Difference Between Venture Capital and Private Equity
It’s not surprising that many people believe venture capital and private equity are essentially the same thing. After all, both have the same goals of investing in companies that have demonstrated a potential for high growth. Both methods raise money for investment and represent roughly $4 trillion in assets around the world.
Main differences between venture capital and private equity
But there are important differences that makes venture capital a different animal compared to private equity. It is such differences that distinguish each method of raising and investing money into companies that demonstrate the potential for serious profit. Before getting into what makes each method different, it is important to understand the similarities.
Similarities between venture capital and private equity
The primary similarity is that both venture capital and private equity are raised from investors. These investors are called Limited Partners or LPs.
The LPs may represent the following.
- Insurance Companies
- Pension Funds
- Sophisticated Investors
Once the money is raised and invested into a company, the goal is to sell once the assets grow in value over time. The companies that are the target of investments are either private or have become private. When the targeted goal has been reached, the investments are then sold.
In addition, there is a 1.5 to 2% charge levied on the LPs for management purposes based on the company’s assets. This fee may be lowered over time as the company grows. Plus, if the firm reaches what is known as the hurdle rate, a carried interest on the profits of the company will occur.
In many ways, venture capital and private equity seem to be quite similar, but the differences are quite stark in other ways. For the investor, it is the differences that will matter when choosing which method is right for their needs.
Differences between private equity and venture capital
Perhaps the most noticeable difference between each method is how they are used to garner strong returns on the investment. Private equity tends to have a higher profile because this method is used to purchase larger percentages of companies that tend to be big and well established.
Venture capital is more focused on startup companies that tend to be smaller but have considerable growth potential. But there are other important differences that should be noted.
Private equity has no real specialization when it comes to the companies which are the target of investment. Any company that has considerable growth potential may be targeted by private equity.
Venture capital mostly focuses on the technology industry, including biotech and cleantech. However, this does not exclude other types of industries, but venture capital seems to be focused in the technology field.
Majority Vs Minority Controlling Interests
The venture capital method is used to purchase a minority interest in the company’s assets. This is quite different from private equity where the majority or controlling interest is purchased. In fact, 100% of the controlling interest may be purchased depending on the circumstances.
Other differences include venture capital using strictly equity to make the investment into a company. While private equity tends to combine equity and debt as its primary method. But perhaps the most important difference is how each expects to earn its profits
How to private equity and venture capital make money
Private equity is used with the intention that the company enjoys long-term success. All it takes is a single company to fail in reaching its potential for the private equity to go down as well. This means the focus is on safer risks that provide a better percentage of success over the long term.
Venture capital is often used to buy into many companies that fail. But the goal is to strike gold with a company that succeeds wildly, such as a Facebook or Microsoft. One success can reap considerable rewards that are more than worth the risk of failure with other investments.
This difference can be seen in how each method oversees the daily activities in the companies that are the target of investments. Private equity, because it owns the controlling interest, will take a much more involved approach to the running of the company to help ensure success. Venture capital is not really interested in the day to day operations which is why they only take a minority interest.
Why the Differences are Important
You could say that venture capital is focused on people. It is the potential of the person or group leading the company that attracts venture capital. The promise that a person has in taking a startup company in the technology field tends to bring in venture capital for the potential of a massive profit gain.
Private equity is focused on the company. It’s potential over the long-term as it grows and fills an important niche in the marketplace. It’s much more of a calculated effort for private equity in terms of how the company will succeed in the coming months and years before it sold. Venture capital is more focused on the fast-rising potential of new companies run by promising management.
It is true that over the years the lines have blurred somewhat between venture capital and private equity. This mostly comes from venture capital that has moved into more mid and late-stage growth of companies instead of being entirely focused on startups.
However, private equity is now being used earlier in the life of companies than it ever has before. While this is a risk that goes against the normal practice of private equity, the growth potential is now being calculated as a more acceptable risk.
Both methods are viable for investing in companies at various stages of their growth. Venture capital is more interested in the explosive growth of a new company and selling when the assets reach peak value. While private equity is more interested in companies that are safer risks, having a more assured place in the market.
For the investor, it is the intent that will make the decision between either method. This is why research and proper evaluation is important with both methods, even if venture capital is more willing to take bigger risks.