Private Equity vs. Venture Capital: What is the Difference?
Private Equity (PE) and Venture Capital (VC) are two common yet distinct investment strategies in the private markets, where the differences are namely tied to the investment criteria in terms of the lifecycle stage and deal size, as well as the capitalization.
In the private markets, private equity and venture capital firms are two forms of capital providers that can offer financing to companies in need of funding—or perhaps, seeking a liquidity event (i.e. “taking chips off the table”)—in exchange for equity in the underlying issuer or payments on debt securities.
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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 management (and their auditors) remain accountable to stakeholders.
In the worst-case scenario, a public company can deliberately misconstrue financial data in their reports, causing investors to incur steep monetary losses, which is the outcome that the SEC 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 shares of the company become delisted from stock exchanges post-sale.
- Top Private Equity Firms ➝ Apollo Global, Blackstone, The Carlyle Group, KKR, Bain Capital, Thoma Bravo, GTCR, Vista Equity Partners
- Top Venture Capital Firms ➝ a16z, Sequoia Capital, NEA, General Catalyst, Kleiner Perkins, Index Ventures
Private Equity vs. Venture Capital: Comparative Analysis
The private equity (PE) and venture capital (VC) 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 will practitioners refer to an early-stage investment into a startup as a private equity investment.
But 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 (Source: Bain 2024 Private Equity Report)
| Asset Class | Lifecycle | Structure | Growth | Risk | Debt | Characteristics |
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| Venture Capital (VC) |
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| Growth Equity (GE) |
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| LBO Buyout |
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Private Equity vs. Venture Capital: Investment Criteria
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 an inflection point is reached, where more capital is necessary to fund its growth initiatives and expansion plans.
- 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.
- Early Stage ➝ The early stage of venture capital funding supports companies that are in the development phase, wherein 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.
- Late Stage ➝ Venture capital funding at the late stage targets more mature companies that may not yet be profitable but have demonstrated significant growth and are generating revenue. 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.
- 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, the investment criteria of a private equity firm and deal origination are oriented around identifying companies that can manage the debt burden, or else the underlying borrower will default on the loan obligations (and become insolvent).
Private Equity vs. Venture Capital: Life-Cycle Stage
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 the perspective of a lender, 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.
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, or the venture firm leading each round of financing (Series A, B, C, D, etc).
The reputation of the venture firm can often function as a positive signal to other venture investors, compelling other co-investors to participate in the funding.
Power Law Distribution in Venture Returns (Source: Peter Thiel, Zero to One)
