While both PE and VC funds make investments primarily in private companies, the types of businesses in which they invest, how they invest, the level of risk involved, and the value creation methods they bring to bear are meaningfully different.
A common question from advisors as they begin to investigate the private alternative fund universe concerns the distinction between private equity (defined in this article as traditional buyout PE) and venture capital. While both PE and VC funds make investments primarily in private companies, the types of businesses in which they invest, how they invest, the level of risk involved, and the value creation methods they bring to bear are meaningfully different. As a result, while we view these two strategies as being on the same spectrum, they can both be additive to a traditional portfolio for investors who can afford illiquidity and have the requisite risk tolerance.
Venture capital firms focus on providing equity funding to entrepreneurs and early stage companies that they believe have the potential to disrupt their industries, with the hope of profiting from the creation of the next Google, Facebook, or Uber. These young companies generally have unproven products, business models, or management teams (or all three). VC firms tend to specialize in one or more technology or life sciences-related areas because technology is almost always required to disrupt markets at scale. Most venture investments range from less than $1 million for a seed stage deal to $10 million for companies such as Uber and Airbnb, as these companies remain private for longer and require sums of capital to operate and grow.
In addition to providing capital, VC firms often provide expertise to help these startups refine their business plans and bring their products to market. Some VC firms maintain in-house operating benches of executives with specialized experience in a particular industry or function such as marketing or design, who can offer critical advice and support to startups until they mature enough to fill such gaps internally. However, while they may contribute key resources to their portfolio companies to assist with execution and achieving growth, their involvement tends to be more limited than that of PE investors.
The venture capital model involves investing relatively small amounts of money in dozens of companies, with the expectation that most of them will fail but that a small number will be sufficiently successful to generate an attractive return at the overall fund level for the amount of risk that was taken. The degree of uncertainty and risk in this model is high - venture capitalists invest on the basis of projected revenue and profit growth, which can range widely from exponential growth for business that are developing truly innovative products and solutions, to the much more frequent scenario of low or even negative growth, as the startup idea confronts the reality of the marketplace and the difficulties of successful execution (this is in contrast to private equity investment theses, which are developed in the context of established business operations and foreseeable cash flows rather than estimated metrics such as total addressable market size). As a result, VC firms generally make minority investments and frequently partner with other VCs to bring capital to companies. Another key reason for this partial, minority ownership is that startup founders invariably want to retain significant stakes in their businesses and avoid giving up control over operations, especially at the earliest stages of a company’s life when their vision is key to the business’ development.
Rapid growth and iteration of business strategy are hallmarks of startup investing, and render the business trajectories of these companies highly unpredictable. The financing needs of these early stage businesses are equally difficult to reliably forecast, with many startups fundraising as frequently as every 12 months. The small minority of startups that are successful tend to quickly become too large for a private equity buyout deal or other conventional transaction - this “unicorn” phenomenon encompasses companies such as Airbnb, which most recently raised capital at a $30 billion valuation, and Uber, which investors have valued at a $68 billion according to Business Insider. In comparison, some PE deals today are no larger than $10 billion in total enterprise value. Further, significant competition from strategic investors such as Google exists for the small minority of startups that achieve rapid growth, and these large strategics are generally viewed by startup founders as better partners than private equity firms.
While venture capital firms are effectively in the business of creating new industries, private equity firms want to see a meaningful corporate track record and operating history that they can use to diligence and underwrite investments. Fundamentally, the skills required to evaluate a founder and an unproven idea are different from those involved in analyzing the incremental profitability potential of an existing business. The presence of existing assets and cashflow as well as future cashflows that are quantifiable within a relatively narrow range is also critical because private equity firms, unlike VC firms, employ significant amounts of debt to make their investments (generally more than half of the total transaction value). Businesses that lack free cashflow for interest payments are highly unlikely to obtain debt financing. Beyond this basic prerequisite, the underwriting that is required by a lender taking on credit risk is significantly different than the decision-making process involved in assessing a potentially “disruptive” idea. As a result, PE firms are generally focused on investing in mature companies with visible future cashflows, where the chance of failure is close to 0%.
In addition, compared to VC funds, private equity funds have a concentrated number of investments with a more even distribution of the fund’s capital across each deal. This is because it is not only easier for VCs to double down on winners by participating in subsequent financing rounds, but also easier for them to cut losses by abandoning a company after making the first, relatively small investment. Unlike in the venture capital model, even a single PE investment failing would be quite damaging to the overall results of the fund, given the much larger equity checks written by private equity firms.
Implementing operational improvements has become an increasingly important part of private equity’s value creation toolkit over time, which, combined with the larger amounts of money at stake compared to VC, means that PE investors usually take controlling or exclusive stakes in companies. Private equity investors use their control stakes to take measures such as implementing organic and acquisition-focused growth plans and to address the full range of corporate matters, including such issues as customer concentration, competitive threats, unsustainable pricing, excessively high cost structures and weak management. Thus, the fact that founders are generally unwilling to cede majority stakes in and control over their businesses fundamentally does not mesh with the value proposition of private equity. Further, a key measure frequently taken by private equity owners is actually replacing management teams, a prospect that would not be welcomed by a new entrepreneur (who would likely still hold a substantial, if not the largest, equity stake in the company).
While venture capital and private equity are both means of getting exposure to the private company universe, the types of investments they make differ significantly, reflecting the different capital and other needs of businesses as they move through the corporate lifecycle. Due to the high failure rate of startup companies, the dispersion of individual investment returns within a VC fund will normally be extremely wide, requiring a relatively high level of risk tolerance from investors. Wide variability in deal-level returns would in contrast be a red flag when evaluating a PE fund opportunity, given that the private equity business model is predicated on achieving 2x invested capital (for example) with all fund investments rather than hoping that a few deals will deliver >10x in order to offset many others where some or all of the equity invested is lost. Because of their different characteristics, private equity and venture capital can coexist well in a portfolio and provide improved long term return potential commensurate with their respective levels of risk.
These materials are for informational purposes only and are not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security described herein. Any such offer or solicitation shall be made only pursuant to the final confidential offering documents which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment therein. This material does not take into account the particular investment objectives, restrictions or financial, legal or tax situation of any specific investor.
Past performance is not indicative of future results. All of the products described are private placements that are sold only to qualified clients through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described may involve long lock-ups and do not provide investors with liquidity.
The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein.
iCapital is a registered trademark of Institutional Capital Network, Inc.
Additional information is available upon request.