Difference between VENTURE CAPITAL AND PRIVATE EQUITY

This article is very important for those who want to startup their own venture

Technically, venture capital is just a subset of private equity.

They both invest in companies, they both recruit former bankers, and they both make money from investments rather than advisory fees.

But if you take a look beneath the surface, you’ll see that they’re significantly different.

Technically, the term “private equity” refers to money invested in private companies, or companies that become private through the investment.

Most people in finance, though, use “private equity” to mean firms that buy companies through leveraged buyouts (LBOs) – so that’s how we’ll use it here.

A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explain the origin of the term LBO.

While both PE firms and VCs invest in companies and make money by exiting – selling their investments – they do it in different ways:

• Company Types: PE firms buy companies across all industries, whereas VCs are focused on technology, bio-tech, and clean-tech.
• % Acquired: PE firms almost always buy 100% of a company in an LBO, whereas VCs only acquire a minority stake – less than 50%.
• Size: PE firms make large investments – at least $100 million up into the tens of billions for large companies. VC investments are much smaller – often below $10 million for early-stage companies.
• Structure: VC firms use only equity whereas PE firms use a combination of equity and debt.

Stage: PE firms buy mature, public companies whereas VCs invest mostly in early-stage – sometimes pre-revenue – companies.    

 RISK

VCs expect that many of the companies they invest in will fail, but that at least 1 investment will generate huge returns and make the entire fund profitable.

Fred Wilson expects that out of 20-25 investments in his fund, 5-10 will fail, 1 will be a home run, 4-5 will produce solid returns, and the rest will be a wash.

Venture capitalists invest small amounts of money in dozens of companies, so this model works for them.

But it would never work in PE, where the number of investments is smaller and the investment size is much larger – if even 1 company “failed,” the fund would fail.

So that’s why they invest in mature companies where the chance of failing in 3-5 years is close to 0%.

Return?

You might now be wondering, “So which model actually produces higher returns?”

There is a lot of controversy over this one, but returns in both industries are much lower than what investors claim to achieve.

Most VCs and PE firms target 20% returns, but VCs have earned less than 10% returns over a 5-year period and many pension funds that invested in PE firms have also seen sub-10% returns.

One difference is that in venture capital, returns are heavily skewed to the top firms: if you think about their business model, that makes a lot of sense – invest in the 1 big winner and you’re set.

Plus, the best deals in VC almost always go to the top firms because the best deals have always gone to the top firms.

That happens in PE as well, but you can earn great returns without investing in the largest and most well-known companies.

VC'S AND PE'S IN INDIA

The Indian Private Equity and Venture Capital Association was established in 1993 and is based in New Delhi, the capital of India. IVCA is a member based national organization that represents Venture capital and Private equity firms, promotes the industry within India and throughout the world and encourages investment in high growth companies. It enables the development of venture capital and private equity industry in India and to support entrepreneurial activity and innovation. The IVCA also serves as a powerful platform for investment funds to interact with each other. In 2006, the total amount of private equity and venture capital in India reached US$7.5 billion across 299 deals.^[1]

IVCA members comprise Venture capital firms, Institutional investors, Banks, Business incubators, Angel investor groups, Financial advisers, Accountants, Lawyers, Government bodies,Academic institutions and other service providers to the venture capital and private equity industry. Members represent most of the active venture capital and private equity firms in India. These firms provide capital for seed ventures, early stage companies, later stage expansion, and growth finance for management buy-ins/buy-outs of established companies. So far, the biggest member firm of IVCA is ICICI Ventures which currently has a $750 million fund, and has $450 million under management.

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