Private Equity vs. Venture Capital
Posted by Pierre de la Fortune on May 27, 2015 @ 12:01 a.m.
Written by Brian DeChesare
Technically, the term “private equity” refers to money invested in private companies, or companies that become private through the investment. Most people in finance, though, use “private equity” to mean firms that buy companies through leveraged buyouts (LBOs) – so that’s how we’ll use it here. There are a couple other categories of PE, so we’ll look at those at the end of this article.
What They Do
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.
Side note: “Equity” above refers to using cash rather than debt, not to shareholders’ equity, equity value, or anything else (the terminology can get confusing).
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.
Some claim that private equity firms simply buy companies, fire people, saddle them with debt, and then sell the company without doing anything to improve operations.
While that can happen, it was far more common during the LBO boom of the 1980s. PE firms may not always overhaul a company’s operations, but they certainly work to improve them and find ways to expand – especially when it’s a recession and there’s not much buying and selling of large companies. In theory, venture capitalists should have a greater incentive to improve a company’s operations because they’re working with early-stage companies. In practice, their involvement depends on the firm’s focus, the stage of the company, and how much the entrepreneur wants them to be involved.
There are always special cases: * Some VCs use debt to make their investments, especially for larger / later-stage investments. * Some “turnaround” PE firms buy less-than-stable companies and focus on operational improvement rather than financial engineering. * Sometimes PE firms acquire less than 100% of a company, especially firms that are “growth equity”-focused.
As you know from the articles on private equity recruiting and venture capital recruiting, the process itself is similar for both industries. If you’re coming in from banking, you get interviews via headhunters or by networking. Unlike investment banking recruiting, buy-side recruiting tends to be a longer, more drawn-out process. The size of the firm plays more of a role than the type of the firm: large PEs and VCs are more likely to use headhunters than smaller ones.
Both types of firms focus on your background and deal experience, but the similarities end there. You will almost always have to complete a case study or modeling test for private equity interviews – since you spend so much time doing analytical and modeling work, that makes sense. VC interviews, by contrast, are more qualitative and fit-focused – especially for early-stage firms. The companies you work with are so much smaller that detailed financial models don’t make sense – the focus is on relationships instead.
Private equity firms focus on recruiting former investment banking analysts – the modeling and due diligence work you do in PE is very similar to what you do on transactions in banking.
Consultants and anyone with an operating background can get into PE, but it’s an uphill battle – they’ll always be skeptical over whether or not you know how to build an LBO model.
VC attracts a more diverse mix – you’ll see ex-bankers, consultants, business development people, and even former entrepreneurs. In the early days – the 1960s and 1970s – many VCs had entrepreneurial backgrounds, but today that is less true and many Partners have never even worked outside of finance. Pedigree is important in both fields, but it matters less in VC – especially if you have a successful track record. If you create the next big thing, sell it for $10 billion, and then want to become an investor no one will say, “But you only went to a state school! Sorry, go away.”
Especially at large PE firms, the work is not much different from banking: there is less grunt work, but you still spend a lot of time in Excel valuing companies, looking at financial statements, and conducting due diligence. You do have more responsibility because you need to coordinate accountants, lawyers, bankers, and other PE firms when you’re working on a deal. As you progress from “mega-PE fund” to “early-stage VC” the work gets less quantitative and more relationship-driven. Some people actually dislike this because they hate cold-calling and constantly finding new companies, while others would much prefer to talk to people rather than work in Excel. So it’s hard to say what’s “more enjoyable” – it depends on whether you gravitate toward sales, analysis, or operations.
You will almost always make more money in PE than in VC because there’s more money to go around and fund sizes are much larger. Theoretically if you’re at the Partner-level in VC and you find the next Google, you could have an outsized payday – but that is very rare. If you’re coming in from banking, base salaries in both industries are around $100K with widely variable bonuses: at the largest PE firms you might be making in the low hundreds of thousands, whereas in VC you might get a smaller bonus than you would in banking. The “ceiling” is hard to determine because no one likes to disclose compensation data unless they have to, but there’s a good WSJ article on what top PE guys make right here. The numbers quoted there are misleading because they only include salaries and bonuses – no carry or ownership in the PE firm itself. But overall, if you want to make the most amount of money in the shortest amount of time then you’re better off in PE.
PE is very similar to banking and attracts some of the more extreme and cutthroat bankers.
VC tends to be more relaxed, partially because people come from more varied backgrounds.
People in PE more often come from pure finance backgrounds, whereas those in VC tend to be technologists-turned-financiers.
Overall the work hours in PE – especially at the biggest firms – tend to be much longer, whereas VC approaches a “normal” workweek.
If you’ve done VC, the main exit opportunities are another VC firm, a startup, or business development. Even moving into PE would be difficult because they want banking or PE experience. Private equity gives you more options within traditional finance, but it would be harder to move to a startup because Excel wizardry and financial projections don’t matter. It would be difficult to move from either of these fields field back into banking or something else on the sell-side – it’s hard to tell a story about why you want to work more and get paid less.
Other Variations on Investing
I noted that there are a couple exceptions to the “rules” laid out above:
These are hybrid firms – “in between” buyout firms and VCs – that do early-stage investments, later-stage investments, and sometimes the occasional LBO.
Examples are Summit Partners, TCV, and TA Associates.
They tend to invest in later-stage startups that already have revenue and customers and need capital to expand their businesses.
Distressed / Turnaround Investing
Distressed investing is more common in the world of hedge funds, but some PE firms do this as well.
Examples include WL Ross & Co., Tennenbaum Capital, and the turnaround arms of Apollo and Cerberus.
Just like Restructuring, these firms are counter-cyclical and require a much more specialized skill set.
Fund of Funds
These firms invest in other private equity firms, hedge funds, mutual funds, investment trusts, and so on – rather than directly investing in companies themselves. Bankers and PE guys often claim that funds of funds are “boring” because you’re analyzing portfolios all day.
But if you’re looking to get paid well and have a better lifestyle, it might make sense to go to one of these rather than traditional PE.
What About Hedge Funds?
I get a lot of questions on this one – but hedge funds vary so much by the strategy they use that it’s difficult to generalize. The main difference between PE and hedge funds is that hedge funds tend to invest in individual securities whereas private equity firms buy entire companies.
However, the lines between the two have blurred and these days a lot of firms actually make both types of investments. I’m not going to delve into HFs here because this is a PE vs. VC article – just be aware that many investment firms are actually combination hedge funds and private equity firms.
Which One Should You Choose?
So, private equity or venture capital?
It depends on your goals – if you’re trying to make the most amount of money in the shortest amount of time possible, PE is better. If you’re from a pure finance background and you like the work and transaction experience you get in banking, PE is better. If you’re more interested in starting your own company one day, you prefer relationships to analysis, or you want a better work-life balance, VC is better. Or you could just bounce around between both of them – what would finance be without high turnover?
For more info please visit: http://www.mergersandinquisitions.com/private-equity-vs-venture-capital/
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