Venture Capital vs Private Equity: A Comparative Analysis
Financing is a vital component of the entrepreneurship process. Notable critical cogs in the wheels of entrepreneurship are private equity (PE) and venture capital (VC). These two financial instruments have become increasingly decisive to most advanced economies’ innovation systems like Singapore’s and to a growing number of emerging economies.
Throughout this article, we shall dissect these two verticals, their characteristics, features and the facets that make them essential drivers of innovation, entrepreneurship and economic growth.
What is Private Equity?
Private equity (PE) is essentially a supply of equity capital by monetary backers to private companies capital raised from Private Equity investors can be utilized to fund new technology, make acquisitions, expand working capital, and to bolster and solidify a balance sheet.
Generally speaking, venture capital is a subset of private equity, typically scoping equity investments made for the launch, early development, or expansion of the business, placing emphasis on entrepreneurial activities rather than on mature businesses.
Features of Private Equity
PE is a vertical of financing whereby capital is injected into an enterprise — commonly mature businesses in traditional industries — in return for equity. PE investing is usually divided into four core strategies: growth, buy-out, rescue and replacement capital.
To finance a company, PE investors usually raise capital from limited partners (LPs) like family offices, insurance or pensions funds, or funds pooled from private wealth individuals. Utilising this capital committed from LPs, PE firms tend to invest in private companies.
At any point when a PE firm sells one of its portfolio companies to another entity or investor, the returns are fairly appropriated to the PE financial backers and the LPs. For example, PE firms typically receive 20% of the returns, while the LPs get 80%
Furthermore, PE firms usually depend on cash flow and genuine financial metrics to drive a usually complex quantitative valuation. As a matter of fact, the leverage buy-out model relies on a mixture of debt and equity to fund takeovers through a special purpose vehicle (SPV).
What is Venture Capital?
Venture capital (VC) is ordinarily characterised as the investment by professional investors of long-term, unquoted, risk equity finance into new companies whereby the principal reward is an eventual capital gain–supplemented by dividend yield.
Generally, venture capital firms play a vital role in nurturing promising and emerging innovative companies in engineering, finance and technology domains. Essentially, aside from funding, venture capitalists provide contacts, technical advice and operational expertise to the entrepreneurial ventures they invest in.
Features of Venture Capital
VC firms are known to put resources into businesses with the aim of increasing their value before ultimately selling at a profit. In contrast to PE firms, VC firms often take a minority stake in the typically tech-focused start-ups/companies they invest in.
In practice, this type of capital allows young innovative founders to transfer part of the financial risk of the business to the VC firm. In exchange, the start-up founders part ways with some of their equity and possible returns on a potential exit of their entrepreneurial venture. Additionally, VC firm representatives get comprehensive control rights as board members.
However, since most VCs invest in companies that aren’t fully established or profitable yet, they tend to be risky investments—though that risk typically comes with the opportunity for significant returns. Essentially, if a start-up the firm has invested in goes public or is acquired, the VC entity makes a profit. For example, Sequoia Capital, the VC firm that invested in WhatsApp, turned its $60M investment into $3B after Facebook bought the company in 2014. Though the VC firm can also profit by trading some of its shares to another investor in a secondary market.
Furthermore, VC firms typically focus on companies at a specific venture capital stage, whether seed, early or late stage. These stages impact how VCs invest. The cash infused by VCs typically comes from groups of wealthy investors, insurance firms, investment banks and other financial institutions.
Similarities and Common Characteristics
- Both financial instruments are private sources of equity funding; however, there is a grey area in between called ‘growth equity’ where they overlap.
- Private equity typically encompasses two main investment areas: venture capital and leveraged buy-outs (“LBOs”).
- VC and PE terms are sometimes used interchangeably since they overlap in some aspects and services they offer. That being said, the dividing line between PE and VC would be the use of leverage/debt financing for PE investments whilst VC is largely financed by equity.
Difference between Venture Capital and Private Equity
The disparities between PE and VC revolve around two areas: investment strategy and stage of business operations.
- For starters, VCs start with people, while PE begins with numbers and metrics. This means that VCs fund early-stage start-ups to help them stay afloat, whereas PE is more interested in the products and mature entities already in the market, boosting them or accelerating their growth.For a more straightforward context, PEs seek to capitalise on the available opportunities by either restructuring an inefficient entity or tapping into considerable market opportunities through capacity expansion.
- Generally, VC entails a minority investment in a business, and if leverage/debt is employed, it’s usually a relatively small part of the transaction. On the other hand, PE usually involves a change of control or acquisition utilising debt (leverage) or various types of capital transactions like buy-outs, mergers, turnarounds, replacement capital, or initial public offering (IPO).
- VC firms put resources into companies with high growth potential, with undeveloped or developing products or revenue. VC backed companies are typically not profitable early on; they instead utilise the VC capital to accelerate growth. In contrast, PE funds focus on making medium and large investments in mature companies with high earning potential and evident cash flow.
- The risk profile in VC (high risk-high return) is comparatively higher than PE (medium risk-medium return). For better context, seven out of ten VC investments typically fail. Out of the remaining three, two might return the money invested with some profit, and perhaps only one will make a substantial profit (20- 40X return).On the other end, PE investments tend to take more calculated risk as compared to VCs. If all else fails, PE investments can be sold at a loss given that these companies are already relatively mature and stable.
Furthermore, PEs are typically benchmarked against the performance of index funds, in terms of returns. So, anyone beating the benchmark by 3%–4% is usually considered successful.
- Prior to investing, VCs tend to be more focused on the quality and experience of the management team in the company. In contrast, PE backers focus more on profit and loss, sales, revenue data for the past five years at least.
- In terms of control, most VCs demand board seats, but do not interfere in nor dictate the operational functions of the company. However, they provide strategic direction, regulatory hand-holding, hiring support, fund-raising support etc.In contrast, PE backers are, in most cases, fully hands-on. PE firms typically take the driver’s seat, especially in restructuring deals. And in growth deal scenarios where the original owners maintain control, PE firms are still heavily involved in operational aspects of the company. This, in all fairness, is understandable since PE firms typically put more sizable amounts of money into businesses in contrast to VCs.
- With regards to the number of investments, VC firms invest in a large number of start-ups at one go. This is to spread the risk and increase the probability of success if some of the companies fail. Essentially, balancing the boat.On the other end of the spectrum, PE firms tend to have stricter mandates and will concentrate on a smaller subset of companies or specific industry focus.
- Lastly, in terms of investment amounts, VC injection tends to be less than of PE. For example, most VCs do not invest more than $10 million in a single start-up. However, PE firms can invest up to $100 million in a single enterprise.
Without a doubt, PE and VC firms play a critical role in the sustainable development of Singapore’s economy. As has been noted, PE & VC aim to help companies accomplish growth by providing finance, strategic technical advice at critical stages of development.
However, a lack of access to finance is still one of the core barriers restraining the development of companies. VCs fill this gap as they tend to finance high-risk projects while supporting small-scale investments which aren’t easily financed by banks.
Such companies tend to be working on innovations or products that are not yet verified by the market, and seen as a source of uncertainty and risk for many traditional financiers.
As seen above, venture capitalists also offer management support, marketing and financial management expertise, hence contributing to an improvement in the reliability of the business.
To summarise the four key takeaways:
- Private equity is later staged to venture capital (PE investments are for later or expansion stages while VC is for the early stage).
- Private equity evaluates actual numbers, not dreams.
- PE firms invest in a few companies at a time, while venture capitalists tend to spread their risk and make their investments in multiple businesses concurrently.
- PE funding is given to mature companies with a consistent and good track record. Conversely, VCs typically fund small businesses with a little proven track record.
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Co-Founder, Chief Executive Officer
Haruhito was the Executive Director of Marcuard Heritage Singapore Pte Ltd, a Swiss multi family office. He was instrumental in building up their European and Asian clientele base which comprised of a global network of asset managers, distribution partners, and legal & tax specialists. Prior to that, he held various positions for 10 years in Deutsche Bank where he gained extensive experience in various Asian markets.
Haruhito has been accredited as a Trust and Estate Practitioner (TEP) by STEP, and as a Financial Industry Certified Professional (FICP) by Singapore’s Institute of Banking and Finance. His vision for Salzworth is to steer it to establish multi-asset class portfolios and funds that seek to achieve steady returns for investors.