If you're an investor or are interested in investing, you may have heard the terms "private equity" and "venture capital". These terms are often used interchangeably, but they are actually quite different. Private equity (PE) is an alternative investment class that seeks private companies, businesses not listed on public stock exchanges. Private equity funds are investment vehicles that provide financing for companies. They usually focus on acquiring stakes in businesses that they believe have strong growth potential. Venture Capital (VC), by definition, is a form of private equity. It is a type of financing that provides early-stage funding to startups or other companies. While they are both considered to be forms of alternative funding, private equity and venture capital differ across a broad host of categories.
In the United States alone, private equity funds control over $6 trillion in assets. Since the 1980s, private equity firms have soared in popularity, and there are now about 8,000 privately backed companies in America. Why has this alternative funding source taken off? Well, private equity can be mutually beneficial for both fund investors as well as the acquired company. PE funds find mature companies that they believe can be bought and sold for a profit. For simplification purposes, one can think of private equity as house-flipping for companies. After a PE firm acquires a company, it may employ a number of different initiatives to increase the company's value and reach a desired internal rate of return. It will attempt to improve operational efficiencies, align the interests of company management with those of shareholders, and analyze and execute growth opportunities. After a given period of time, the PE firm can then sell this company for a large profit. But how does this process benefit the target company? While management may give up their majority stake, they receive a large amount of financing for the purpose of company growth or rehabilitation. By the time of selling, the company is likely in a much healthier place or has substantially grown since it was acquired.
A common strategy used by PE firms is the leveraged buyout. A leveraged buyout (LBO) is the acquisition of a company using a substantial amount of debt, and can be used to take a public company private. The acquiring company issues bonds against the assets of the target company so that the assets of the acquired company can actually be used to back them up. When looking for LBO targets, PE firms target a number of characteristics, including:
- A strong market position
- A competitive advantage
- Stable cash flows
- Low capital expenditures
- Value creation opportunities
- Strong management
PE funds have a specific type of organization. The fund's partners are known as general partners and are in charge of managing the fund and choosing portfolio companies. General partners are also tasked with obtaining capital from other investors known as limited partners. Limited partners typically come in the form of institutional investors like pension funds, endowments, insurance companies, and high-net-worth individuals. Limited partners do not influence investment decisions and are liable for their individual investments. Distribution agreements outline how limited partners will be paid in relation to general partners when investments generate returns. General partners typically charge both management and performance fees. A 2% assets under management fee is standard, meaning that if the general partners manage a $100 million fund, they will receive $2,000,000 from this fee. Additionally, a performance fee of roughly 20% is customary, meaning that if the fund earned $100 million in profit, the general partners would be paid $20 million.
- The Blackstone Group Inc.
- KKR & Co. Inc.
-The Carlyle Group Inc.
- CVC Capital Partners
- Bain Capital
Venture Capital is a form of private equity. Unlike traditional private equity, which usually invests in mature companies, venture capital exclusively targets early-stage companies or startups. This means that VC firms tend to have a different risk profile than PE firms; they are willing to take on much riskier companies. Targeted startup companies are believed to have extreme long-term growth potential. Unlike PE firms, VC firms are unlikely to acquire a distressed company with the hopes of turning it around. Similarly, VC firms are unlikely to engage in leveraged buyouts. Instead, VC firms look for innovation and the exploitation of an industry niche when evaluating investment opportunities. Unlike private equity partners, which typically come from finance backgrounds, venture capitalists tend to come from a variety of backgrounds and have specific industry expertise. Below are some of the other key differences between private equity and venture capital.
While private equity spans a wide array of industries, from healthcare to consumer goods to technology, venture capital is often limited to a few specific industries given its nature. Venture capital is most commonly associated with technology startups, leading many firms to be located in San Francisco, a hub of innovation in technology.
PE firms mostly buy a majority equity stake if not 100% of their target companies. This way, they have direct control and can make decisions regarding operations. VC firms, on the other hand, tend to obtain a 50% or less equity stake in the companies in which they invest. Given the risky nature of growth-stage companies, VC firms are more likely to invest in a large number of companies to diversify and mitigate risk. If one investment fails, the effect on an entire VC portfolio will be minimized compared to a PE portfolio.
Private equity deals tend to be much larger than venture capital deals overall. This is due to the fact that PE firms tend to be much wealthier than VC firms and look to acquire more equity stake. Many PE deals tend to be within $25 million and $100 million. In contrast, VC deals tend to be under $10 million. Again, this ties back to the fact that venture capital firms will often split shares with other equity partners.
While both types of firms get involved in business operations, private equity firms are much more likely to work intimately with companies they acquire. They appoint their own executive leaders, manage capital structure as they see fit, and eliminate inefficiencies. Venture capital firms may appoint their own leader on the board of directors or find consultants and mentors for their companies, but they will not be as intimate as PE firms. Startup founders want to maintain control to a higher degree than leaders of mature companies do.
- Intel Capital
- Kleiner Perkins
- Sequoia Capital
- Tiger Global Management.
Angel investors present an additional source of funding for early-stage businesses. They are individuals that invest their own cash in companies. They are often very wealthy and prominent people; almost all are considered accredited investors.
Since angels aren't tied to financial institutions, they can invest as they see fit, meaning that they may have a greater risk appetite in relation to banks, PE firms, and VC firms. Similar to venture capitalists, angels target startups, typically in technology or a field that the angel has experience in. However, angel investments tend to be much smaller than venture capital investments; since they are individuals investing their own capital, they tend to invest under $1 million and most often between $25,000 and $100,000.
One stark difference between angel investors and venture capital is involvement. While angels typically have industry expertise, they rarely get directly involved in business operations. Another key difference is investment length. Venture capital investments tend to be much longer than angel investments, with the potential to last over a decade. It is fairly uncommon for angels to be invested for a period longer than five years.
In short, there are many ways for businesses to receive funding. Private equity, venture capital, and angel investors are uniquely effective in various situations, and it is important for business owners to research specific sources of funding before making any decisions. While there are many disparities between these types of investors, the major differences lie in business stage, involvement, and amount of funding.
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