The investing landscape can be daunting and confusing to the uninitiated.
Whether you’re looking for capital financing, investment options or careers in the investment playground, you’d likely come across terms such as private equity (PE) and venture capital (VC) and wondered, what’s the difference? Which one is right for you?
Before making any commitments, it’s important to understand the subtle nuances of these investment classes, and this article will do just that.
Understanding Private Equity and Venture Capital
Private equity (PE) in its simplest form is any type of funding provided as investment to a company or other entity that is not publicly listed or traded.
It’s an alternative form of capital fundraising to debt financing for entrepreneurs and company founders, in which PE funds and investors directly invest in companies to gain partial or complete ownership.
A PE investment can take many forms – turning around or selling off assets in troubled companies through distressed funding; taking over and improving promising companies through leveraged buyouts; and providing funding to start-ups and young businesses that show potential through venture capital, among others.
These are just some of the well-known forms of PE, and each PE firm tends to have a specialty of their own.
Overlaps in Similarities
Venture capital (VC) is just one form of private equity, and in this article, it will be compared with the leveraged buyouts (LBO) form of PE as people in the world of finance usually equate PEs with LBOs.
At first glance, both VC and PE invest in companies with good growth potential and exit when the time is right to make a profit.
Both these forms of investment aim to help their target companies perform better as the means to generate high returns when it is time to exit the investment through sale of their equity.
Given the overlaps between these two forms of investment, it’s easy for people outside of investment circles to mistake one for the other.
However, there are several key differences between PE and VC.
What’s the Difference?
When we breakdown the investments further into the type and size of investment as well as investment timelines and their risk and return profiles, we start to see clear differences between the two.
VC tends to target companies in the nascent stages of development, often pre-profitability, while PE firms will buy into more mature companies with proven track records that just need a little push to break through the next stage of growth.
There’s a difference as well in terms of the target companies’ industries, and though that varies as well from firm to firm, the trend for VCs is to invest in more tech-driven companies whereas PE firms are open to companies across all industries.
Looking at the type and size of investment, the percentage acquired clearly delineates the two. PE firms’ aim is to gain a controlling stake, and they almost always buy 100% of a company at sums in the $100 million to $10 billion range. Venture capitalists are usually interested in a minority stake of less than 50%, with more modest buy-ins of a few millions to tens of millions.
Given the difference in sum invested, VCs are usually funded only with equity (i.e. cash), while PE firms may use a combination of equity and debt.
The investment horizon for VCs are shorter, exiting in 4 to 7 years, while PEs usually require a longer time frame for the investments to mature, cashing out only after 6 to 10 years.
The risk level is higher for VCs, as these investments are channelled into nascent companies with little track record and often before it becomes profitable. And with under 50% stake in these companies, VCs have lesser say on the direction of the company as well, putting it in the high-risk category with moderate chance of losing all money compared to PE’s investment model.
The quantum of potential returns justifies each mode of investment – high risk VCs, when successful, provides more than 10 times the return on targets, while PEs consistently bring investment returns of >15% with lower rates of failure.
In evaluating which companies to invest, VCs typically look first at the people, before seeing if the numbers can back it up, whereas the starting point of PE’s due diligence are usually the numbers.
Due these differences, VC firms invest smaller amounts of money in dozens of companies to find the one or two winners that will generate huge returns to make the entire fund profitable.
PE funds on the other hand, invest in a smaller, more select pool of mature companies where the chance of future failure is near zero, with larger investment sums to steer it towards its determined course.
In essence, both PEs and VCs are about profit making – they’re just taking different routes to arrive at that destination.
Neither is better than the other.
It’s just a matter of picking what’s right for the company, the management styles of its people and the risk and reward appetite of its investors.
Contact The Sea Capital, your trusted private equity investment company, for comprehensive services, including PE and pre-IPO advisory.
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