What is the difference between private equity and venture capital?

Private equity (PE) refers to the investment sector focused on capital allocation into equity  and operations in companies that typically aren’t publicly traded. As such, there is no centralized platform through which the general public can access the investments made by private equity firms . Due to this, PE funds usually differ from traditional asset classes like stocks and bonds with respect to returns, liquidity, risk, and size.

PE firms usually invest in private companies or buy majority stakes in public companies to make them private. There are several classifications of private equity, such as venture capital, buyout funds, distressed investing, and mezzanine financing. The specific objectives of these investment strategies may differ, but they all attempt to earn a higher rate of return than can be achieved in public equity.

Other distinct characteristics of PE include long investment horizons (4-7 years) and significant use of leverage to increase returns.

Venture capital, on the other hand, is a category of investment in private companies that focuses on  early-stage companies (sometimes even idea stage!). Venture capital is often noted for its exceptionally high failure rate of portfolio companies, with the gains in the sector typically coming from a very few portfolio companies that deliver spectacularly outsized returns, potentially offsetting otherwise majority losses in the venture portfolio. 

Investing in startups and early-stage companies is, of course, subject to high risks. Some of the risks of VC investing are:

• Extremely small startups may not be able to withstand the leverage  of large corporations moving markets.
• Some startups are based on innovative ideas with no proven market for their product.
• The success or failure of startups can depend on the character of the founders and their ability to judge market sentiment and consumer preferences effectively.

At an early stage, there are very few financial metrics to judge, and VC firms often make investments based on their intuition and professional network’s knowledge of the founding team.

As a result of the factors mentioned above, VC firms use a very high discount rate to discount future cash flows when valuing startups, leading to lower valuations. This discount rate reflects the additional return required by investors to compensate them for high levels of risk. The rates can go up to or even exceed 50%, whereas the discount rates used in traditional equity valuation are far lower.

Investing in venture capital doesn’t just offer the potential for outsized returns. In addition to generating considerable economic growth, many innovative developments result from VC-backed startups. Some examples of VC-backed startups include Airbnb, Facebook, and Alibaba.

• From a technical standpoint, venture capital can fairly be considered  a subcategory of private equity. However, when capital market participants and everyday investors talk about private equity, they are referring to firms that invest in private companies, invest in public companies to take them private, or in some cases provide funding to companies in financial distress.
• One other large difference between PE and VC investments is the way they earn returns. PE funds generally focus on companies that are established. Typically, these companies have leadership issues and are struggling with day-to-day operations. The PE funds seek to buy out a majority stake in the target company and take over management and operations. In many cases, they will also alter the capital structure of the company. PE firms use debt to achieve higher internal rates of return (IRR).
• VC firms typically invest in early-stage companies with little to no operational or financial history. Such companies generally burn through large amounts of cash to fund operations as they get started. In many cases, these companies are looking to acquire customers to flesh out their vision before ever expecting to turn a profit. In contrast to PE funds, VC firms use little to no leverage and ask for a minority stake in the company in exchange for funding and providing expertise. VC firms typically sit on the board of the company but don’t interfere with day-to-day operations.