Blurring Private Equity and Venture Capital Distinctions

Most financial industry professionals would consider private equity and venture capital firms as competitors or at least semi-competitors. On the one hand, both types of firms are after a fixed amount of investor cash.  In this sense, private equity and venture capital firms are competitors after the same color of cash.  Firms within their respective categorizations also compete with each other to be the best performing financial asset class.

On the other hand, once investor cash is allocated,  private equity and venture capital monies are generally thought to do different things, which would indicate that they are only semi-competitors. Venture capital firms generally target earlier stage, more risky businesses in such industries as life sciences, clean energy technology, software development, and other information technology companies.  Businesses generally on the radar of venture capitalists may lack sufficient revenue to cover working capital needs.  Venture capital firms generally aim to invest in pre-successful companies when valuations are low.

In contrast to venture capital firms, private equity businesses generally target more mature, established firms and industries.  Private equity firms generally target a majority share position in already profitable companies.  The financing for many private equity deals generally stems from cheaply (or expensive) available debt, with the target firms’ cash flow and assets used to cover bank lending takeover costs.

These distinctive categorizations are becoming less black and white since the onset and recovery from the 2008 financial crisis according to Nick Hazell and Simon Walker of the international law firm Taylor Wessing LLP.  These two observers, and many others, find at least three reasons for the current shift:

• First, although still somewhat nervous due to macroeconomic conditions, both private equity and venture capital firms have a lot of cash (or access to low cost financing) that is searching for an investment opportunity.  With so much cash comes the willingness to allocate resources in areas previously off-target.
• Second, in conjunction with the availability of cash is the heightened attention (more so than ever) to being the best performing asset class and fund (a good part of this is due to the availability of return data over the past 20 years).  With the competitive market as a backdrop, private equity and venture capital firms are looking at deals with higher expected returns, and that pushes these firms into previously uncharted territory.
• Third, private equity and venture capital firms are timing the economy.  The current state of the economy can rightly be classified as being in a moderate recovery stage.  Given that continued growth is likely over the coming two to three years, venture capital firms are shifting attention to companies with stronger revenue growth.  These firms generally have less downside risk, so even though such deals require higher initial investment, venture capital firms may evaluate such deals with a higher expected return than the earlier stage companies previously in the target range.  At the same time that venture capital firms are considering later stage companies, private equity firms are moving towards earlier stage companies.  Private equity firms are moving in this direction due to a higher expected return on technology companies – among others. Technology is not the only industry behind this shift, but is the main driving industry behind the private equity industry’s move towards venture capital territory.

Overall, the line between private equity and venture capital firms’ business models is being blurred by market pressure to be the best performing asset class, availability of low cost debt and/or cash, and industry/economy timing factors causing professionals from both industries to consider deals previously off the table.