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, each brings its own advantages to a traditional portfolio as long as the investors can afford illiquidity and have the risk tolerance.
Venture Capital
Venture capital firms focus on providing equity funding to entrepreneurs and early stage companies that they believe can disrupt their industries; the VC firm is thus hoping to profit 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 a late-stage deal. Recent years have seen the emergence of mega fund-raisings involving equity checks above $100 million for companies such as Uber and Airbnb, as these companies remain private for longer and require larger sums of capital to operate and grow.
In addition to providing capital, VC firms often provide expertise to help these start-ups 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.
These specialists can offer critical advice and support to start-ups until the companies mature enough to fill such gaps internally. However, while VC firms may contribute key resources to their portfolio companies to assist with execution and 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 businesses that are developing truly innovative products and solutions, to the much more frequent scenario of low or even negative growth, as the start-up 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 start-up 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’s development.