When we talk of investing, our discourse revolves around the conventional asset classes – equity, debt and cash.
Those with substantial disposal money to invest, move beyond this realm into alternative asset classes. Real estate, distressed securities, structured products, commodities and collectibles like art and antiques are on the table. Both, private equity and venture capital are on the menu too.
Private equity and venture capital are forms of financing where money is collected from limited partners (LPs) and invested into promising private companies in the hope of making a fabulous return. Do note, these are private companies, not publicly listed companies on the stock exchange.
What is Private Equity, or PE?
A PE firm invests in businesses with a goal of increasing their value over time before eventually selling the company at a profit. To invest in a company, a PE firm will raise pools of capital from limited partners to form a private equity fund. Once they’ve hit their fundraising goal, they close the fund and invest that capital into promising companies.
PE investors may invest in a company that’s stagnant, or potentially distressed, but still shows signs for growth potential. Although the structure of investments can vary, the most common deal type is a leveraged buyout or LBO.
In a leveraged buyout, an investor purchases a controlling stake in a company using a combination of equity and a significant amount of debt, which must eventually be repaid by the company. In the interim, the investor works to improve profitability, so that the debt repayment is less of a financial burden for the company.
When a PE firm sells one of its portfolio companies to another company or investor, the firm usually makes a profit and distributes returns to the limited partners that invested in its fund.
What is Venture Capital, or VC?
A VC firm funds and mentors startups or other young, often tech-focused companies, in exchange for equity in the company. A firm's array of companies is called its portfolio, and the businesses themselves, portfolio companies.
As companies grow, they go through the different stages of venture capital. Additionally, firms or investors may focus specifically on certain stages—which impacts how they invest.
When a VC provides an early-stage company with a relatively small about of capital to be used for product development, market research or business plan development, it’s called a seed round. A seed round is often the company’s first official round of funding. Seed round investors are typically given convertible notes, equity or preferred stock options in exchange for their investment.
The early stage of venture capital funding is intended for companies in the development phase. This stage of financing is usually larger in sum than the seed stage because new businesses need more capital to start operations once they have a viable product or service. Venture capital is invested in rounds, or series, designated by letters: Series A, Series B, Series C and so on.
The late stage of venture capital funding is for more mature companies that may or may not be profitable yet, but have proven growth and are generating revenue. Like the early stage, each round or series is designated by a letter.
If a company a VC firm has invested in is successfully acquired or goes public, the firm makes a profit and distributes returns to the limited partners that invested in its fund. The firm could also make a profit by selling some of its shares to another investor.
The key differences
Private equity refers to investments or ownership in private companies. It’s also used as a term for the PE strategy of investing. Venture capital investments are a form of PE investment that tend to focus more on early-stage startups. So, VC is a form of private equity.
They mainly differ in the following ways:
- The types of companies they invest in
- The levels of capital invested
- The amount of equity they obtain through their investments
- When they get involved during a company's lifecycle
VC firms often take a minority stake—50% ownership or less—when they invest in companies. PE firms often take a majority stake—50% ownership or more. They usually have majority ownership of multiple companies at once. A firm's array of companies is called its portfolio, and the businesses themselves, portfolio companies.
Typically, PE investments are made into mature businesses in traditional industries in exchange for equity, or ownership stake. VC firms often invest in tech-focused startups and other young companies in their seed. As most of these companies are not fully established or profitable, they can be risky investments—but with that risk comes the opportunity for big returns.
Using capital committed from LPs, PE investors invest in promising companies. When a PE firm sells one of its portfolio companies to another company or investor, returns are distributed to the PE investors and to the LPs.
A VC firm makes a profit if a company they’ve invested in goes public or gets acquired, or by selling some of its shares to another investor on the secondary market.
Exit route strategies differ, but according to this article, most of the funds raised through initial public offerings (IPOs) recently have been to offer an exit to existing PE or VC funds—rather than for growth capital for companies.
All the above information has been sourced from Pitchbook.
