What’s the Difference Between Private Equity vs. Venture Capital?

For those who are new to alternative investments, the terms “private equity” and “venture capital” can be a bit confusing. What exactly are they? And what is the difference between private equity and venture capital?

To help you make sense of these popular private market opportunities, we’re comparing private equity vs. venture capital—as well as discussing the reasons you might consider investing in them using an IRA. 

Let’s start by defining each.

What Is Private Equity?

Private equity (PE) refers to the equity or ownership of shares/assets in companies that aren’t publicly traded.

As such, there is no centralized platform through which the general public can access private stock. For this reason, 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
• 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.

Private equity firms often finance acquisitions and buyouts with debt. Such deals are known as leveraged buyouts (LBOs). PE firms then attempt to create value by implementing operational and managerial efficiencies in the target firm.

A big chunk of created value comes from the method of exit, i.e., the manner in which the PE firm liquidates its investment in the target firm. This can be done through:

• An initial public offering (IPO)
• A secondary sale to an investor
• A management buyout (MBO)
• Liquidation of the company

One of the main reasons for PE’s outsized returns is its long-term outlook. The managers of public companies often come under pressure from investors and traders to drive share price increases. This is a short-term goal and often comes at the cost of focusing on more important metrics like profitability and product quality.

Private equity fund managers, however, don’t have to answer retail investors and can focus on the long-term prospects of the acquired company.

There are a number of ways in which retail investors can invest in private equity. The most popular of these are business development companies (BDCs), which are private equity investment firms that issue publicly traded equity.

Another option for Main Street investors is purchasing shares of an exchange-traded fund (ETF) that holds shares of a PE firm. ETFs are similar to mutual funds and usually attempt to replicate the performance of an index, but they are more liquid than mutual funds and can be bought and sold continuously during trading hours.

What Is Venture Capital?

Venture capital (VC) is a category of private equity that focuses on investing in early-stage companies. (Sometimes even at the idea stage!)

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 power of large corporates.
• Some startups are based on innovative ideas with no proven market for their product.
• The success or failure of startups depends on the character of the entrepreneurs and their ability to judge market sentiment and consumer preferences effectively.

At an early stage, there are very few financial metrics to judge, and venture capital firms often make investments based on their intuition.

As a result, 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, though. 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.

Read more: 10 Companies Founded During a Recession

Comparing Private Equity vs. Venture Capital

From a technical standpoint, venture capital is a sub-category 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 significant difference between private equity vs. venture capital 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. These 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. In many cases, these companies are looking to acquire customers before turning 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.

Why Invest in Private Equity or Venture Capital?

Going public is a long and often tedious process that takes companies anywhere from months to several years. This discourages many companies from listing on publicly traded indices.

As a result, the number of publicly traded companies in the U.S has fallen by close to 50% over the last 25 years. As an investor, this means that there are fewer opportunities for you to invest in promising companies at an early stage if you exclusively invest in public companies.

However, you can gain access to these companies through investing in private equity and venture capital funds. PE investments are also often connected to low levels of return correlation (meaning their performance tends to be independent of other asset classes), which makes them excellent for investment diversification. Apart from the tax benefits, this also helps investors counter risks and generate a better, more spread-out portfolio.

Read more: What You Need to Know About Investing in Startups

Invest in Private Equity and Venture Capital Using Your IRA

Want to invest in private equity or venture capital? Traditionally, you had to be wealthy and well-connected to invest in private equity and venture capital opportunities.

Not anymore.

Alto makes it easy to invest in alternative assets—including private equity, venture capital, real estate, securitized collectibles, and crypto—with all the tax benefits of a traditional or Roth IRA, plus surprisingly low investment fees.

Whether you’ve accumulated a healthy nest egg or are just starting to plan for the future you want, Alto provides everyone the opportunity to invest in private equity, venture capital, and more.

What’s more, by doing so in a Roth IRA specifically, you’ll never pay taxes on your gains so long as you wait until eligible to take distributions.

Open an  Alto IRA today and start investing in the opportunities that most interest you. Who knows, you might just invest in the next Facebook or Tesla.

Originally published March 22, 2022