If you read financial news, you’ve probably encountered the terms “private equity” and “venture capital.” You might even have an inkling of what these terms mean. But unless you work in the industry, you might not feel confident explaining to someone else exactly how they differ.
As it happens, private equity firms and venture capital firms have a lot in common. Often, so do their leaders. Both invest in companies that aren’t traded on public equities markets, for example. Both also aim to generate profits for their own investors.
Private equity firms have some important attributes that make them different from venture capital firms, however, and for that matter from other types of financial firms. Here are six features that private equity firms tend to possess.
1. They Often Aggregate Outside Capital
Independent private equity firms tend to aggregate capital from outside the firm. In other words, they don’t use their principals’ own money. At least, not exclusively, as family offices tend to do.
Many venture capital firms take this approach as well. However, the two types of firms may source funds from different types of investors, with private equity firms tending toward institutional investors rather than individuals.
It should be noted that some big financial institutions and fund managers have private equity divisions that act as “in-house” capital allocators. They may use only their parent companies’ money.
2. They Rarely Invest in Very Young Companies
Unlike angel investors, private equity firms tend not to invest in seed-stage companies. They even tend to avoid early- to mid-stage growth companies, where venture capital firms are more eager to invest. Instead, private equity usually focuses on later-stage and mature companies with varying degrees of growth potential.
3. They Often Focus on Specific Industries, Niches, or Opportunities
Private equity firms often target specific industries or “theses” for investment. For example, one private equity firm might focus on energy and infrastructure, while another plays in the software space. It typically comes down to the experience, strengths and knowledge of the firm’s leaders.
4. They May Act As Minority Partners or Majority/Sole Owners
Some private equity firms prefer to take minority, non-controlling stakes in companies. Others prefer to be majority (controlling) or even sole owners. Some do a mix of both, depending on the circumstances.
5. They May Take Advisory or Director Roles With Portfolio Companies
As part of their investments, private equity firms sometimes take on advisory or directorship roles with portfolio companies. This gives them more say in the companies’ affairs and can create opportunities for younger private equity firm employees, in particular.
“Organizations are beginning to understand the benefits of infusing their strategy-making process with fresh perspectives by recruiting early-career professionals to their boards,” says Harry Kraemer of the Harvard Business Review.
On the other hand, some private equity firms prefer more passive investments and don’t ask for input on day-to-day management.
6. They Often “Buy and Hold” (But Not Forever)
Private equity firms often have an investment time horizon of three to five years, according to Private Equity List. This is longer than “active management” funds focused on public equities markets but not as long as some institutional investors, such as insurance companies.
What’s in a Name?
Some professional investors, it should be noted, prefer not to label themselves as “private equity” or “venture capital” or put themselves in any other sort of box. They are simply professional investors seeking the best use of the capital at their disposal.
There’s nothing wrong with this position. However, we have seen that private equity firms do have some distinct attributes that set them apart from other capital allocators. Now that you know them, hopefully you feel up to the task of explaining what private equity firms do the next time someone asks.
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