On the surface, private equity and venture capital seem rather similar to one another. Though the differences between the two industries are more subtle and mostly live under-the-surface, they are nonetheless important and help delineate the unique roles PE and VC play in the investment landscape. Here’s how to tell them apart.
In 1946, Harvard Business School dean Georges Doriot and MIT president Karl Compton got together with a few other business partners to form the American Research and Development Corporation (“ARDC”).
Widely regarded as the first private equity (“PE”) firm in history, ARDC represented a seismic shift away from the way investments in private companies were previously structured. Back then, only the wealthiest people in the world could invest in privately-held companies. For example, Gilded Age titans like Laurance Rockefeller (John D. Rockefeller’s son) provided equity financing to companies in the then-emerging aviation industry, like Douglas Aircraft and Eastern Airlines.
ARDC was the first instance in which individuals and institutions (outside of the very wealthiest) could invest in private companies. By early 1947, ARDC had attracted more than $3.5 million in capital, and its founders were ready to allocate the private equity firm’s funds to promising new companies that were being started and run by the millions of veterans who were returning home from the European and Pacific theaters of World War II.
Around the same time, Whitney family heir John Hay Whitney partnered with Benno Schmidt to found J.H. Whitney and Company. The duo made $10 million worth of equity investments into a portfolio of startups, each of which had been denied loans from banks. Whitney described his firm as a provider of “private adventure capital” on the recommendation of an associate who suggested that he position his firm as one that had an affinity for “risk” and “adventure”, unlike the investment bankers they were so often confused for.
The term proved to be catchy enough to stick around. Later, Whitney shortened it to just “venture capital”. Today, the asset class that he helped create consists of nearly 2,000 firms and more than 3,600 funds. Combined, the venture capital (“VC”) industry boasts over $500 billion in assets under management (“AUM”), and the country’s tens of thousands of VC-backed startups employ a total of over 2.5 million people.
Private equity has similarly blossomed. From ARDC’s first seven-figure fund to becoming a behemoth market with over $9.8 trillion in AUM, private equity has become both a mainstream investment choice and the world’s best-performing asset class. Given the massive success of these two industries, perhaps it’s worth becoming a bit more familiar with both of them. In particular, what types of companies do PE and VC firms invest in, how much equity do they take, and what types of returns do they each expect? Let’s take a closer look.
PE and VC: Differences and Similarities
On the surface, private equity and venture capital seem rather similar to one another. In particular, both PE and VC firms take an equity stake in private companies, and both complement banks as providers of capital to entrepreneurs and business owners.
However, the similarities essentially end there. Though the differences between the two industries are more subtle and mostly live under-the-surface, they are nonetheless important and help delineate the unique roles PE and VC play in the investment landscape. Here’s how to tell them apart.
General Investment Criteria
While PE and VC firms come in all shapes and sizes, each with their own specific set of investment criteria, these two industries typically target companies with different tenures, growth rates, profitability metrics, valuations, and more.
For starters, while private equity firms usually target larger, more mature and later-stage private companies, venture capital firms have a penchant for earlier-stage businesses. Specifically, VCs often start to take interest in companies in their seed or pre-seed stages, while PE firms might wait until a company raises a Series C, D, E (or even later) round of funding before committing capital.
As a result, VCs naturally target riskier and less developed companies than PE firms. On one hand, this typically means that a majority of early-stage startups in a VC fund’s portfolio ultimately fail. The upside, however, is that VC-backed companies are often highly-scalable ventures that experience rapid revenue growth and new customer acquisition. The ones that succeed and make it to an acquisition, merger, or IPO can return 10x or even 100x a VC’s original investment, making up for the preponderance of startups that don’t fare as well.
On the contrary, PE firms gravitate towards companies with longer-tenured business models that command a sustainable track record of generating cash flow. Unlike VC firms, which generally put more emphasis on top-line growth, PE firms care more about a company’s profitability, likely in large part because an acquired company’s free cash flow is often needed to pay off the debt used to acquire the company.
In addition, private equity firms are typically more exacting about what they’re willing to pay for a deal. This isn’t to say that VC firms don’t exercise price discipline when exploring deals, but venture capitalists are often more receptive than PE firms towards the idea of paying higher multiples for hot, hypergrowth firms that have potential to display “hockey-stick growth” in the future.
Deal Size and Structure
On average, private equity firms commit significantly more capital in a given deal (in terms of dollars invested) than venture capital funds. While the median VC deal size was about $10 million, the median PE deal size hovers at nearly $200 million. The average private equity buyout, meanwhile, exceeds $1 billion, thanks to the proliferation of mega-buyouts like KKR’s $15 billion CyrusOne deal.
Deal structures also vary significantly between the two industries. In private equity, the leveraged buyout (“LBO”) model dominates. Popularized in the 1980s, an LBO is a form of financing that uses a combination of equity and debt (hence “leverage”) to acquire either a controlling interest or full interest (“buyout”) in a target company.
This lies in sharp contrast to venture capital firms, who typically eschew debt financing and purchase minority, non-controlling stakes in portfolio companies. Additionally, it’s uncommon for startups to rely on a single VC firm to fund its operations. Rather, (successful) startups are often in high demand, and will usually accept checks from a handful of prominent VCs.
On the whole, VCs will make up roughly half of a company’s capitalization table by the time an exit occurs. However, this is not always the case. VCs owned just 17% of Facebook upon its initial public offering in 2014, 18% of Snapchat at its 2017 public debut, and a mere 14% of Pierre Omidyar’s eBay upon its 1998 public offering.
Targeted Returns
On average, private equity firms target roughly a 20% to 25% internal rate of return (“IRR”) and a 2.5x to 3.5x multiple on invested capital (“MOIC”). Notably, these targeted returns are significantly higher than that of public equities, which (as proxied by the S&P 500) have returned only 14.7% in the last 10 years and just a little over 10% over the long run.
On the portfolio level, venture capital funds target higher IRRs. Early-stage funds, for example, typically seek returns in excess of 30%, while mid-stage (e.g., Series B) VCs may target returns on par with those sought by typical PE firms. Late-stage VCs, which focus on investing in large, mature private companies that are approaching a liquidity event (most commonly an IPO) seek higher returns that are typically in excess of 50%.
Additionally, venture capital funds in general tend to feature lengthier lockup periods and longer investment holding periods than their private equity counterparts. While PE funds typically plan for three to six year exits, it’s not out of the ordinary for VCs to maintain positions in companies for a decade or longer. This is especially true for early-stage VCs, which commit capital at the earliest stages of a startup’s life and may not encounter an exit opportunity until many years later. However, it is important to note that late-stage VCs typically feature shorter holding periods that are more akin to (or even shorter than) PE funds.
Of course, none of these rules are bright-line delineations between the two camps, and certain funds in the venture capital and private equity may see significant overlap. For example, late-stage VCs and PE funds specializing in growth equity may essentially be dealing with the same segments of the market, and can feature similar holding periods, targeted rates of return, company investment criteria, exit strategies, and other traits.
It’s a big deal for a company to go public. By the time a company hits the public exchanges, they’ve already enjoyed years of uninterrupted success as private companies. Along the way, these superstar firms will have created thousands of new jobs and generated billions of dollars in revenue. They’ll also have created eye-watering amounts of wealth for their founders and early backers to a degree unrivaled even by the best-performing publicly-traded stocks in history.
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