Private Equity vs Venture Capital

  Private equity firms make investments in mature companies that are not publicly listed. Strategies for investments include leveraged buyouts, venture capital, growth capital, distressed investments, and mezzanine capital. A list of private equity firms Venture capital firms make investments in early-stage and young companies. Venture capital is financing and venture capitalists are the investors. Major venture capital firms are Accel Partners, Benchmark Capital, First Round Capital, Sequoia Capital, Oak Investment Partners, and Highland Capital Partners.  

Similarities between Private Equity and Venture capital firms

  Both private equity and venture capital firms raise funds from wealthy individuals, pension funds, banks, insurance companies, and foundations. Private equity and venture capital firms structure is very similar, so let us understand the structure in detail

• A private equity fund is a stand-alone investment vehicle managed by a private equity firm on behalf of a group of investors. They are set up as a limited partnership.
• General partners (GP) are the partners of a private equity fund and are responsible for managing the investments within the fund. GP’s have unlimited liability towards the fund.
• Limited Partners (LP) provide capital and consist of pension funds, endowments, foundations, funds of funds, sovereign wealth funds, wealthy individuals, and banks. LP’s liability extends only to the capital they contribute. They are not involved in the management of investments.
• Distribution waterfall specifies the method in which a private equity fund makes distributions to GP and LP.
• Carried interest is the share of a fund’s net profits allocated to GP and is usually 20%.

 

• Management Fees are calculated as a percentage of committed capital paid annually to GP and are commonly 2%.
• Ratchet specifies the allocation of equity between stockholders and management.

Evaluating financial performance of private equity and venture capital firms

  1. Internal rate of return (IRR) Internal rate of return (IRR) is most commonly used to measure private equity performance. It is a time-weighted return expressed as a percentage.

A). Net IRR is net of management fees, carried interest, and other compensation to GP. It is relevant for LP.

B). Gross IRR is calculated net of fees not taking into account management fees or carried interest.

2. Multiples

A). DPI (distributed to paid-in capital) multiple measures the LP’s realized return and is the cumulative distribution paid to the LP’s divided by the paid-in capital.

B). RVPI (residual value to paid-in capital) multiple measures the LP’s unrealized return and is the NAV after distributions divided by the paid-in capital.

C). TVPI (total value to paid-in capital) multiple measures the LP’s realized and unrealized return and is the sum of DPI and RVPI.

 

Difference between Private Equity and Venture Capital

  Beyond these similarities, there are a large number of differences also, so let us see the main differences in a simpler form  

Parameter	Private equity	Venture capital
Stage of Investment	Mature companies	Early-stage companies
Type of companies	Invest in companies across all industries	High growth  companies in the technology sector
Investment structure	Equity and debt	Equity
Ownership	Majority stake	Minority stake
Focus	Value-driven corporate governance	Capabilities of the management team
Value creation	Financial engineering, operational improvement, and EBITDA growth	Growth in company
Risk	Low risk	High risk
Management Team	Experienced Investment bankers	A new team of the diverse mix including investment bankers, consultants, and entrepreneurs
Investment Size	From $100 million up to tens of billions	$50,000 to $5 million
Investment Period	10 years	10 years
Cash Flows	Stable and predictable cash flows	Low predictability
Product Market	Strong market position	New product market with uncertain future
Products	Established products	The product is based on new technology with uncertain prospects
Working Capital Requirements	Low requirements	Increasing requirements
Liquidity	Lack of liquidity	Lack of liquidity
Exit strategy	Moving to other hedge funds or venture capital, switching back to advisory roles, launching their own fund, or entering into entrepreneurship	Initial Public Offering, sale, buyback of shares, recapitalization, and merger & acquisition

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Strategies of Private Equity and Venture capital firms

• Growth capital makes investments in mature companies looking for expansion. The investment may serve restructuring, financing acquisition, or entering new markets.
• Leveraged buyouts (or LBO) is when a company uses a large amount of debt to make an acquisition. LBO transactions are of mature companies having stable and predictable cash flows.
• Distressed strategy is investing in equity or debt securities of companies experiencing financial or operational distress.
• Mezzanine capital is structured as a hybrid of debt and equity. Most small companies use mezzanine financing for a leveraged buyout or major expansion.
• Venture Capital makes investments in less mature companies, start-up companies, or companies in early-stage development.

Major deals of Private equity

• Dell has acquired EMC Corporation for $60 billion, it is the largest technology acquisition. The acquisition brings various EMC subsidiaries, including SecureWorks and VMware, under Dell.
• Symantec has announced the acquisition of Blue Coat Systems, a Bain Capital-backed company for $4.7 billion.
• Advent International has announced the close of its eighth flagship fund, Advent Global Private Equity VIII by raising $13 billion. The fund is among the largest in history.

Major deals of Venture capital

• Acerta Pharma, a portfolio company of BioGeneration Ventures, Frazier Healthcare, and OrbiMed has been acquired by AstraZeneca for $2.5 billion. AstraZeneca has the option to purchase remaining shares.
• Cisco, a networking company, has agreed to acquire Jasper Technologies, an Internet of Things company, backed by Sequoia, Wing Venture Capital, and Benchmark Capital, for $1.4 billion.
• Ride-hailing service Uber has closed $5.6 billion in Series G funding. Uber is valued at $61 billion.
• Snapchat, a messaging app startup, has raised $1.8 billion in Series F funding from investors including General Atlantic, Sequoia Capital, Fidelity, and IVP. Snapchat is valued at $17.8 billion.

Recent funding

• Globally private equity firms have raised $345 billion by closing 807 funds in 2016. Investors plan to invest more capital in private equity firms in the coming years.
• Venture capital firms have raised $55 billion by closing 382 funds in 2016. Information Technology was the main sector of investment. Venture capital firms have invested in 7,751 US companies a total of $69.1 billion in 2016. Venture capital will be an essential component of private equity fundraising over 2017, with 940 funds currently seeking capital and $16 billion already committed to funds that have held an interim close.

Conclusion

If you are interested in adding value to existing companies, reorganizing and restructuring them then private equity is more suitable. You can make a lot of money in a short period with support from private equity firms. The returns are high and provide diversification benefits. If you are innovative, want to bring a revolution, or start your own business then venture capital will be desirable. However, they are riskier.

Author: Rabia J. –  Sr. Analyst