There has been explosive growth in both the size of the market for private assets and the demand for those asset classes from institutions, the historical investors in the space, all the way to individuals. 2021 has been no exception as IPOs continue to pop and M&A activity remains robust, both driving the returns for private investors and fueling interest from new investors. As someone who has worked in the private investment space for many years, it is important to know what private investments encompass and in this piece I will give a quick overview of Private Equity and Venture Capital investments. This primer is meant to be a starting point for learning more about the industry and investment opportunities. As with any investment, please consult with a qualified advisor before making any new investments.
Private Equity (PE) and Venture Capital (VC) are investing strategies that sit at the end of a spectrum of private company investments. VC sits on one extreme and focuses on investing in a range of start-up and growth companies before they become profitable. (This has changed in recent years as more companies are staying private for longer, and thus VC now regularly invests in larger, profitable growth companies.) Because the majority of these companies have limited operating history and limited profits, if any, they cannot access the public markets to help finance their growth in normal times. Thus, they require private investors to provide funding to help them reach their potential. Most VC-backed companies fail and a venture capitalist is considered to be doing a good job if 4 companies in a portfolio of 20 generate positive returns. Given the high level of risk and company failure, venture capitalists expect these 4 companies to generate huge returns (10x+ their initial investments) to compensate for the losers. Most positive exits occur through IPOs although strategic M&A is a major exit strategy these days.
Private Equity (PE) sits on the other extreme of the spectrum and invests in mainly mature, profitable companies and some growth companies, that can handle leverage to help generate investor returns. PE investors typically invest in the equity of private companies and use leverage to fill the valuation gap. Valuations are generally based upon a measure of modified cash flow, EBITDA. PE companies are able to tap the public and private financing markets to finance their operations due to their size and positive operating history. PE funds (traditionally Limited Partnership vehicles) will typically have 10 to 15 companies in a portfolio and expect all of them to generate positive returns with low losses. Any returns over a 3x multiple of invested capital are considered to be a home run as most PE investors will target 2x returns and IRRs in the mid-to-high teens on a single investment. PE investors typically sell their companies to other PE firms, strategic acquirers or through IPOs. In recent years we have seen SPACs (special purpose acquisition companies or blank check companies) become an increasingly popular way for venture and private equity backed firms to go public. They have their own risks to consider, but that is outside the scope of this article.
Venture Capital and Private Equity investments have continued to increase in popularity due to recent high returns in a low interest environment and a perceived low correlation with public market returns. If this continues, no one knows and, frankly, the industry remains relatively opaque and not suitable for most investors. While an investment in a PE or VC fund may seem sexy right now, they tend to be very expensive, are hard to sell, and require a lot of knowledge to understand good investment opportunities from bad. If you choose to look at PE or VC investments, please work with an advisor with experience in the space. Funds that have access tend to be those that are unproven or less desirable. If you have questions about funds you are considering, please reach out and we will be happy to provide some basic questions to ask and things to watch out for as you complete your due diligence. As always, caveat emptor.