Private Equity vs. Venture Capital

Year 2021 has been a landmark year for dozens of privately held businesses in India! In the first four months of the year, our country has churned out at least 10 billion-dollar startups and attained the coveted unicorn status. During the same duration, more than 15 companies came up with initial public offerings (IPOs), marking an end to their unlisted status. When we dissect the evolution of these businesses, we notice that while a wide variety of investors provided the necessary financial support to the founder(s), one category of investors abbreviated as, “PE/VC” appears very frequently. The term stands for Private Equity/Venture Capital and refers to all kinds of funds that pool money from a bunch of investors which are then used to acquire equity stakes in unlisted firms. 

Private equity (PE) is actually a broad concept which can be generally applied to investments made in non-public companies. Venture capital (VC) is a very specific case of private equity which is involved in funding startups in their nascent or early stage. Venture Capitalists (or VCs) become the initial financiers when other lenders like banks are not in a position to give loans. Over the years, as VCs started taking large bets and shoveling millions of dollars into younger companies involved in unproven, cutting edge technologies, their popularity amongst the entrepreneur community skyrocketed.

While technically, VC is a subset of PE, today we have ‘typical PE firms’ and ‘typical VC firms’. They differ in many ways- they tend to buy stakes in companies of different types and sizes. Even the total disbursement amounts and percentage of equity ownership can differ significantly. Let us get more clarity on these differences

PE vs VC: Financing corresponding to life cycle of a company

The business life cycle analysis helps in mapping out the different stages and corresponding funding requirements of a company. During the inception stage, it may require pre-seed or seed funding to convert its idea into a business. As the start-up successfully moves to the next stages of growth, additional external financing is sought out in subsequent funding rounds starting with Series A, then Series B, C, D, and so on up till the IPO date. The financial institution specializing in funding operations early on is called a Venture Capital firm and the one investing in final stages of company’s development (and even much later in maturity phase) is referred to as Private Equity firm. 

In order to meet their stated objectives, these firms structure and launch VC fund(s) and PE fund(s) respectively to form a portfolio of unlisted companies:

• #1- VC Fund: Typically invest in a portfolio of “Early stage”, fast-growing innovative startups. 

• Consider Singapore-based venture capital firm BEENEXT which closed BEENEXT Emerging Asia Fund in June 2020. A press release stated that fund will also target early-stage Indian startups in the ecommerce, fintech, healthtech, agri-tech, edtech, and AI/data driven technology domains.
• Some of the world’s leading VC firms are- Intel Capital, Accel, Sequoia Capital, New Enterprise Associates, Bessemer Venture, Khosla Ventures, etc.
  
• #2- PE Fund: Commonly invest in a portfolio of more mature/stable companies or revenue generating companies looking for some revitalization
  • The Kiwifruit Fund by Original Capital Fund 1 is a good example of private equity fund dedicated to investing in the New Zealand kiwi fruit sector. The horticulture industry has been around for centuries and is a proven business model.  The strategy is to apply the capital in existing orchards or development of orchards so that consistent cashflow yields can be offered to the investors. Consequently, PE fund is highlighting stability and sustainability as main investment theme. 
  • Some of the world’s leading PE firms are- KKR & Co., The Carlyle Group, TPG, The Blackstone Group, Warbug Pincus, Advent International, etc.

Other key differences

The average number of investee companies in a VC fund will be usually much higher than a PE fund. Why is it so? It is because VCs take on substantial risks. The idea is still untested or the business model is still unproven. So, most VCs prefer to spread the risk by investing in a large number of companies. On the contrary, there is a relatively limited risk for PE firms since they park money in well-established firms. 

Because of lower risk, PEs will almost always prefer to take majority stakes i.e. 51-100%, and employ more complex strategies like leverage buyouts (LBOs). VCs would keep it simple, prefer pumping money in smaller tranches in multiple funding rounds as they see young companies achieving the mutually discussed milestones or key performance indicators (KPIs).

The change in market dynamics –

Today we come across many PE and VC firms which are charting out in each others’ territory. Crunchbase news reported that PE Investors now lead a growing proportion of early-stage funding. In the last one decade, the proportion PE lead deals in Stage A and B funding has trended up from 15% to 24%. Sequoia India, a traditional venture firm, recently revealed that “it now operates seed, venture, and growth funds – a structure that allows it to remain a relevant partner for founders at all stages of their journey”. 

Why are firms changing their investment strategies making it tougher to categorize them as VC-Only or PE-Only? PE/VC players have been operating in the Indian capital market for more than three decades now. There is an intense competition among these investors to have a strong brand among founders and become the lead investor. There is a constant need to build a deal flow of the best potential deals available in this illiquid segment of the market. 

Due to these competitive pressures and the flexibility to pick up lucrative opportunities available in the market, we can have scenario #3 where a firm may participate in both early-stage (seed/early-growth) and later stage (expansion/replacement) financing rounds 

• #3: Invest across all stages in a lifecycle of a firm
• Poseidon Asset Management based in US focuses on the burgeoning cannabis industry. They have successfully launched two funds till date having a diversified strategy. While Fund One invested in companies covering a range of company stages, Fund Two is a venture capital fund focused on Series A and later companies. Rationale given by the company is that it wants to capture significant opportunities along the growth and maturity curve of cannabis industry.

Conclusion :

As we start to discover the fascinating world of private finance more deeply, we realize that although at first glance PE and VC firms may look alike, they have many notable differences. PE is an umbrella definition within which many different activities and types of deals may take place. VC is a form of PE specializing in funding early-stage startups. It is important for entrepreneurs and investment professionals to understand these differences in order to appreciate the purpose served by these investment funds in a better way.