Private equity (PE) and venture capital (VC) firms have the same goal: maximising returns. Yet PE buyout and VC early-stage funds go about it in very different ways.
Many prospective investors fail to appreciate that the two most popular alternative asset classes adopt often directly opposing methods to drive performance.
VC’s deliberate diversification
In asset management, diversification undergirds risk governance and value creation. Because their trade relies on blockbusters, venture capitalists invest in dozens of start-ups.
Since only a handful of transactions will turn into winners, VCs acknowledge that luck is an important driver of success.
But diversification only matters in the early years of a fund’s life. Very quickly VCs have to home in on their most promising investments. They must systematically put most of their capital behind their star assets and disregard at least 75% of holdings. At that stage, craft takes over. That is why so few venture capitalists are consistent strong performers. Many lack talent, although they occasionally get lucky.
PE’s restrained diversification
PE fund managers do not need to diversify as much as their VC counterparts. There are two main reasons why.
Firstly, they control a portfolio asset via majority ownership or contractual terms such as supervoting rights. Unlike VCs, they can take resolute decisions without the need to placate management or co-investors.
Secondly, they target mature companies that generally do not face the kind of business and market uncertainty that affects young firms. Consequently, with leveraged buyouts, the probability of failure is much lower.
That explains why, with the exception of multi-strategy global vehicles that back numerous businesses and projects, a PE firm typically sponsors 10 to 12 buyouts per fund. For instance, the KKR Europe IV fund was allocated across 12 companies between December 2014 and March 2019.
One interesting trend in recent years: because of intense competition, many PE firms have invested funds across fewer assets. Weaker diversification could prove inadequate in an economic downturn.
VC firms coddle star entrepreneurs
Unicorn founders can do no wrong as long as the path to exit is clear. If misbehaviour puts an initial public offering (IPO) at risk, only then will the VC backer step in. Otherwise, a VC will do anything it can to support investees with the most traction.
The star performers in a VC portfolio can shoot for the moon, often through a heavy cash burn, in pursuit of an ambitious national or international rollout and the launch of many initiatives in adjacent segments. Think Uber in food delivery or WeWork in schools with WeGrow. These days such plans can get funded before proof-of-concept is asserted.
Bear in mind, the willingness among VCs to stick it out for many years – sometimes for a decade or longer – is a new phenomenon. Back in the dotcom era, venture capitalists were as short-termist as today’s leveraged buyout (LBO) fund managers.
Buyout firms quickly milk their cash cows
PE fund managers do not care much for the executives running their portfolio assets. Admittedly, some of these executives have built reputations as operational experts who can produce cashflow uplifts through such hit-and-run strategies as sale and leasebacks, non-core disposals and so on to help PE backers produce healthy returns. But on the whole, PE owners leverage the fact that they retain sole control.
Many look to re-sell companies within months of buying them to mitigate the impact of the time value of money (TVM) on the internal rate of return (IRR). This is called playing the ‘TVM game’.
Another way to play the TVM game is through dividend recapitalisations: rejigging the capital structure by repeatedly adding fresh LBO loans and upstreaming cash to recoup the initial outlay as early as possible. From that point onward, the PE owner has no downside exposure and future proceeds originating from the portfolio company will constitute capital gains.
While not all fund managers are guilty of such practices , the largest PE groups tend to implement quick flips and divi recaps on an industrial scale.
VC firms are ruthless with underperformers
At the other end of the performance spectrum, venture capitalists must shed their least-promising assets very early in the life of a fund’s investment period. Three-quarters to 90% of a VC portfolio will deliver negative or negligible returns.
Adapting rapid prototyping to business models, entrepreneurs test on a small scale first to determine whether an idea works before giving the go-ahead or the go-by to its full rollout. This partly defines venture capitalists’ policy of exiting investments that fail to deliver on early promise.
After the first four years of a 10-year fund, a VC firm should be able to focus exclusively on its most likely home runs and not spend much time on or assign any more capital to the dogs in its portfolio.
PE firms hold onto their lemons
It might sound counterintuitive, but once the equity portion of a leveraged buyout is underwater, a PE owner would rather hold on for as long as possible than cut its losses early. This is the opposite of what is taught in investment management courses.
This is due to three factors, the second two of which are most relevant:
- The longer a portfolio company is held, the more time it has to restructure, refinance, and, with luck, absorb and overcome the downturn or temporary setbacks that sapped profits. PE firms need time to preserve their equity in distressed businesses. Hopefully, something — an unexpectedly improved macro landscape, a desperate government bailout or a synergistic bid by a deal-hungry rival — comes along to save the day. This is the bias of loss aversion as applied to PE.
- As long as it owns the asset, the PE firm can keep charging management fees.
- What’s more incredible, because of how returns are calculated, selling an investee company at, say, 10% below its original equity value represents a negative internal rate of return (IRR) of 10% at the end of the first year. That compares to -2.1% annualised returns after five years or -1.05% after 10 years. To hide bad news, PE owners are better off not pulling the plug on troubled assets.
Swashbucklers and buccaneers
To sum up, PE and VC firms alike follow a two-pronged investment strategy to optimise both portfolio diversification and holding periods:
- The best-performing VCs have a long pedigree as business builders that make numerous small bets and fail fast by shedding their worst assets swiftly while backing start-ups with potential. Hence the incentive to aggressively boost valuations and hunt for unicorns to compensate for many losers.
- The PE fund managers with the highest returns are freebooting financial engineers who bet big, bag easy proceeds expeditiously and realise investment failures slowly. In this way, they seek to turn these assets around and also cushion the negative impact they may have on the fund’s blended returns. Hence the many buyout zombies wallowing in a state of aimless lethargy.
Venture capitalists are swashbucklers that seek business risk — disruption — and champion innovation to generate long-term economic value. Buyout specialists pile up financial risk — leverage — and perform liquidity tricks to play the TVM game.
PE and VC performance-enhancing techniques are not just different, they are precise opposites.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Amer Ghazzal