Technically, venture capital is just a subset of private equity.
Nov 28 2013 10:29 AM
They both invest in companies, they both recruit former bankers, and they both make money from investments rather than advisory fees.
While both PE firms and VCs invest in companies and make money by exiting – selling their investments – they do it in different ways:
Company Types: PE firms buy companies across all industries, whereas VCs are focused on technology, bio-tech, and clean-tech.
% Acquired: PE firms almost always buy 100% of a company in an LBO, whereas VCs only acquire a minority stake – less than 50%.
Size: PE firms make large investments – at least $100 million up into the tens of billions for large companies. VC investments are much smaller – often below $10 million for early-stage companies.
Structure: VC firms use only equity whereas PE firms use a combination of equity and debt.
Stage: PE firms buy mature, public companies whereas VCs invest mostly in early-stage – sometimes pre-revenue – companies.
Risk & Return
VCs expect that many of the companies they invest in will fail, but that at least 1 investment will generate huge returns and make the entire fund profitable.
Fred Wilson expects that out of 20-25 investments in his fund, 5-10 will fail, 1 will be a home run, 4-5 will produce solid returns, and the rest will be a wash.
Venture capitalists invest small amounts of money in dozens of companies, so this model works for them.
But it would never work in PE, where the number of investments is smaller and the investment size is much larger – if even 1 company “failed,” the fund would fail.
So that’s why they invest in mature companies where the chance of failing in 3-5 years is close to 0%.
You might now be wondering, “So which model actually produces higher returns?”
There is a lot of controversy over this one, but returns in both industries are much lower than what investors claim to achieve.
Most VCs and PE firms target 20% returns, but VCs have earned less than 10% returns over a 5-year period and many pension funds that invested in PE firms have also seen sub-10% returns.
One difference is that in venture capital, returns are heavily skewed to the top firms: if you think about their business model, that makes a lot of sense – invest in the 1 big winner and you’re set.
Plus, the best deals in VC almost always go to the top firms because the best deals have always gone to the top firms.
That happens in PE as well, but you can earn great returns without investing in the largest and most well-known companies.