Due to the similar structure, venture capital and private equity funds are usually confused with each other. However, they have many key differences that make them distinct from each other. Funds in general, are large sums of money that are saved up for a specific purpose. This money is regularly grown by investing and is professionally managed. Now that you know what funds are, let’s move onto what venture capital and private equity funds are.
Understanding private equity funds
Here’s the life cycle of a company-
The first slope depicts the life cycle of a private company, which climbs up and eventually meets its end. However, before climbing back down the company can choose to file an IPO (initial public offering), thereby declaring itself a public company. So when do private equity funds come into action? Observe the circled mark below the IPO. This is the point where private equity funds finance companies. As the name suggests, private equity funds are involved in buying equity from well-established companies that require a push to go public. This is a huge advantage of private equity funds, as the amount of risk is minimum and the returns are also high. The reason being, private equity funds usually buy most of the shares. Along with sufficient revenue, it also gives them more control over the firm and allows them to manage their assets effectively. With that being said, the ones on the top make millions in revenue each month. According to Investopedia,
The Blackstone Group.Inc was:
Founded in 1985 and headquartered in New York, with offices in London, Hong Kong, Beijing, and Dubai, The Blackstone Group Inc. (BX) leads with $619 billion in total assets under management.
The company invests across a broad range of market sectors, including energy, retail, and technology. While private equity ($103 billion) is its largest category of investments, Blackstone also has hundreds of billions of dollars in holdings in real estate, credit, and hedge fund solutions.
Here are the members involved in a fund:
If you opened a private equity fund, you would be the general partner or GP for short. Whereas the ones who invest in your fund would be the limited partners (LP). Essentially, you have full control over the fund and you’re allowed to make your own investment decisions. Whereas all the LPs can do is just invest and collect returns. The work environment in private equity funds is extremely stressful, especially because the LPs are constantly raging at the GP, even though they have no legal power to make decisions. However, the GP doesn’t literally do everything. There is another member involved, called the investment advisor. This handpicked individual provides investment advice to the GP. So if the GP wants to buy a company, the investment advisor will give his/her own advice about the investment. This helps the GP make better decisions and reduces the burden.
To get a deeper understanding of how private equity funds work, I recommend the book: Learn to Earn: A Beginner’s Guide to the Basics of Investing and Business
Understanding venture capital funds
Unlike private equity funds, venture capital funds invest in early-stage companies that show immense potential for growth. Tech startups in particular are the ones that receive venture capital in exchange for around 20-50% equity. Yes, they don’t buy most of the shares, since the risk is already so high. Investing in startups and bringing them public is an extremely difficult task that involves massive risk.
Here’s what scalefinance.com has said about the same:
The common rule of thumb is that of 10 start-ups, only three or four fail completely. Another three or four return the original investment, and one or two produce substantial returns. The National Venture Capital Association estimates that 25% to 30% of venture-backed businesses fail.
However, if even one of the companies manages to go public and finds success, the returns would be enormous. Although a huge chunk of the returns would be spent on gobbling up the losses, there would still be a reasonable profit for the fund to seek more investors. This high-risk high reward strategy works well for many funds. Just see how much venture capital funds make!
Members involved in a Venture Capital Fund
The two key members involved in venture capital funds are the same as those of private equity funds. However, as venture capital funds invest in startups, there are two general partners involved. One of them is an investor and the other is an entrepreneur. Both of them have to be highly skilled and experienced in their field because management is key to success.
Investopedia sheds light on the same, by saying:
Founders must have the skill, knowledge, and passion to carry them through periods of growing pains and discouragement. They also have to be open to advise and constructive feedback from inside and outside the firm. They must be agile and nimble enough to pivot the company’s direction given unexpected economic events or technological changes.
The payment structure in both funds
Now that you’ve understood both VC and PE funds, you may be curious about how the profits are distributed among the members. Suppose your fund makes a 10% return. The first 8% of all your net income goes into your investors’ (LP) pockets. Whereas the other 2% is your earning. When you reap 20% returns, however, your LPs will receive 80% of the total income and you will get a measly 20%. Now you must’ve realized that the percentage of returns collected by the GP increases with the number of returns! Your goal is to make more returns in order to get the same share of profits as your LPs. This happens when you climb up from 20 to 22%.
What do venture capital funds do?
enture capital funds invest in early-stage companies that show immense potential for growth. Tech startups in particular are the ones that receive venture capital in exchange for around 20-50% equity. Yes, they don't buy most of the shares, since the risk is already so high.
What are the two key members involved in private equity funds?
If you opened a private equity fund, you would be the general partner or GP for short. Whereas the ones who invest in your fund would be the limited partners (LP). Essentially, you have full control over the fund and you're allowed to make your own investment decisions. Whereas all the LPs can do is just invest and collect returns.
What should the GP do in order to increase personal income?
The percentage of returns collected by the GP increases with the number of returns. Your goal is to make more returns in order to get the same share of profits as your LPs. This happens when you climb up from 20 to 22%.
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