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.
Table of Contents
- How Do the Private Markets Work?
- Private Equity vs. Venture Capital: Comparative Analysis
- What is the Difference Between Private Equity and Venture Capital?
- Private Equity vs. Venture Capital: Investment Strategy
- Who are the Top Private Equity and Venture Capital Firms?
- Private Equity vs. Venture Capital: Investment Criteria
- Private Equity vs. Venture Capital: Sources of Returns
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 (post-IPO), the company and management team are placed under far more regulatory scrutiny, with mandatory 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.
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).
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) |
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| Growth Equity (GE) |
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| Private Equity (PE, Buyout) |
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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 (Source: Bain 2024 Private Equity Report)
What is the Difference Between Private Equity and 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) |
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| Growth Equity (GE) |
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| LBO Buyout |
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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.
- 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 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.
- 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.
- 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 reliance on debt is one of the core drivers of returns in an LBO investment. In fact, the purchase price is funded mostly using debt, reducing the equity contribution by the private equity firm. Therefore, the paydown of debt (or principal amortization) over the course of the holding period contributes to higher returns on the LBO investment.
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).
