The Blurring Lines between Private Equity & Venture Capital

  • February 1st, 2016
  • Nate Nead

Private equity (PE) is often tangled with venture capital (VC) because they both invest in companies and use a variety of exit strategies, like selling their stake during IPOs. However, there are some significant differences in the way they do business. Both invest in different types and sizes of companies, spend different amounts and even claim different percentages of equity.
The average expected return for both PE and VC firms has declined over the years; back in 2002, the target return for a PE or VC firms was a little over 25%, but today, companies are targeting an average of 19% and actual returns are about half of this objective. Though there are significant contrasts though PE and VC firms, Jess Brandon, a senior analyst at RBC, says that the similarity in returns and the current, high stock valuation is pushing these companies to adopt one another’s procedures as they proceed with endeavors to leverage the declining yields.
Let’s have a closer look at the core differences between PE and VC firms, and try to characterize the variables that are pushing them to adopt one another’s strategy;

Core differences: PE and VC Firms
PE firms buy established businesses. Private equity firms buy inefficient companies, take total control, and make them more efficient to escalate revenue. They also attempt to capitalize on mispriced assets. Venture capital firms, on the other hand, only purchase only 50% or fewer stakes in start-up companies which they believe have the greatest growth potential.
While PE firms invest in a particular company and concentrate their expertise on the particular sector, VC firms like to diversify and reduce their risk profile. Usually, VC firms are limited to technology, biotechnology, and clean air companies. VC firms also limit their investment to $10M in each company. PE firms are open to how much they to invest.
The core difference between the two is where they put their money. PEs invests in established businesses while VEs invest in start-up growth.

Risk and Return

Though VC firms know that most of the companies they invest will not be profitable, they expect that at least one of them will turn in huge profits, and make the fund profitable. Fred Wilson, a $1B New York based VC fund, expects that out of the 25 growth companies it has invested in, about ten will fail, one will turn extraordinary profits, about five will give solid returns, and the rest will be wiped out. VC firms, only use equity to finance their purchases, but private equity investors use both equity and debt.

PE firms have concentrated exposure, in one, or a few particular industries, and so they have to bear additional risk. Their holdings in the companies are so large that, if one if one of the companies failed, the fund would mostly fail. However, shouldn’t higher risk, translate to higher returns?

Modern portfolio theory proposes that greater risk is compensated with higher returns, but here, VC firms, even with the higher risk, are targeting the same returns as PE firms and actual returns for both, are also very similar.

The Convergence in Strategy

How are VC firms adopting the PE strategy?

Traditionally, venture capitalists have invested in ‘the big idea’ start-up companies that are destined to change the way we do things, with future trends and technology in mind. However, perhaps, the argument for lofty valuations and no real compensation for higher risk is making VC firms’, re-thing their strategy around producing more rationale returns for a given level of risk. As a result, VC firms are now trying to adopt more of a stable growth and ‘later-stage’ investment strategy.

Biz Journals, a research company, confirms that ‘explosive growth firms’ are existing VC portfolios, and an increasing number of VC firms are incorporating PE practices. A Survey conducted by NVCA shows that 71% of VC firms believe that PE will become more active buyers of later stage venture-backed companies.

The graph below shows that PE and VC firms are converging on growth capital, and VC firms are closing less early stage deals.

 

pitchbook data

 

VC activity seems to be in decline over the last few quarters, as investors cling on valuation and recent concerns about stalling growth in China. Also, the startup map reveals slowing growth, especially in Europe. Promises of growth, are mostly coming from ‘late stage enterprises’.

How are PE firms adopting the VC strategy?

Given the higher valuation, and volatile market PE firms have two options- chase companies at higher valuations, or look for smaller deals with the potential for high returns. Trends research by Pitchbook shows that PE firms like the later approach because lately, of all PE deals completed, 47% fall under $25M. Historically, most deals were above $65M. PE firms will now have to adapt the VC model, understand more technology companies, take riskier bets and drive growth through diversification.

At the same time, PE firms are also raising and deploying cast at such an astonishing rate. The fundamental laws of demand and supply suggest they will make now some investments in ‘early stage companies.’ Since the 2008 meltdown, PE firms have worked hard to spruce up beaten down assets for which they had paid high prices, and extract greater returns. Many of their dead investments were in the tech sector. Given current trends, the tech sector is likely to dominate the world in the future. Many PE firms are now searching for mid-stage tech companies what show hopes of growth potential.

Takeaways

Judging the observations above it can be inferred that PE and VC firms are now adapting to the changing markets and uniting at their core differences. Many companies, like Bain Capital and the Carlyle, understand the changing dynamics and have adopted both PE and VC practices. The decline in estimated returns shows that both parties are now struggling and trying to leverage returns by taking on one another’s means, as VC firms are reducing risk by moving to ‘later stage’ investing and PE firms are diversifying with growth potential.

About the Author

  • Nate Nead

Nate Nead is a licensed investment banker with InvestmentBank.com. His practice focus revolves around software & technology, internet & media, oil & gas, real estate and manufacturing. He works to assist companies through scale and growth and eventual strategic exit from their businesses.

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