Many savvy investors consider venture capital to be the best asset class in the marketplace. Yet for some investors, these two simple words incite fear and terror. The mere mention of the name is enough to make them shake in their boots. In this article, we lift the lid on the crazy world of private equity and venture capital and explain why you should actively seek out both types of opportunities.
Private equity and venture capital are different, though both involve investing in private unlisted companies. Firstly, we will take a look at private equity before moving on to venture capital. Then finally we will explain how both forms of investment can play their part in turning a good idea into a multinational conglomerate, making investors seriously rich in the process.
What is private equity?
Private equity is a broad term that can involve various scenarios. Most commonly, it involves buying stakes in mature private listed companies and eventually taking them public, i.e. helping companies to float on a stock exchange. Though sometimes private equity firms get involved with the aim of the company selling out to a larger company at some point in the future. The selling company can be either a listed or an unlisted company.
Who are the key players?
Private equity investment is made by institutional investors such as pension funds, hedge funds, investment banks and large private equity (PE) firms funded by high-net-worth and sophisticated investors (HNW & SI). Because private equity involves large scale direct investment often to gain influence at board level, the industry is dominated by companies with deep pockets.
Typically institutional investors prefer to entrust specialist Private Equity firms to make the investment on their behalf. This is mutually beneficial as the private equity firm can focus on identifying companies that if given more investment can use the funds to expand and increase profitability.
Most private equity investment is not just about giving money to the best companies. Quite often these highly experienced private equity professionals are able to exert influence over the existing board they are investing in and guide the existing directors to make business decisions which will result in better profitability to the company.
PE professionals are notoriously ruthless and will ensure that the directors of the recipient company make business decisions solely for commercial reasons as opposed to sentimental ones.
Private equity is often playing the long game. Frequently PE firms hold positions in companies for several years. Consequently, many HNW & SI who invest in PE firms are expected to be tied in for a considerable time, sometimes five years plus. Though PE firms usually target returns back to clients for between 4 to 7 years. This is why this investment is suited to professional investors. Many PE firms will not entertain a client for less than £100,000. Whilst some firms have far more exclusive entry levels, putting it out of reach for the average person.
Investment returns in private equity are exceptional. It is one of the few markets that have outperformed all the major indices over the long term (25 years). The chart below shows how PE has performed against the major American indices over the past 20+ years. As you can see PE has delivered over 50% better returns per annum. The power of compounding has resulted in PE delivering a 9 times return on equity over 21 years compared to 4 times for American indices. In contrast the FTSE 1000 has effective stayed the same over this time period.
These illustrated returns have factored in PE fees, which are significant. PE tends to attract the best talent and PE firms often do a lot of research before marking an investment. So in reality the return on capital made by the firms they invest in is far higher.
Types of private equity
It should be noted that PE can be split into various categories by location eg World, US, Europe, Asia, etc. And PE can be split into sectors such as Healthcare, Real Assets, Retail, etc. Though most commonly PE is split into the type of deals the PE firms undertake. There are generally seven types of private equity deals and we list them below:
1. Growth capital
This is about investing in mature companies with proven business models. A PE firm may restructure the company’s operations or get the company to enter a new market. Though it can also be about using finance to fund an acquisition.
This involves buying a mature company that is already generating significant and steady cash flows. PE firms make buyouts when they believe that they can extract value by holding and managing a company for a period, then exiting the company once it becomes more profitable. Usually, buyouts involve securing large sums of debt capital to fund the buyout.
3. Debt/Mezzanine Finance
Quite often larger private companies seek to raise capital without giving up equity as the owners are confident in the long-term prospects of the company. One way of raising finance is through a bond raise. However, once this has been done the bondholders have the first charge over the company’s assets. This is where mezzanine finance comes in. Some PE firms are happy to lend money with little security in the pursuit of higher yields. Though, this involves more risk for the PE firm so they need to do a lot of due diligence to be confident in the borrower’s ability to repay any loan.
4. Fund of Funds
Investments are made in PE funds rather than directly in the equity of companies. By investing in a fund of funds, investors have diversification which hedges their risk.
5. Special situations & distressed funds
This involves targeting companies that would benefit from restructuring or a turnaround. Investments usually profit from a change in the company’s valuation as a result of the special situation. (i.e. company spin-off, asset stripping, tender offers, bankruptcy proceedings.
6. PE Real Estate
PE firms can target real estate companies and make changes to the company’s portfolio by either buying or selling assets or renovating existing ones.
7. Venture Capital.
We discuss this at length in the next part of this article. Venture Capital is about investing in start-ups and young companies, with little to no track record. The preferred route is holding a stake in the company until it goes public via an IPO.
Private Equity in action
Softbank invested $20 million in Alibaba back in 1999. Fast forward to 2014 when Alibaba went public and the and the return of equity resulted in $50 billion profit.
Private Equity is big business with approximately $4 trillion under management.Funds Europe
What is venture capital?
As discussed earlier, Venture capital (VC) is a form of private equity that focuses on investing in start-up businesses with a long-term investment timeframe.
Whilst VC can be risky for investors who put up the funds, the potential for high returns is an attractive payoff. For new companies or ventures that have a limited operating history (under two years), venture capital is becoming an increasingly popular avenue for raising money, especially if they lack access to capital markets, bank loans, or other debt instruments.
The main downside for the company is they are often giving up on a large percentage of equity. Usually, companies offer various lines of funding. At each line of funding, the company will raise the price of its shares. Consequently, early fundraising rounds are where investors can enjoy the best investment return. It is not uncommon for early-stage investors in successful growth companies to experience a 100 times return on capital.
What are venture capital funds?
Venture capital funds manage pooled investments in high-growth opportunities in start-ups and other early-stage firms and are typically only open to HNW & sophisticated investors.
Venture capital has evolved from a niche activity at the end of the Second World War into a sophisticated industry with several players. It is anticipated that this sector will continue to grow.
Uniqueness of venture capital
The biggest difference between venture capital and other private equity deals is that venture capital tends to focus on emerging companies seeking substantial funds for the first time, whilst private equity tends to fund larger, more established companies that are seeking a cash injection or a chance for company founders to sell some of their holding before going public.
American VC backed companies raised nearly $330 billion in 2021. This is almost double the previous record of $166.6 billion set in 2020. In the UK, the venture capital market has been consistently growing year on year.
Private equity firms don’t typically participate in the smallest fund raising rounds. This is because these companies are looking at spending billions of pounds or dollars each year so they prefer to target investments that allow them to put in larger amounts of funds. Consequently, there is an opportunity for HNW & SI to bridge the funding gap.
In the UK, the government has incentivised HNW & SI to participate in start-up businesses. Since 1994, the UK government has run the Enterprise Investment Scheme which offers excellent tax breaks to qualifying UK investors. To date, the scheme has helped over 33,000 companies raise more than £24 billion through the scheme.
More recently, the UK government has introduced the Seed Enterprise Investment Scheme. This gives even more generous tax breaks to qualifying investors. Many venture capitalists consider Seed EIS as the most generous VC scheme in the world. The image below outlines the key tax benefits of both schemes. The biggest benefits are income tax relief, loss relief, and Capital Gains Tax exempt returns. You can find out more about these schemes by clicking on the appropriate links in the text above.
For SEIS-qualifying companies, the majority of their investment is covered by HMRC. A 45% rate taxpayer only has 27.5p risk exposure in the pound. Whilst an EIS-qualifying company only has 38.5p risk exposure for 45% tax rate earners. Conversely, all returns are exempt from CGT. Unlike typical private equity deals, investors can participate in EIS and SEIS investments at very modest entry levels.
EIS in action
Revolut (a 2015 fintech start-up) raised £1,030,000 from 433 investors on a round of funding through EIS in 2016. This means the average investment was just under £2,400. Two years later, the company was valued at 19 times what these investors paid for these shares. Fast forward to July 2021 and Revolt had an $800 million funding round that valued the company at $33 billion.
Advantages and disadvantages of Venture Capital
VC provides funding to new businesses that do not have access to stock markets and do not have enough cash flow to take on debts. This arrangement can be mutually beneficial:
- Businesses get the capital they need to fund and grow their operations.
- Investors gain equity in promising companies often with tax incentives.
In later rounds when private equity firms participate, the growth company will be able to leverage the experience of these PE firms to help perfect their business model and target more cost effective forms of capital finance.
|Advantages of Venture Capital Funding||Disadvantages of Venture Capital Funding|
|1. Provides early-stage companies with the capital needed to undertake operations.||1. VCs tend to demand a large share of company equity.|
|2. Unlike bank loans, companies do not need cash flow or assets to secure VC funding.||2. Companies that accept VC investments may find themselves losing creative control as their investors demand immediate returns.|
|3. VCs can also provide mentoring and networking services to help a new company secure talent and growth.||3. VCs may also pressure a company to exit their investment rather than pursue long-term growth.|
Key stages of venture capital
There are different types of Venture capital. Each definition can be divided according to where the company is in its development. Typically, the younger a company is, the greater the risk for investors. Below we list the key stages of VC:
- Pre-Seed. This is the earliest stage of business development when the founders try to turn an idea into a concrete business plan. The directors may employ in a business accelerator to secure early funding and mentorship.
- Seed Funding. This is the point where a new business seeks to launch its first product. Since there are no revenue streams yet, the company will need VCs to fund all of its operations.
- Early-Stage funding. Once a business has developed a product, it will need additional capital to ramp up production and sales before it can become self-funding. The business will then need one or more funding rounds. These rounds are often called Series A, Series B, etc.
For small businesses, funding is initially provided by angel investors and high-net-worth and sophisticated investors.
Angel investors are experienced investors who have amassed their wealth in a multitude of ways. Angel investors are either retired business executives or entrepreneurs who have sold out of their own business empire.
These investors are looking for start-ups that have:
- Experience. They want to see that the management team has expertise in the sector they are working in.
- Good business plan. A business plan offers investors an insight into the directors’ vision of the future. The plan must be well thought out and factors in contingencies for the external environment.
- Undertaken due diligence. Prospective investors need to know that the management team has fully researched the sector they are operating in.
- Exit strategy. Investment is about making a good return on equity and the owners must have an understanding of their route to market, to allow investors to exit.
Is venture capital the best investment class?
In our opinion, the answer is a resounding yes. If you are able to successfully identify a company that is primed for rapid growth you can experience phenomenal gains.
Jeff Bezos invested $250,000 in Google in 1998. Had he still kept all those shares from that funding round his equity position would be worth almost $5 billion today.
For UK investors there have been several companies that have raised funds from the Enterprise Investment Scheme that have gone on to become billion pound companies. Early stage investors have seen exceptional returns on capital. Furthermore, the majority of the investment risk has been offset by income tax relief and loss relief. These tax breaks are not available once a company reaches a certain level of maturity.
However, all investment carries risk and venture capital is considered speculative despite generous tax breaks. This is why it is important to invest in venture capital with a disciplined strategy.
Venture Capital Process
A lack of funding is the main obstacle preventing promising start-ups from going on to become multinational conglomerates. This is why early-stage business owners must understand how to use finance to scale their businesses.
The first step for any business looking for funding is to devise a business plan. This plan should concentrate on showing the competitive advantage of the business, explaining how and why people will use their products or services.
Utilise tax efficient schemes
The plan should show how investors’ funds will be spent, to make the company cash flow positive. If you are looking at getting favourable tax concessions such as EIS or SEIS funding, the business plan needs to be tailored to the requirements of HMRC. This is to attain advanced assurance for that line of funding. This makes an investment more favourable to prospective qualifying investors.
Snare private equity
Once the first few funding rounds are completed and you have utilised all your tax allowances your business should be of a size where private equity firms will look into your business. They will review your business plan and undertake due diligence to see whether the business can be scaled successfully, through a large injection of capital.
Have different funding rounds
Once due diligence has been completed, the PE firm will pledge capital in exchange for equity in the company. These funds can be provided all at once, but usually, the capital is provided in rounds. At each round, the PE firm will pay a higher price for the shares as the company starts to gain traction and becomes more valuable.
The company needs to find a way for early-stage investors to successfully exit the company. The optimum route to market could be a merger, an acquisition, or listing on a stock exchange through an initial public offering (IPO).
One of the other benefits of VC is that it is not completely correlated with the major stock markets. If used correctly this type of investment will allow you to diversify risk from your existing portfolio whilst potentially improving your return on investment. This is especially the case If you are utilising the generous tax breaks available from certain venture capital schemes.
If you are a qualified investor who is interested in venture capital or private equity and would like to know more about how these investments work, you should contact investor relations who will happily send you a free brochure that will deepen your knowledge in this area of the markets.