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Private Equity vs. Venture Capital

By: Gridline Team | Published: 01/06/2023
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Est. Reading Time:
6 minutes

Private equity has been around since 1901 when investment banker John Pierpont Morgan (JP Morgan) bought Carnegie Steel for $480 million. One of the sellers, Henry Phipps, took his share and created a private equity fund called the Bessemer Trust. The Bessemer Trust has around $180 billion in assets under supervision.

In 1946, the first venture capital fund was formed, called the American Research and Development Corporation (ARDC). ARDC gained notoriety after achieving 500X returns through its Digital Equipment Corporation (DEC) investment.

On the surface, private equity and venture capital (VC) are similar. After all, private equity involves several strategies, including venture capital.

However, the two concepts are quite different. Private equity is an umbrella term that encompasses a wide range of investments, ranging from distressed companies to leveraged buyouts. At the same time, venture capital is a specific type of private equity investment that focuses on buying equity in early-stage companies.

Let's take a closer look at the differences between private equity and venture capital.

Venture Capital Invests Earlier

Venture capital investments typically occur earlier in a company's life cycle than private equity. VCs usually invest in businesses in the early stages of development, sometimes before launching their product or service. This early-stage investment requires a high degree of risk, as there's no guarantee that the business will be successful.

In contrast, private equity investments tend to take place later, when the company is already established and generating revenue. More mature businesses are typically less risky than early-stage companies, as they have already proven their ability to generate revenue and have a more established customer base.

Venture Capital Deals are Smaller

The corollary of investing earlier is that venture capital deals are usually much smaller than private equity deals. The median angel or seed round is $1.8 million, the median early VC round is $6 million, and the median late VC round is $11.5 million. 

In contrast, private equity deals often reach hundreds of millions or even billions of dollars. In the first half of 2022, the median buyout deal size was close to $1 billion. 

Thus, while venture capital investments are riskier, they also provide the potential for outsized returns due to their smaller size.

Venture Capital Acquires Minority Equity Stakes

Venture capital investments typically involve the purchase of a minority stake in the business. This means the VC takes a smaller ownership stake than the founders, who often retain most shares. This is different from private equity investments, which usually involve the purchase of a controlling stake in the business.

In addition, venture capital investments usually involve equity, while private equity investments often involve a combination of equity and debt. This provides private equity investors with financial engineering options that can help them maximize returns.

Private Equity is More Broad

The private equity asset class is highly diversified, and investors can choose from a wide range of investment strategies. The most common PE strategies include buyouts, venture capital, growth capital, fund of funds, and secondaries. Let’s take a closer look at these strategies beyond VC.

Buyouts

Buyouts involve the purchase of a controlling stake in a company. In a buyout, the private equity firm acquires enough shares in the company to exercise majority control and appoint its directors to the Board. The goal of a buyout is to improve the company's financial performance and, ultimately, to increase its value and generate returns for investors.

This can be achieved through various strategies such as cost-cutting, operational improvements, or strategic acquisitions. Buyouts can be done in multiple ways, including leveraged buyouts, management buyouts, and dividend recapitalizations.

A leveraged buyout is a type in which the private equity firm borrows money to acquire the company. This allows the firm to purchase a more significant stake in the company with less equity capital. The debt is typically repaid with the cash flows of the company.

A management buyout is a type in which the private equity firm partners with the company’s management team. The management team contributes equity capital to the deal and is vested in the company’s success.

A dividend recapitalization is a leveraged buyout strategy in which the private equity firm issues dividends to its investors using the company’s cash flows. This is an attractive strategy for investors since it allows them to realize returns without waiting for the company to be sold or go public.

Growth Capital

Growth capital provides funding to companies looking to expand and grow their operations. Several strategies can be used to deliver growth capital, including expansion financing, buy-and-build, capital injection, and recapitalization.

Expansion financing involves funding companies looking to expand into new markets, launch new products, enter into new partnerships, or acquire competitors. In one recent example, the coworking firm Table Space raised $300 million in private funding from Hill House to expand its operations in India. With more physical space, the company can tap into a growing demand for flexible coworking solutions.

Buy-and-build is a growth capital strategy that involves building an extensive portfolio of companies, typically in the same sector. This approach can create a dominant market position and critical mass that can be leveraged to generate returns. For instance, private equity firm Thoma Bravo spent over $30 billion in 2022 acquiring a range of cloud-based cybersecurity and fintech businesses. Their related portfolio of companies provides an attractive platform for growth.

In addition to buy-and-builds, growth capital can also be used to invest in a single company's expansion directly. This may involve capital injection into a specific project, such as the launch of a new product or a recapitalization of existing assets to provide additional liquidity.

Turnaround

Turnaround investments involve taking over a distressed company and turning it around through operational restructuring, cost-cutting, and other changes. These strategies can generate value for investors by improving the company’s financial performance and increasing its market value.

The key to a successful turnaround has the proper operational and financial expertise. Private equity firms have the resources to bring in a wide range of advisors and consultants to help turn around a business. In addition, they have the capital to fund any restructuring or reorganization that may be required.

One turnaround artist who has built a reputation for successfully turning around struggling companies is David Mussafer, managing partner of Advent International.

In one case, Mussafer took a stake in Lululemon, nearly doubling its revenue growth with a new e-commerce strategy, international expansion, and bringing a data-driven approach to its stores. The coronavirus pandemic only accelerated the company's growth, with its shares up nearly 100% since its 2020 lows.

Fund of Funds

Fund of funds (FoFs) involves the pooling of capital from multiple investors to invest in various private equity funds. This provides benefits to investors in that they can access a much larger variety of investments than they would have access to on their own. This also has the advantage of diversifying the investment portfolio and spreading the risk.

In addition, FoFs can provide crucial operational support to the fund manager, such as advice on legal and regulatory issues, as well as allow for economies of scale when negotiating with private equity funds. With the additional resources and expertise of a FoF, investors can access more attractive terms than they would have had access to on their own.

Secondaries

Secondaries are private equity investments that involve purchasing existing investments in private equity funds. These investments aim to purchase these interests at a discount, allowing investors to realize returns they would not have had access to otherwise.

Secondaries can also be an attractive option for private equity funds that are looking to exit their existing investments in a fund. By selling their interests on the secondary market, they can quickly liquidate their positions and reinvest their capital in more attractive opportunities.

Takeaways

Private equity is an umbrella term that encompasses a wide range of strategies. While venture capital is a form of private equity that involves buying equity in early-stage companies, private equity also includes strategies such as buyouts, growth capital, fund of funds, and secondaries.

By understanding the differences between private equity and venture capital, investors can make more informed decisions about where to allocate their money. Gridline offers private equity and venture capital opportunities for investors to choose from, at minimums that let investors build diversified portfolios of private market assets.

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