Investigation: Can Financial Resources Close the Gap Between Venture Capital and Private Equity?
Investigation: Can Financial Resources Close the Gap Between Venture Capital and Private Equity?
Football and tennis, although both involving a ball and enthusiasm, are fundamentally distinct sports. While football necessitates team coordination and strategies for success, tennis is an individual competition that highlights precision and accuracy.
Similarly, venture capital (VC) and private equity (PE) may appear similar due to their investment nature, but they present unique approaches, risks, and expertise.
VC vs PE: Unpacking the Differences
Traditionally, VC finance focuses on early-stage, high-growth startups with the potential for extraordinary returns. These ventures are characteristically risky, often unprofitable, and leverage advancements in technologies such as AI or Web3. By allocating smaller amounts of capital per deal to a broad pool of startups, VCs aim to distribute the risks and rely on the Pareto principle—the majority of investments will break even or fail, but a few promising successes are expected to be "unicorns."
On the flip side, PE companies invest in established industries, acquiring controlling stakes in businesses like manufacturing and retail. Their objectives are to boost profitability through operational optimizations, strategic management, and financial restructuring. Since these investments are later-stage and relatively lower risk, PE funds opt for larger investments aimed at steady returns rather than explosive growth.
The Middle Ground
A gap exists between the two investment sectors, particularly for mid-sized companies that exhibit good unit economics and consistent revenue growth, typically around 50%. While these firms are appealing due to their potential, they often fail to attract PE attention due to their focus on profitability rather than growth, rendering them too mature for VC investment but exceeding the growth thresholds of VC funding and the risk appetite of PE.
Finding a Middle Path
New investment models are bridging the gap between VC and PE, providing opportunities for mid-sized companies overlooking traditional investment criteria.
A Hybrid Strategy
Over time, the lines between VC and PE have become blurred, as fund managers seek to acquire underperforming startups at appealing discounts, adopting a hybrid VC-PE strategy. These investors aim to create profits by renovating these mid-sized startups and subsequently selling them at a profit.
Shifting Landscapes
Economic headwinds, such as reduced VC funding, have catalyzed the emergence of hybrid VC-PE funds, offering opportunities for companies that have been overlooked by traditional investment models.
In the U.K., for instance, Resurge Growth Partners acquires struggling startups in order to revitalize them. It supports startups in transitioning from the VC growth model to a profitability-centric PE focus, preparing them for possible future investments. These startups are not failed businesses but instead face funding challenges, being too small for PE attention but too large for VC interest.
Similarly, Tikto Capital invests in profitable SMEs and tech businesses, helping them grow and ultimately make an exit to PE firms. In Asia, Turn Capital introduced their Opportunities Fund, which focuses on acquiring controlling interests in undervalued companies with promising potential upsides.
Geographically, this shift has been more prevalent in the U.S. and E.U. The funding ecosystem is primarily composed of ex-tech founders with the necessary skills to acquire and revitalize startups. In contrast, VCs in Southeast Asia have tended to be ex-bankers and executives of traditional businesses, focusing on encouraging growth and boosting valuations before exiting.
Adapting and Diversifying
In response to the challenging market conditions in the VC sector, some VCs have adjusted their approaches, such as by adopting PE-like strategies or exploring alternative investment opportunities. Some Web3 VCs have even begun trading liquid assets, like DeFi tokens and stablecoins, in pursuit of quicker returns and lower risks.
This diversification does not come without challenges, however. VCs may lack expertise in these areas, requiring collaborations with investors having the necessary skills to help them navigate new investments.
For context, many VCs are considering shifting strategies as the Web3 sector has slowed since 2023, with Bitcoin surging following Trump's election victory. Additionally, valuation disparities have closed, eliminating early-stage discounts, and some Web3 startups have even conducted "KOL rounds," offering better terms to influencers than early backers.
However, transitioning to alternative strategies can come with obstacles.
Exploring Alternative Strategies
While VCs could potentially explore PE or trading opportunities, their success may be limited without specialized expertise. In order to minimize risks and ensure the best capital allocation, VCs should consider partnering with skilled investors to navigate new avenues.
In the event a VC moves toward PE, launching a new fund with a "dumbbell approach" might be a more prudent step than raising capital to make later-stage investments for an existing fund. This strategy would prove more justifiable to limited partners (LPs), and it could also facilitate knowledge sharing and skill complementarity, thus preparing VCs to contribute to later-round investments.
For teams diving into territories beyond their primary skills, it's crucial to possess the right abilities. Take for example, one of the founders of Resurge Growth Partners, who played a significant role in crafting the European PE business of a major asset manager. Meanwhile, another collaborator spearheaded a VC that funded high-growth enterprises across the United States and the United Kingdom.
In terms of shifting away from VC, venture capitalists might explore creating succession funds. These funds enable them to restart the clock on assets from prior funds by transferring them to a new entity they manage. Although more popular within PE, some VC firms like New Enterprise Associates and Insight Partners have developed such institutions. This provides them with an extended period to see returns materialize amidst financial droughts.
As we draw closer to 2025, I predict VC-PE blend funds gaining significant traction as consolidation of startups and investment funds accelerates. Only the most robust will survive, yet I believe these survivors will prosper. Additionally, I foresee a heightened focus on cash flows and the route to profitability, rather than the undying pursuit of growth at any cost. Excessive revenue multipliers may well disappear from the picture.
Please note that the following information is not financial, tax, or investment advice. You should consult a licensed expert regarding your specific circumstances.
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Joash Lee, a venture capitalist with expertise in both VC and PE, saw an opportunity in the mid-sized gap by founding a hybrid VC-PE fund. This fund, Resurge Growth Partners, aims to revitalize struggling startups and prepare them for profitable acquisitions by PE firms.
Similarly, private equity investor Lee has partnered with Tikto Capital, investing in profitable SMEs and tech businesses with the goal of eventual PE exits. Lee's versatile approach illuminates the blurring lines between traditional VC and PE investments.