Private Equity vs. Venture Capital

by Adarsh Raj Bhatt in Glossary

Image credit: Unsplash

Key Takeaways

  • Funds that are invested in assets that are not present or accessible through the public market are known as “private capital.” As the name suggests, these investments are private and include classes of assets like VC, private equity, real estate, private debt, natural resources, and private infrastructure.
  • For the past 30 years, the private equity industry has become increasingly prevalent and new asset classes developed as opportunities for private investment. More and more funds in private equity focused on debt, infra, and real estate.
  • There are multiple distinctions between angel investors, VCs, and private equity investors. However, people still confuse the three categories because they have commonalities and the differences are sometimes blurry. The most noticeable and clearest distinction between them is the average stage of the companies that they make investments in.
  • A private equity firm generally exercises more control than a growth equity firm. This is because growth equity investments are generally minority investments and are able to exercise limited control over how the founders/leadership manage the company’s operations.

What is private capital?

Funds that are invested in assets that are not present or accessible through the public market are known as “private capital.” As the name suggests, these investments are private and include classes of assets like: 

  • Venture capital, which invests in early-stage startups that show positive signs of tremendous growth.
  • Private equity invests in businesses with private ownership or in public corporations through a buyout deal.
  • Real estate, which invests in private real estate, including residential and commercial properties.
  • Private debt, which invests in debt that is not bank-funded. These debt investments are also not traded/issued in the open market.
  • Natural resources, which include water, timberland, farmland, oil and gas, mines, etc.
  • Infra, which includes airports, utilities, toll roads, and other private infrastructure.

Investors known as limited partners, or LPs, enter into limited partnerships to manage interests in asset classes like those discussed above. GPs (general partners) are those who manage the investment. They do this by coordinating with limited partners to call and deploy funds. 

The assets/groups of assets mentioned above initially materialized as offshoots of private equity. With how mainstream the private industry became, new asset classes developed as opportunities for private investment. More and more funds in private equity focused on debt, infra, and real estate. With the passage of time, these asset classes became more established and went on to become independent investment categories of their own. Today, they come under private capital. 

Private fund managers differ from public market fund managers as they proactively help run startups and manage the assets in their portfolios. They help shape the strategy of the startup and actively participate in asset management.

There can be considerable variation in the kinds of private capital investments out there. However, their intent remains largely the same — to sustain the growth of or provide value to the assets/businesses in their portfolio. This fits into the broader goal of these funds, which is to ensure a robust ROI (for their investors) over a stipulated period of time.

There are several different ways investors can reach the private capital market. They can use the exchange-listed funds (just like in the case of public markets) to access the private capital asset classes. Normally, investors take the path of funds that are private and unlisted. Another route to market is a direct investment in asset classes.

Here are three different fund structures:

  • Commingled fund: a structure where several investors put their money into a common fund which is then invested as a whole. 
  • Fund of funds: an advanced version of a commingled fund that has two levels where a common fund is formed from the money of several investors. Then, this common fund makes investments in other private capital funds.
  • Separately managed account: a fund structure where one fund manager handles an investor’s money. 

Angel investors vs. venture capital vs. private equity

There are multiple distinctions between angel investors, VCs, and private equity. However, people still confuse the three categories of investors because they have commonalities and the differences are sometimes blurry. The most noticeable and clear distinction between them is the average stage of companies they invest in. 

The following are the major differences to remember about these three classes of investors:

Business stage

Angels (or angel investors) are generally the first class of investors to pour capital into startups. Then, come the VCs, followed by private equity funds. 

Angels invest in startups in their earliest stage, when they don't have any customers or revenue. Their development might be at a level where they only have a business plan, MVP, or prototype. Of course, some angel-funded startups could very well be at the other end of the spectrum where they have proper cash flow or revenue.

VCs make investments in startups with promising revenue models. If this condition is not satisfied and the model is not proven, then VCs generally require that the startup have a concrete revenue strategy along with a robust customer base.

Private equity firms step in when the startup is further along in the development cycle. They make their investments in startups that have been generating revenue and benefitting from good profit margins, consistent cash flow, and the capacity to pay interests on a sizable debt.  

Investment Size

Angel investments are generally at least $10K to $100K; sometimes they can be to the tune of a couple of million dollars. Y Combinator investment sizes - in the case of startups enrolled in its accelerator program - are usually known to be about $120K in exchange for 7% of the startup. 

The variety of investment sizes for venture capitalists is much broader than that of angel investments. VC deals vary based on the startup, its niche, industry, market, etc. Generally, VC firms invest $1M-$20M. 

The average size of investments made by private equity firms is significantly greater than that of VCs and angels. This is because they invest in startups that are in their later stages. The range of investments is so broad that some private equity firms (that are middle-market) could invest something like $5M while other larger ones could invest >$1 billion. These larger firms are global behemoths like Blackstone. Given this kind of range, there’s no use in trying to find the average investment size in the case of private equity firms.

Investment Type 

The startups that angels are interested in are fledgling companies that qualify for only equity investments, not any kind of debt. Most angel investments are an exchange of cash for stock in the startup. 

We say “most” angel investments because there are some startups that are so early in their development that they rely on a SAFE, (i.e., a Simple Agreement for Future Equity), which is used in place of a convertible note. How this financing instrument differs from a standard angel investment is that the angel(s), in exchange for the cash, receives the right to purchase future equity.

Venture capitalists' investments in startups are generally known to take the form of:

Their goal is to maximize equity upside. As a result, even a VC investment in convertible debt will be driven by the ultimate aim of equity ownership. An investment deal of preferred stock will receive rights and privileges that are meant to offer protection to VCs. Two ways of doing this are: 

  • Restrict/mitigate the investor’s downside through a first out provision.
  • Save the investor from dilution of equity interest in the future through rights, ratchets, or warrants

While private equity investors usually make equity investments, they additionally borrow a lot of capital to improve their IRR (levered). A private equity investment firm might seek to use the maximum possible debt by executing a leveraged buyout (LBO).

Investors 

What does the investment team of each of the three classes of investors actually look like? 

Angels are generally founders who successfully exited from startups that they established or helped establish. They have an excellent sense of what the purpose of the founder in the startup is; they also frequently possess narrow but deep product knowledge. 

Investment divisions in VC firms are frequently a combination of founders and finance experts. This mixture of founders and professionals can be seen on the “Team” pages of VC firm websites, such as that of a16z.

Private equity investment teams tilt more toward finance veterans, corporate strategists, or veteran corporate operators. 

Risk 

Levels of risk are simple to grasp. Usually, the more early-stage the startup is, the greater the risk. Private equity investments are generally low-risk and in the later stages of a startup that has been derisked. 

An important point to understand about risk in this context is that it can be manipulated by the use of financial engineering. Leverage, in particular, can cause the risk in the investment to spike. For instance, even if it’s a private equity firm that is investing, if an extremely high amount of leverage is used to secure considerable equity, then the risk involved in the investment could become quite high. 

Returns

While all investors (including angels, VCs, and private equity firms) aim to maximize their returns on a risk-adjusted basis, the differences in their risk profiles translate into widely differing returns for each class of investor. 

While there are always exceptions, it’s generally seen that angel investors enjoy the highest returns (of 100x, sometimes even more, but here’s the catch. These sky-high returns only happen when the startups make it. Most of them don’t, implying that all the money invested in them is lost.

VC investments in later-stage companies could be as great as 10x. Compared to angel investments, the risk is lower as fewer companies fail -- implying that fewer VC investments end up equal to zero.

Private equity firms aim for returns of at least 20%. The risk is lowest for their investments as very few startups at that scale fail -- implying that very few private equity investments equal zero in the end. 

Industry

It’s extremely tricky and rarely accurate to try to identify any differences in industry focus among angels, VCs, and private equity firms. They differ widely by industry focus. That is why it’s only possible to evaluate them on an individual investor-by-investor or firm-by-firm basis. 

Assessment of suitability for investment

Since angels enter the picture in the early stages of the startup, when there are not a lot of concrete metrics that represent business performance available, angel investors screen startups based on qualitative parameters like the background of the founders, the overall factors that might drive the success of the startup, and what the plan is for achieving product-market fit. 

While venture capitalists pay a ton of attention to the background and overall identity of the founders, they pay at least as much attention to definite metrics like customer lifetime value, profitability, burn rate, etc. 

Lastly, private equity firms focus on essential metrics related to the startup’s finances like cash flow, EBITDA, free cash flow, etc. They are also focused on predicting the internal rate of return that they can reasonably hope for.

Examples

Three well-known angel investors are YC (Y Combinator), Naval Ravikant, and Techstars. As for VCs, three major firms are a16z, Google Ventures, and Sequoia Capital. Lastly, three key private equity firms are Blackstone, Apollo, and KKR.  

Growth equity vs. private equity

Typically, private equity deals seek to acquire a majority stake in the startup they are investing in. Sometimes, this takes the form of acquiring 100% ownership in the startup. A standard private equity transaction sees the firm acquiring a majority (or even 100%) interest in a successful corporation that was established a long time ago (i.e., a late-stage startup). The firm focuses on ways to earn the maximum possible returns by using a mixture of: 

A typical company in a private equity firm’s portfolio has been operating successfully for quite some time after being acquired by the firm. It is infused with extra capital by the firm to help it expand. 

Growth equity investment firms invest in startups that are held privately and looking to grow. They sponsor a private equity transaction by investing in those securities of the startup that are privately traded and illiquid. Though their investment is generally quite large, the stake tends to be a minority stake. At other times, the firm could end up acquiring a majority interest in a startup if the percentage of voting securities acquired are in the majority. The kinds of companies in a growth equity firm’s portfolio are generally in spaces like tech, consumer goods/services, financial offerings, and healthcare. 

Considering the typical distinctions between the investment stakes of a growth equity firm and a private equity firm, the latter generally exercises greater control than the former over the functioning of a startup. This is because growth equity investments are generally minority investments where the firm is typically entitled to one seat on the board of directors and is able to exercise limited control over how the founders/leadership manage the startup's operations. Because the startups in a growth equity firm’s portfolio are generally undergoing massive periods of growth, expansion, and/or scalability, the firm pays a lot of attention to founders who are exceptionally skilled in effective management.   

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