Private Equity Trumps Venture Capital

Forget venture capital. In times of economic trouble, private equity is the way for entrepreneurs to succeed. Pro or con?

Pro: PE Is a Bridge Over Troubled Water

Core to the traditional model of Venture Capital (VC) is the assumption that, through investment in a large number of disparate, disruptive technologies, losses can be limited to the initial investment, while gains can be ridden out and, ultimately, the significance of the winners will far outweigh the losers. By their nature, VCs are looking for a big win on some and cutting losses of most. Accordingly, their investment timeframe is typically shorter. The model is built on momentum in the broader market generated by demand for more, newer ways to do things, thus requiring rapid adoption of disruptive technology by consumers (read: willingness to accept risk). This entire cycle, from inception to completion, is based on the broad willingness to assume larger risk positions. From inventor to consumer, demand for risk tends to be higher.

Private Equity investments tend to concentrate more on going concerns in established markets that may be in a down cycle, or depressed state. They are based on longer investment cycles that align with the business’s strategic objectives. Because of these characteristics, the focus tends to be on maintaining and building behind existing management structures, multiple investments in similar sectors, and a more balanced combination of financial fundamentals and growth, as opposed to purely explosive growth. The strategy tends to embrace fewer opportunities with larger investments and results in more of a "buy and hold" philosophy.

The recent collapse of capital markets, stock indices globally, and massive contraction in consumer spending all decidedly represent a cycle favoring healthy fundamentals, longer investment cycles, and a more guarded approach to risk (note the historically high volatility levels). The price-earnings ratio will tend to rule the roost in this environment, on both the supply and the demand side. Given the outlook for a slow, grinding bottom to this recovery, disruptive technologies are going to take a back seat to clean, solid, healthy technologies that represent lower risk for the purchasing agent and consumer.

Con: VC Is a Nurturer for Businesses

As with many things in life, one size certainly doesn’t fit all. A company’s funding strategy needs to take into account many things, including its stage of development, target market, customer adoption, balance sheet, and cash flow, among others. For startups, especially technology companies focused on innovation, venture capital funding is the way to go.

Venture Capitals make money by investing in companies poised for growth and striving to fill unmet needs with innovative products and solutions. They often start working with an entrepreneur at the business plan stage, nurturing along promising technology or ideas and putting the right management team in place to scale the business. VCs continue to invest in promising companies and manage their risk by making additional funding contingent on specific milestones. This also is highly motivating and provides discipline to the management team.

Private equity firms, by contrast, make money through financial engineering and generally participate at a much more mature stage of a company’s development cycle. Investment is often accompanied by leverage to increase returns and provide strict discipline for the management team.

In times of economic trouble, lending slows, thus contracting private equity firms’ ability to invest; good VCs invest throughout the cycles. Further, companies with excessive leverage can’t fund growth as much because they tend to hoard cash to service debt—this doesn’t serve the needs of a growth-oriented entrepreneur.

Many tremendous success stories started with VC funding—including Google (GOOG), Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN)—and many started in down economic cycles. Sybase and CommerceOne, two successful companies I had the privilege to lead, both started and thrived with VC funding. No private equity firm would consider investing in such risky propositions. Smart investment from VC partners during those early, critical stages makes it all possible.

Opinions and conclusions expressed in the BusinessWeek Debate Room do not necessarily reflect the views of BusinessWeek, BusinessWeek.com, or The McGraw-Hill Companies.

Reader Comments

Philp Alford

Not sure what the point of this is. PEGs and VCs are not comparable. They operate at different stages of a company's life cycle and have very different investment models (PE is leverage based) and hence return criteria for their investors. VCs provide equity capital for early stage ventures into new technologies and ideas. PEGs acquire ownership by providing liquidity via equity and debt for owners of generally mature businesses that no longer fit within a portfolio e.g. divisions of public companies, or who see opportunity to liquidate substantial positions e.g. privately owned companies.
The real question is which investor type has added more value to our economy and society as a whole. I would have to land on the side of VCs--as Hoffman remarks, just look at the companies on NASDAQ. His examples are not good as I don't believe any of these companies were started or initially funded by VCs (not sure Amazon ever had VC money?) They came later to the party but their equity and human capital did help get these companies to where they are today and hence contribute to the benefits they have delivered to all of us as their investors, customers, employees, etc.

Bob Ackerman

I've got to give this one to Mark..

Venture capital is really about financing the creation of value from ideas. At its core, the focus is on innovation. \ Risk capital backing entrepreneurs who see an opportunity to "do things better--differently" has been at the core of the innovation economy that has created more than 12.5 million jobs in America over the past 30 years, representing 17.5% of US GDP. Far from a short term investment orientation, Venture Capital tends to have a long term orientation with a focus on building new companies and creating new jobs.

Private equity has changed quite a bit over the past 10 years. Once upon a time, the PE investment focus was on taking underperforming enterprises and restructuring them to improve their competitiveness. Unfortunately, with the availability of "cheap debt" over the past 7 or 8 years--PE became about Financial Engineering--buying companies--loading them up with debt--return capital and profits to the PE firm--and selling the debt-laden company on to the public or a new buyer (the greater fool?) Jobs and value are not created in the process. If PE is to revive itself, let's hope they drift back to creating value their restructuring efforts.

Given the challenges facing our economy today--I'll take venture capital and its focus on innovation and new good creation.


Steve Krupa

When we talk about the prospects for VC and PE investing we need to think past the returns generated during the respective dot-com and credit bubbles. Both of these asset classes represent sound investment alternatives when properly executed along an investment model that looks toward long term capital appreciation. The historical model for success in both of these asset classes has been that of highly involved, private investment over a long holding period, averaging about 7 years, which is much longer than any single macroeconomic cycle (re: our current recession). The VC investor focuses on financing and building profitable companies around new ideas and new technologies, while the PE investor focuses on buying existing, usually underperforming businesses and revitalizing them through operational and financial restructuring. Today, there exist excellent opportunities for deploying these approaches, but investors will need to research to uncover firms with industry-specific expertise, valuation discipline and a long-term involved approach to corporate governance, management support and investment. In the near-term I expect VC firms to focus on later stage opportunities where business models have demonstrated some traction, while PE firms will compensate for lower debt-to-equity ratios by investing in smaller companies at comparatively lower valuation multiples. Firms that move to these approaches and demonstrate these characteristics should deliver strong results for those investors patient enough to participate in the 10-12 year life of a typical VC or PE limited partnership.

Bruce B.

I agree with Mark's side on this issue. One comment, though. Microsoft was not started with VC funding. It was self financed. MSFT did allow Dave Marquardt, then of TVI (now with August Capital), to invest a (relatively) small amount several years after MSFT was founded and before they went public. But it was not for the money. MSFT's success was well established before any venture money came into play.

mike

Venture Capital is a type of Private Equity. Duh.

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