THE DIFFERENCES BETWEEN VENTURE CAPITALISM, PRIVATE EQUITY, AND HEDGE FUNDS
Shows like “Shark Tank” or “The Prophet” are more than likely to ring a bell. For many, these shows give a glimpse of the business world and what goes on behind closed doors. While these shows may be informative in highlighting colloquial business lingo, they provide just an introduction to the investment world, leaving out the details that are vital in the decision process.
Three common investment vehicles are: Venture Capital, Private Equity and Hedge Funds. They all share a common purpose—make the investors money. However, they do so in different ways.
Venture capitalism (VC) funds are intended for investors seeking equity stakes in startups, small businesses or entrepreneurs with a promising business idea. In other words, VC funds are meant to fund the dreams of infant ideas with a lot of potential. Though VC funds generally tend to be in the form of capital, it is not uncommon for these funds to also offer technical or managerial expertise. The first step when any young business is seeking VC funds, they approach a venture capital firm or an angel investor with a pitch that includes their product or idea, a solid business model, their operating history, and other relevant information. If the investor or firm believes in the pitch, due diligence is then completed and the firm or investor will pledge an allotted amount of capital in exchange for equity in the company. The now budding business will then be left with the resources that they need to move their company forward. With that said, the VC firm or investor knows that their equity in the company is not permanent. Venture capital funds are made with the intention of an exit plan. The firm or investor will customarily exit the company within a few years after acquiring an initial public offering (IPO) or via a merger, both being dependent on the company’s successes (1). VC firms and investors aim for high stakes for high rewards.
Private equity (PE) funds are quite similar to VC funds in that they are used to acquire equity in a company, however there are many differences that need to be highlighted. Unlike VC funds, PE funds are not exclusive to startups and small businesses (2). PE funds are often used to acquire equity in companies in any industry that are not publicly listed or traded but are usually well established and mature companies. However, they can be used to purchase publicly listed companies with the intention of taking control of them and pulling them from public stock exchanges to make them private. Most often, private equity firms will use large amounts of capital to have complete or near complete control of a company in order to chart its future business plans. VC firms however, usually acquire less than half of the company’s equity so that their risk can be diluted. Start-ups and infant businesses tend to be more unpredictable whereas a mature company will have a track record. PE firms are able to amalgamate their money into a single company because the risks are slimmer with an established company, thereby giving the firm an opportunity to revamp the company’s infrastructure in hopes of generating more profit. Similar to VC funds, PE funds are invested with the intention of an exit plan. Once the acquired company has increased their overall worth commonly within a 5-10-year window, the PE firm makes an exit by selling their stake in the company; higher stakes for high rewards.
A Hedge fund (HF) is a group of investors that come together with consolidated funds and use specialized firms to guide their investment. Unlike VC and PE funds, HFs are intended to bring the investor quick gains and returns, thus focus is for the short term. HFs commonly amass small stakes in companies or highly liquid assets like equities, bonds, and currencies, offering wider investment latitude than any other fund (3). The advantages of HFs are with the right investment strategies, they can yield profitable returns when equity and bond markets fluctuate. They also offer diverse investment styles to provide the investor a more tailored strategy that fits their needs. HFs can generate profit faster than VC and PE however those profits are often in smaller amounts. HFs tend to be riskier but are ideal for those with looking to invest large sums of money for irregular but positive returns.
The bottom line is that every investment is made with the goal of generating more money. Venture capitalism, private equity, and hedge funds represent three common ways that investments are made, all having their own unique way to acquire a positive return. The choice ultimately lies in the investor to choose the right strategy and right portfolio for their money.