The Private Equity and Venture Capital Masters of the Universe
What do they do, how are they similar and different, and why are they so rich?
The big tech companies that now run our lives were initially funded with venture capital — Amazon, Apple, Uber, Facebook, Google, Microsoft, Netflix, and others such as Moderna (of COVID vaccine fame). And, many of the best known consumer bankruptcies of recent years were owned by private equity firms — Bed, Bath, and Beyond, Serta, Toys R Us, Sears, Hertz, J Crew, Friendly's Restaurants, and Neiman Marcus, to name a few.
Do you ever wonder what these venture capital (VC) and private equity (PE) masters of the universe do, how they generate such wealth (for themselves), how they are similar and different? If so, read on.
How are they similar?
1. Funders
VC and PE firms raise investment capital from large sophisticated investors such as pension funds, college endowments, and super-wealthy families. Why them? As Willie Sutton once explained about robbing banks, “that’s where the money is.” These investors are the limited partners (LPs) and the VC and PE firms act as the general partners.
2. Liquidity
These investments are illiquid. The LPs commit funds for many years and, unlike mutual fund investments, the LPs must accept being unable to get immediate access to their invested funds. These investment returns are typically not distributed for many years.
3. Compensation
The general partners are compensated in a structure known as "2 and 20." They receive a management fee of 2% of the invested funds each year as well as 20% of the investment profits that are generated by the fund. Even if the returns are low, the firms still receive their 2 and 20. If you're thinking it's a "heads we win; tails we don't lose" structure for them, you’re astute. Nice work if you can get it, but it's a mystery why the LPs pay such high fees.
In addition, this compensation provides the infamous carried interest that is taxed more favorably than ordinary income. The compensation and tax structure has created this billionaire class of general partners.
4. Deal structure
The financial engineering is complex and sometimes not fully understood by anyone other than them and their lawyers. The deal terms are designed to protect the interests of the general partner firms, sometimes to the detriment of other involved parties such as LPs, employees, lenders, local communities, and, perhaps, other shareholders.
5. End game
The ideal outcome is either a sale of the business or an initial public offering. At that point, these investments may be "cashed out" and the proceeds are ultimately returned to the LPs. In the industry patois, this is a liquidity event.
Dunkin' (née Dunkin Donuts) is a good example, now having been acquired by PE firms for the second time. The Boston Globe tells their story of a previous acquisition by other PE firms in 2006, followed by going public in 2011, and now followed by going private again. Most recently, they’re known for the brilliant Ben Affleck TV commercials (here and here) and their stylish tracksuit merch. Who said PE firms don’t add value?
How do VC and PE firms differ?
1. Target companies
VC firms invest in smaller, high-growth, and unprofitable companies that are in need of investment (so-called "growth capital"). PE firms invest in mature, lower-growth, and usually profitable companies that are perceived to be under-performing, in need of operational re-engineering, or offer an opportunity for industry consolidation. VC firms want their portfolio companies to maximize growth; PE firms want their companies to maximize profitability and cash flow.
2. Investment size
VCs make minority investments. They don't fully control these companies but have influence through seats on the board of directors. PEs buy complete ownership in their companies and fully control the company's strategy and operations.
3. Success rate
VCs expect most of their investments to fail, but a few will generate huge returns (the so-called "power law" in the patois). PEs expect most of their investments to succeed, but with smaller profits from each of them.
To use a baseball metaphor, VCs swing for home runs, knowing they'll often strike out; PEs hit for lots of singles and doubles while trying to minimize strike outs. As in baseball, either approach can be a winning strategy.
4. Deal structure
VC-funded companies have little or no debt. This is sensible because they are not generating positive cash flow and thus would have no ability to sustain debt repayments. PE-owned companies take on the maximal debt they believe the company's cash flow can handle. In this manner, they are leveraging the equity investments they've made. In an earlier era, these deals were known as "leveraged buy-outs." That term became declasse and they were rebranded as the more respectable-sounding private equity. Same soup, different urn.
For investors, how do these asset classes perform, net of fees?
It's hard to know. Certainly some VC and PE funds generate very high returns, and the firms are sure to brag about those, but it is unclear whether, over time, they consistently do so as a group as there's no comprehensive and publicly available database of investment performance.
It is likely that, as in most things in life, there is a wide range of performance where some firms’ investment funds have generated enormous returns, while others languish in the land of mediocrity. Because the fees are so high, much of the profits accrue to the investment firms themselves, rather than the LPs who have provided the risk capital.
For employees, which target company is a better place to work?
A VC-funded company can be a great professional experience when things are going well. There’s high growth, capital is available for new investment opportunities, career development opportunities abound, and employees often receive valuable stock option grants, along with the requisite espresso machines and on-site massages.
However, if the business is struggling, the company may be unable to raise more capital. In that scenario, it can face a death spiral and be forced to shut down with little warning. We hear about the success stories but the reality is different. Most VC-funded companies ultimately fail with the stock options worthless and the espresso machine a consolation prize in an ex-employee’s kitchen. You don't hear as much about those outcomes.
PE-funded companies face slower growth and pressure to cut expenses. This is partly because they have taken on so much debt to generate cash for the investors. Layoffs and benefit cuts can be part of the turnaround strategy and this is demoralizing. However, the company should have significant value — otherwise the PE firm would not have made the acquisition — so it is unlikely to go out of business. For the surviving employees, there is more job security than with a VC-funded company that was doing poorly.
The biggest risk with PE-owned companies is the enormous debt burden that they typically carry. If the economy sours or business tanks for any reason — e.g., a pandemic or a recession — the company has little financial wiggle room and bankruptcy can follow. If you live in Massachusetts, you may be following the Steward Health Care debacle. It’s a good example of who pays the price when a PE deal goes south. (Hint: it’s rarely the investors.)
PE and VC firms are high risk and return opportunities for investors. For employees and communities, they're also high risk, but rarely high returns.
As usual, pointed, articulate and enjoyable reading. Great with numbers, great with words. Thanks Jimmy!