What is the difference between Venture Capital and Private Equity?

Venture capital can be viewed as a segment of private equity, from an academic point of view. But for the purpose of making investment decisions, their respective 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, liquidity, tax benefits, control vs. minority share acquired, investor expertise, and others. (See comparison chart below.)

In simplest terms, private equity is capital that is invested in private companies. 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. Private equity investors tend to target fairly 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 ROIexpectation* Depends on inherent risk of specific firm and industry. Target can be20%/yr over five years, more likely10%/yr or less Many failures, some solid returns, a few spectacular successes. Expectations must reflect the risks. Investment size ($) 100 million to10′s of billions for big PE funds;10+ million for small funds & indiv. Less than10 million Liquidity horizon 6 to10 years 4 to7 years Share acquired by investor/fund Control (often100%) 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 with respect to management, unless purpose of acquisition is to improve company performance Investors provide advice, connections, distribution; monitor cash burn; etc.

An expert elaboration is as follows:

 

Technically, venture capital is just a subset of private equity.

 

They both invest in companies, they both recruit former bankers, and they both make money from investments rather than advisory fees.

 

 

 

 

While both PE firms and VCs invest in companies and make money by exiting – selling their investments – they do it in different ways:

 

Company Types: PE firms buy companies across all industries, whereas VCs are focused on technology, bio-tech, and clean-tech.

 

% Acquired: PE firms almost always buy100% of a company in an LBO, whereas VCs only acquire a minority stake – less than50%.

 

Size: PE firms make large investments – at least $100 million up into the tens of billions for large companies. VC investments are much smaller – often below $10 million for early-stage companies.

 

Structure: VC firms use only equity whereas PE firms use a combination of equity and debt.

 

Stage: PE firms buy mature, public companies whereas VCs invest mostly in early-stage – sometimes pre-revenue – companies.

 

 

 

Risk & Return

 

VCs expect that many of the companies they invest in will fail, but that at least1 investment will generate huge returns and make the entire fund profitable.

 

Venture capitalists invest small amounts of money in dozens of companies, so this model works for them.

 

But it would never work in PE, where the number of investments is smaller and the investment size is much larger – if even1 company “failed,” the fund would fail.

 

So that’s why they invest in mature companies where the chance of failing in3-5 years is close to0%.

 

 

 

Return

 

There is a lot of controversy over this one, but returns in both industries are much lower than what investors claim to achieve.

 

Most VCs and PE firms target20% returns, but VCs have earned less than10% returns over a5-year period and many pension funds that invested in PE firms have also seen sub-10% returns.

 

One difference is that in venture capital, returns are heavily skewed to the top firms: if you think about their business model, that makes a lot of sense – invest in the1 big winner and you’re set.

 

Plus, the best deals in VC almost always go to the top firms because the best deals have always gone to the top firms.

 

That happens in PE as well, but you can earn great returns without investing in the largest and most well-known companies