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Private Equity vs. Venture Capital

Step-by-Step Guide to Understanding Private Equity (PE) vs. Venture Capital (VC)

Last Updated June 11, 2024

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Private Equity vs. Venture Capital

How Do the Private Markets Work?

The private markets refer to the investment of capital into privately held companies rather than publicly traded companies listed on a public stock exchange (NYSE).

Since privately-owned companies, as implied by the name, are not listed on any public exchange, the regulatory pressure and mandatory filing requirements with the Securities and Exchange Committee (SEC) are fewer.

But to truly grasp the private markets and the pros/cons of the decision to “go public,” understanding its counterpart—the public markets—is necessary.

Once a private company undergoes an initial public offering (IPO) and issues shares in the open markets, the formerly private company is now deemed to be a publicly traded company.

Once publicly traded, the company and management team are placed under far more regulatory scrutiny, with more disclosure requirements established by governmental entities, namely the SEC.

The general public, since the company chose to partake in raising capital in the public equities markets, obtains access to the audited financial statements, business model, and long-term strategy, as mandated by the SEC to protect the “best interests” of investors.

Therefore, the equity of a public company, or shares (i.e., partial ownership stakes), can be freely traded in the secondary markets by institutional investors like hedge funds and retail investors—albeit the portion of the ownership stake is marginal on a relative basis.

The regulations are intended to ensure the financial reporting of public companies is fully transparent and that management (and their auditors) remain accountable to stakeholders.

In the worst-case scenario, a public company can deliberately misconstrue financial data in its reports, causing investors to incur steep monetary losses—the outcome that the SEC was established for and strives to prevent.

While venture capital firms invest in privately held companies, private equity firms invest in private and public companies. In the latter scenario, the transaction is termed a “take-private” because the company’s shares become delisted from stock exchanges after the sale.

The private equity sector and the investment strategies can be segmented into three buckets:

Investment Type Description
Venture Capital (VC)
  • Early-Stage Investing (i.e. Startup Funding)
Growth Equity (GE)
  • Growth-Stage Investing (i.e. Expansion Capital)
Traditional Buyout (LBO)
  • Late-Stage Buyout Investing

Private Equity vs. Venture Capital: Comparative Analysis

The private equity (PE) and venture capital (VC) asset classes share many commonalities in their business model, such as the raising of external capital from investors, formally termed limited partners (LPs).

On behalf of the limited partners (LPs) of the fund—the investors that committed capital to the fund—the general partner (GP) allocates the contributed capital into investment opportunities to achieve a positive risk-adjusted return.

The most common limited partners (LPs) of private equity and venture capital funds include:

  • Pension Funds
  • University Endowments
  • Insurance Companies
  • Sovereign Wealth Funds (SWF)
  • Fund of Funds (FoF)
  • High-Net-Worth Individuals (“Ultra”)

One nuance, however, is that venture capital technically falls under the private equity umbrella—albeit rarely, practitioners will refer to an early-stage investment in a startup as a private equity investment.

However, one notable development that emerged in recent times is the allocation of capital toward private equity has increased substantially, considering the resilience exhibited in returns of the private equity asset class across historical periods.

Global Private Capital Raised, By Fund Type

Global Private Capital Raised by Fund Type (Source: Bain 2024 Private Equity Report)

Overview of Private Equity vs. Venture Capital

The following chart describes the investment strategy and criteria of the three subsets within private equity: venture capital, growth equity, and late-stage buyout.

From right to left, the columns answer each of the following questions for each investment strategy:

  • Lifecycle ➝ What lifecycle does the investment firm invest at?
  • Structure ➝ Does the investment firm obtain a minority or majority stake?
  • Growth ➝ What is the target growth rate of potential investment candidates?
  • Risk ➝ What is the risk profile of the investing strategy?
  • Debt ➝ What percentage of the purchase price is funded using debt rather than equity?
  • Characteristics ➝ What are the key characteristics of each strategy?
Asset Class Lifecycle Structure Growth Risk Debt Characteristics
Venture Capital (VC)
  • Early-Stage
  • Minority (<25%)
  • 100%+
  • High
  • None (or <2%)
  • Early-Stage Startup
  • Pre-Product (or Pre-Revenue)
  • Innovative Offering
  • Large Total Addressable Market (TAM)
  • Growth Oriented
Growth Equity (GE)
  • High-Growth Stage
  • Minority Stake (<50%)
  • 25%+
  • Moderate
  • None or Low (<10%)
  • Double-Digit Revenue Growth
  • Continued Market Traction
  • Shift Toward Operating Improvements
  • Potential to Become Profitable (or Break-Even)
  • Proven Product-Market-Fit (PMF)
LBO Buyout
  • Late-Stage
  • Majority Stake (>50%)
  • 3% to 8%
  • Low (Excluding Default Risk)
  • High (>50%)
  • Consistent Generation of Free Cash Flow (FCF)
  • High Debt Capacity
  • Steady Profit Margins
  • Non-Cyclical Operating Performance

Private Equity vs. Venture Capital: Investment Strategy

The equity investors that contribute capital to the startup, at the risk of losing the entire initial investment, include angel investors and early-stage venture capital (VC) firms.

Of course, there are exceptions to the rule, but most companies continue to grow until they reach an inflection point, at which point more capital is necessary to fund their growth initiatives and expansion plans.

  1. Seed Stage ➝ The seed round involves a venture capitalist providing a startup with a relatively modest amount of capital, which is used for activities such as product development, market research, or business plan development. Usually, the seed stage is the company’s first round of institutional funding. In exchange for their investment, seed round investors commonly receive convertible notes, equity, or options for preferred stock.
  2. Early Stage ➝ The early stage of venture capital funding supports companies in the development phase. The financing stage usually offers a larger sum than the seed stage because new businesses require more capital to initiate operations once they have developed a viable product (or service). Venture capital funding near this stage is disbursed in successive rounds or series, which are designated by letters, such as Series A, Series B, Series C, etc.
  3. Late Stage ➝ The funding provided at the growth stage targets more mature companies that may not yet be profitable but have demonstrated significant growth and are generating revenue. The objective of the growth equity firm is to support the growth initiatives of the established company and offer guidance to the management team to reach the next level of growth, which is ideally an initial public offering (IPO). Similar to the early stage, each funding round in the late stage is identified by a letter, with Series D, Series E, and Series F being more typical. However, late-stage funding rounds can extend up to a Series K.
  4. Exit Stage (Profit Realization) ➝ When a company that a firm has invested in is either successfully acquired or goes public via IPO, the firm realizes a profit and distributes returns to the limited partners (LPs) that invested in its fund. The firm can generate a profit (spread between sale price and purchase price) by selling shares to another investor via the secondary market.

Since lenders are unlikely to offer loans to an early-stage startup—which is most likely unprofitable—the other option on hand is equity issuances to raise capital to fund its operations (and future growth).

The investment carries more risk than most asset classes, but the potential payoff—where the upside is uncapped, at least in theory—often makes these high-risk investments worthwhile.

In contrast, private equity firms specialize in leveraged buyouts (LBOs), wherein the acquisition target is purchased with the post-LBO capital structure composed of a substantial percentage of debt financing.

  • Venture Capital (VC) ➝ The funds contributed by the venture firm are to confirm the commercial viability of the product and facilitate product development if deemed necessary. While most of the portfolio is expected to fail, the returns from a successful investment can offset those losses and enable the fund to achieve its target returns.
  • Private Equity (LBO) ➝ The use of debt is one of the core drivers of returns in an LBO investment, with operational improvements (EBITDA margin expansion) and multiple expansion (Exit Multiple > Entry Multiple) constituting the rest.

The acquired company—or portfolio company (“portco”)—continues to operate after the acquisition but with an entirely different capital structure. In short, the debt burden placed on the company causes management to be far more risk-averse because the interest payments and mandatory principal amortization are fixed, for the most part, across the term of the borrowing.

Therefore, a private equity firm’s investment criteria and deal origination are oriented around identifying companies that can manage the debt burden; otherwise, the underlying borrower will default on the loan obligations (and become insolvent).

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Who are the Top Private Equity and Venture Capital Firms?

The top private equity and venture capital firms as of 2024 are as follows:

Top Private Equity Firms Top Venture Capital Firms

Certain institutional firms continue to grow until their assets under management (AUM) reach a point where a transition toward a multi-strategy (“multi-strat”) approach is inevitable.

For instance, Bain Capital actively invests in the late-stage buyout market, while Bain Capital Ventures (BCV) invests in the early-stage market (and both are part of Bain & Company, the management consulting firm).

Top Private Equity vs. Venture Capital FirmsTop Private Equity and Venture Capital Investors: Firm Examples (2024)

Private Equity vs. Venture Capital: Investment Criteria

In the private equity (PE) industry, an inherent attribute of each investment is the reliance on debt financing as one of the core drivers of returns.

Conversely, debt financing is seldom used in the venture capital (VC) industry, aside from hybrid securities with certain features that are somewhat comparable to debt (e.g. convertible bonds).

The investment criteria of venture firms are oriented around growth and the potential to disrupt a traditional market.

Venture Capital (VC) — Investment Criteria

  • High Revenue Growth (100%+)
  • Strong Management Team
  • Innovative Product Offering
  • Potential to Disrupt Existing Market (Traditional Offering)
  • Proof of Concept or Product-Market Fit (PMF)
  • Sizable Market Size or Total Addressable Market (TAM)
  • Favorable Term Sheet (Provisions to Mitigate Risk of Dilution)

Venture Capital Investment Criteria

Bain Capital Venture Capital Strategy and Investment Criteria (Source: Bain Capital Venture Capital)

If a startup is profitable at the “bottom line,” that would be perceived as an anomaly, and perhaps management could even receive criticism for not spending enough and investing in facilitating the rapid growth of the startup.

Lenders, the primary source of capital to finance a leveraged buyout (LBO) transaction, are normally risk-averse and prioritize capital preservation—i.e., mitigation of the risk of incurring monetary losses on a lending arrangement—above all else.

The private equity industry has increasingly become more reliant on operational improvements (i.e., margin expansion, cost-cutting initiatives) to drive value creation, which is a stark contrast to the earlier days of the industry, whereby a debt-to-equity (D/E) ratio of 80%+ was the norm.

Debt to EBITDA Multiple Ratio

Debt to EBITDA Ratio for LBO Loans (Source: Bain 2024 Private Equity Report)

However, the percentage of debt has gradually reduced over time as the private equity industry has matured.

Currently, most lenders set a minimum equity contribution of 25% to ensure that incentives are aligned among all stakeholders.

Unlike common equity, debt has a relatively fixed yield on the date of issuance, although there can be some variance between the expected and actual return received by the lender.

The companies that meet the investment criteria of private equity firms and are actively pursued as a buyout target are, more often than not, established and mature companies with a track record of sustained profitability, even amid recessions and periods of unfavorable economic conditions.

Private Equity (LBO) — Investment Criteria

  • Consistent Revenue Generation (3% to 5% Revenue Growth)
  • Stable Generation of Free Cash Flow (FCF)
  • Consistent Profit Margin (Exceeds Industry Average)
  • Non-Cyclical Operating Performance
  • Low Purchase Multiple (Underpriced)
  • Sound Management Team (Rollover Equity)
  • Value Creation Opportunities
  • Potential Add-Ons (Synergies)

Private Equity Investment Criteria

Bain Capital Private Equity Strategy and Investment Criteria (Source: Bain Capital Private Equity)

Private equity firms nowadays must devise value-creation strategies to optimize the operating leverage and cost structure of the acquisition target to grow recurring revenue and profit margins rather than relying solely on revenue (i.e., economies of scale).

Margin Expansion in LBOs (2024 Bain)

Margin Expansion as Value-Creation Strategy in LBOs (Source: Bain 2024 Private Equity Report)

In fact, the generation of consistent, stable free cash flow (FCF) by a company with minimal variance in its profit margin is perceived to be of higher priority than revenue growth to most, if not all, firms.

The costs incurred from debt financing—the periodic payment of interest expense and principal amortization—can only be paid off using free cash flow (FCF), rather than revenue, unfortunately.

A company’s business model and operating performance are, for the most part, contingent on the industry in which it operates. Hence, the percentage share of LBO investments flowing into sectors like enterprise software and industrials outpace riskier sectors by a substantial margin.

Enterprise Software Contracts vs. 1st Lien Debt

“Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first-lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.”

Robert F. Smith, Vista Equity Partners

Buyout Volume by Sector

Share of Global Buyout Deal Count by Sector (Source: Bain 2024 Private Equity Report)

Private Equity vs. Venture Capital: Sources of Returns

The characteristics of an ideal buyout candidate, such as a track record of generating strong recurring revenue, consistent profit margins, low customer concentration risk, and non-cyclical performance, each align with established, mature companies.

Private equity firms specialize in LBOs, a risky transaction whereby a significant percentage of the purchase price is funded by debt capital.

The less equity contributed by the private equity firm—or financial sponsor—to fund the acquisition, the higher the return on the LBO — all else being equal.

From a lender’s perspective, a potential borrower with those aforementioned attributes is likely to be approved and provided the required financing. Hence, the investment criteria of a private equity firm are akin to the criteria set by lenders.

The three core drivers of returns on an LBO are as follows:

  1. Operational Improvements ➝ EBITDA Growth, Higher Profit Margin, Increased Free Cash Flow, More Efficient Operations
  2. Debt ➝ Increased Reliance on Debt to Fund Purchase Price, Paydown of Debt over Borrowing Term (i.e. “Financial Engineering”)
  3. Multiple Expansion ➝ Exit at Higher Multiple than Purchase Multiple (Exit Multiple > Entry Multiple)

In comparison, venture capital firms invest in the equity of startups, which is a high-risk bet by itself. In fact, most startup investments in the portfolio of a venture fund are anticipated to fail.

The Power Law in venture capital (VC) is a principle that states a single investment has the upside potential to yield an outsized return far larger than the other investments combined.

Generally speaking, startups tend to be more attentive to the lead investor, which refers to the venture capital firm leading each round of financing (Series A, B, C, D, etc).

The venture firm’s reputation can often function as a positive signal to other venture investors, compelling other co-investors to participate in the funding.

Power Law of Return (Peter Thiel VC Quote)

Power Law Distribution in Venture Returns (Source: Peter Thiel, Zero to One)

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