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.
Rapid growth and iteration of business strategy are hallmarks of start-up 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 start-ups fund-raising as frequently as every 12 months. The small minority of start-ups that are successful tend to quickly become too large for a private equity buyout deal or another conventional transaction.
This “unicorn” phenomenon applies to companies such as Airbnb, which most recently raised capital at a $30 billion valuation, and Uber, which investors have valued at $68 billion according to Business Insider. In comparison, some PE deals today are no larger than $10 billion in total enterprise value. Furthermore, significant competition from strategic investors such as Google exists for the small minority of start-ups that achieve rapid growth, and such investors are generally viewed by start-up founders as better partners than private equity firms.
Private Equity
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 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 cash flow, as well as future cash flows 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 (which are generally more than half of the total transaction value). Businesses that lack free cash flow 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 from 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 cash flows where the chance of failure is close to 0%.
In addition, private equity funds have a more concentrated number of investments than VC funds, with a more even distribution of their 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. In private equity, by contrast, even a single investment failing would be quite damaging to the overall results of the fund, given the much larger equity checks being written by the firms.
Private equity firms are increasingly involved with making operational improvements in the companies they invest in to create value. Given that, and the larger amounts of money at stake, PE investors usually take controlling or exclusive stakes in the companies. That way they can do things such as implement organic and acquisition-focused growth plans and address business issues such as customer concentration, competitive threats, unsustainable pricing, excessively high cost structures and weak management. The PE value proposition does not mesh with company founders unwilling to cede majority stakes in and control over their businesses. A key measure frequently taken by private equity owners is to actually replace 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).
Conclusion
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 needs and other requirements of businesses as they move through the corporate life cycle. Given the high failure rate of start-up 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.
The wide variability in deal-level returns would, in contrast, be a red flag when evaluating a PE fund opportunity. That’s because the private equity business model is predicated on achieving something like two times invested capital with all fund investments, while the VC model hopes that a few deals will deliver more than 10 times the return to offset partial or total losses elsewhere.
Because of these different characteristics, private equity and venture capital are distinct enough to coexist well in a single portfolio to provide improved long-term return potential commensurate with their respective levels of risk.
Kunal Shah is senior vice president and Caroline Rasmussen is vice president of the origination and due diligence team at iCapital Network, an online alternative investments platform.