10'000 Hours / Getty Images And while you’re unlikely to find yourself directly involved with private equity or venture capital in the future, it’s important to understand how these deals may affect investors.
What Is Private Equity?
Private equity refers to the investment in a private company in exchange for controlling interest in the firm. A private equity firm often takes an active role in the management of the companies it invests in. When a private equity firm makes an investment, the money is typically pooled together from all the investors, then used on behalf of the fund. Investors in private equity often include high net worth individuals, insurance companies, pension funds, and endowments. One of the most well-known private equity firms is Blackstone. The company’s investors are primarily institutional investors, such as endowments and pension funds. The firm specializes in purchasing the majority stake in established companies and helping them with growth. Their current holdings include Bumble and Ancestry, among others.
What Is Venture Capital?
Venture capital is technically a form of equity financing. Private firms with institutional investors purchase a stake in other companies with the goal of earning a profit. Venture capital firms often specialize in investing in young companies and startups to help them get off the ground and grow. An example of a venture capital firm is Google Ventures, which backs founders and startups across a variety of industries. To date, the company has invested in more than 500 companies, with roughly 300 active investments. Google Ventures has many well-known companies in its portfolio, including Uber, Stripe, 23 and Me, and more.
Private Equity vs. Venture Capital
Private equity firms tend to invest in more established companies with five or more years in operation that have had the chance to prove themselves. Venture capital firms tend to target newer companies and startups. The companies they invest in can have as many as five years in business, or they may be just getting off the ground.
Ownership Status
When private equity firms invest in a company, they purchase a majority share and take an active role in management. They don’t necessarily purchase 100% equity in the company, but they generally acquire at least 51% to have a controlling share. Venture capital firms are more likely to be minority investors in a company. They tend to purchase less equity and allow the current management to maintain control, betting that it will result in higher profits.
Investment Size
Private equity firms purchase more established companies, and they purchase a controlling share (as compared to a non-controlling interest). As a result, private equity deals are far more expensive. These firms could spend hundreds of millions, or even billions, of dollars in their investment. Because venture capital firms are acquiring a minority stake in a company and targeting newer firms, they don’t usually put up as much money. They might spread their total investment out over many phases, putting in anywhere from $1 million to $10 million in the early stages.
Tools
Private equity firms often use leveraged buyouts to purchase a majority stake in other companies. As a result, they use a combination of both debt and equity. Venture capital firms, on the other hand, rely more heavily on equity. They may rely on debt as well, but that would be more likely during later investment rounds rather than the early stages of investment.
Expectation of Return
The ultimate goal of both private equity and venture capital firms is to make money, yet the two types of firms have differing expectations. Because private equity firms invest in more established companies that have proven themselves—and because they purchase a majority stake in the company—they have a higher expectation of return. A private equity firm would expect two to three times their initial investment on each deal. Venture capital firms, on the other hand, typically invest in younger companies. These investments are more of a leap of faith, meaning there is more risk involved. They expect a greater return than private equity firms on the deals that turn a profit but expect that a majority of their return will come from just a few investments. The rest may result in losses.
Similarities Between Private Equity and Venture Capital
Despite the differences between private equity and venture capital, they also have some critical similarities. First, both private equity and venture capital involve outside investors putting money into companies in the hopes of a return on their investment. This often happens when the company either goes public or is acquired. Private equity firms and venture capital firms are also structured similarly. Both of these firms are usually limited partnerships, where one or more partners manage the money, while the others simply contribute. In the case of these investment firms, the limited partners are often private individuals, companies, or pension funds. The general partners are those at the fund handling the investment decisions and process. Ultimately, private equity firms and venture capital firms have the same end goal: to maximize profits.
What It Means for Individual Investors
Individual investors are rarely involved in private equity or venture capital unless they have very high net worths. But this doesn’t mean these deals have no effect on investors at all. First, an investment from a private equity firm or venture capital firm can be extremely beneficial for a company. Not only will that company have more financial resources at its disposal to help it grow, but in the case of private equity, it also means hands-on help in managing the firm’s growth. Such an investment could even propel a company toward an initial public offering (IPO). This was the case with Bumble and Uber. Both companies eventually went public after private equity or venture capital investments. That being said, the opposite can happen as well. For example, Keurig Green Mountain, Inc. was a publicly traded company up until 2015. The company was acquired by an investor group, causing the firm to go private. Existing shareholders then each received $92 per share, and the company ceased trading on the Nasdaq. As you can see, individual investors can be directly impacted by certain private equity deals. This type of situation would be less common with venture capital deals, however, since those firms are newer and less likely to be publicly traded.
