What venture capital funds can learn from private equity funds?

Author: Paweł Maj, Investment Director, Warsaw Equity Group

The vast majority of investment funds focus exclusively on one model. Either venture capital or private equity. There are relatively few examples, such as Warsaw Equity Group, where we combine these worlds by investing both at VC and PE growth stages. We work with startups on strategic and operational level focusing on value creation. You can read more about our investment criteria in our tab: Investment criteria – Warsaw Equity Group

Just as important are the differences between VC and PE as the similarities that unite them. VC funds are said to be more dynamic than PE. Here, the growth of a startup is more important than operating profit. Meanwhile, PE funds are said to be more conservative and focus on investing in profitable companies.

According to analysts’ predictions, 2023 will be a time of great change in the start-up market. The article published in My Company Poland (February 2023) includes my opinion on this topic. As investors, we’ve turned away from “growth at all cost” approach and started to focus on startups that combine growth with good unit economics.

Therefore, let’s compare VC and PE funds and see what VCs can learn from PE funds.

Differences:

PE funds usually invest by buying existing shares from the current owners (cash in the hands of shareholders) and VC funds usually invest by increasing capital (new issue of shares, cash in the bank account of a given company).
PE funds typically invest in mature companies that are generating positive cash flow, while VC funds invest at a much earlier stage (before companies are profitable, and pre-seed and seed VC funds even before a finished product is created or a startup begins to generate revenue).
PE funds usually take control of a company by buying between 50% + 1 and even 100% of the shares. VC funds, on the other hand, usually invest in minority stakes (usually around 5-20%).
When investing, PE funds assume that each of their companies will be successful (i.e. their shares will be sold at a higher valuation than when they were bought), as they invest in mature companies (already generating profits and positive cash flow), which are much less risky than investing in start-ups. On the other hand, VC funds invest in startups at a much earlier stage (when they are still unprofitable, and in the case of pre-seed funds, even when a startup doesn’t have a product ready), which means that they expect as many as half of their investments to fail (defined as selling their shares for less than the value of their investment), This means that they expect even half of their investments to fail (defined as selling their shares below the investment value, and in extreme cases even losing everything if a startup goes bankrupt), but at the same time they hope that 5-10% of the portfolio companies will be spectacular successes (increase in company value by 30 times or more), enabling the fund to generate a profit for its investors.
PE funds usually invest alone and VC funds usually co-invest with other VC funds.
PE funds generate a return on their investments mainly through financial engineering (leverage buyouts of the companies they invest in) and by increasing the EBITDA of the portfolio companies (optimisation of internal processes as well as mergers and acquisitions), and VC funds mainly through the rapid revenue growth or unique IP of their portfolio companies.
VC funds invest in a much larger number of companies than PE funds. VC funds invest at a much earlier stage and with a higher risk per deal, thus spreading the risk of the portfolio and increasing the probability of investing in a fund returner (an exit that generates at least an amount equal to the size of the fund) by investing in a much larger number of companies/start-ups (a pre-seed fund should invest in +100 start-ups, but a later-stage fund might invest in only 20-30 start-ups). PE funds invest at a much later stage of a company’s development with much less risk, so they can accept a much smaller number of companies in the portfolio (typically 10-30), which also allows them to focus more on each of them.

Similarities:

VC and PE funds raise capital from external investors called LPs (limited partners), including fund of funds (private and public), high net worth individuals, pension funds, insurance companies, corporations and university endowments.
VC and PE funds invest in private companies (or, in the case of PE, in listed companies which they delist after purchase) with the aim of earning a return on their investment in the future.
VC and PE funds charge their LPs (investors) a management fee of 1-2% per annum, calculated on the value of the assets under management, and a carried interest (performance fee) of approximately 20% of the profits generated for the LPs (assuming the fund’s profits exceed the agreed minimum profit level, known as the hurdle rate).
VC and PE funds invest through investment vehicles that typically operate for 8-10 years, half of which is spent building a portfolio (initial investments) and half on building value/supporting companies and exits.
VC and PE funds expect to earn 3x the capital they have raised for their investors over the 8-10 year life of the fund, although each has a diametrically different approach to portfolio risk management.
VC and PE funds are very selective, investing in around 1% of the companies analysed.

What VCs can learn from PE funds:

Involvement in each portfolio company as an owner, not just a minority shareholder.

VC funds focus primarily on supporting their stars (best performing companies with the potential to return 30x or more of the amount invested) and spend less time or none at all on their remaining portfolio companies. PE funds, on the other hand, support each of their portfolio companies, working to build value and maximise the potential sale price, as each investment (even the less successful ones) has a significant impact on the performance of the overall fund. In addition, PE funds commit their entire teams to supporting portfolio companies, employing advisors, experts and mentors not only to help with the next round or exit, but also to provide strategic and operational support.

Take full responsibility for each portfolio company.

VC funds often co-invest with other VCs, with the lead investor (usually the fund that invests the largest amount in each round) having the most decision-making power and the other investors in the round playing a more passive role. What’s more, in the case of a next round, new investors (including a new lead investor in particular) take over decision-making from existing investors. This blurs the lines of decision making and responsibility in the company, and at the same time the founders/managers of the company are often faced with a dilemma in taking advice, especially if it is conflicting.

On the other hand, PE funds invest alone and take full responsibility for the portfolio companies, as they are the only investor and cannot transfer responsibility to anyone else. From the company’s perspective, this means that a PE fund is much more involved in supporting its portfolio (hiring a much larger team, investing more time and resources), which also translates into a much higher probability of success for such an investment.

A long-term approach to working with portfolio companies.

VC funds invest with a 3-5 year horizon to exit, but they work closely with their startups for the first 12-24 months after their investment, hoping that the startup will attract more investors in the next round to take responsibility for its growth. This short-term perspective also applies to the approach to financing capital needs – VC-backed startups are indeed in a continuous fundraising process (the interval between rounds is on average 12-24 months), and most of the cash raised in follow-on rounds comes from new investors.

On the other hand, PE funds take a long-term approach to their investments, remaining hands-on throughout the investment period and providing their companies with all the capital they need to develop until the exit (PE fund portfolio companies usually do not need to raise capital from follow-on rounds until the company exits or at least goes public). For the company, this means that it can focus fully on its operations without being distracted by raising the next rounds of financing, as is the case with VCs).

Careful approach to investments in terms of valuations and due diligence.

VC funds decide relatively quickly to invest in a given startup (usually within a few weeks from the first meeting to the signing of the term sheet), often accepting high valuations relative to the stage of the project and its traction (in this case, VCs assume that the startup will quickly grow up to its valuation, an extreme example of which we saw between the 2020-2021 bull market, during which investors accepted valuations several times higher than the long-term average), and conducting superficial due diligence.

On the other hand, PE funds take months, not weeks, to make an investment decision, approach the company’s valuation cautiously (assuming that the EBITDA multiple at the exit will be similar to the one at the time of investment, so that the increase in the company’s value, which will generate a profit for the fund, will come mainly from the increase in EBITDA during the investment period and possible financial leverage of the transaction), and carry out in-depth due diligence (covering the team, the company, the technology, the market, the competition).

Ongoing operational involvement with portfolio companies.

VC funds rarely become operationally involved (focusing mainly on helping their portfolio companies raise capital and exit), and when they do, they respond to existing problems by putting out fires rather than systematically building value.

PE funds, on the other hand, analyse each of their companies in detail and become operationally involved if there are alarming signals, bringing in external advisors/experts if necessary.

Article was originally published in Polish language in January 2023 (MamStartup.pl):Czego fundusze venture capital mogą nauczyć się od funduszy private equity? – MamStartup