. Born and raised in a New York suburb, Friedland graduated SUNY-Albany magna cum laude in three years and then earned his law degree from the University of Pennsylvania Law School. Friedland clerked for…
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