Early Investing

Understanding the Difference Between Private Equity and Startup Investing

Understanding the Difference Between Private Equity and Startup Investing
By Adam Sharp
Date June 5, 2020

Vanguard Group, the investment fund giant with $6.2 trillion of assets under management, announced Wednesday it is launching private equity funds that may soon be available for many people to invest in.

Here’s how Institutional Investor described the development: 

Vanguard Group is shaking up private equity, offering its first funds focused on the asset class through a partnership with HarbourVest Partners.

The private equity funds will initially be offered to institutional clients. Qualified individual investors will be able to invest at a later date, according to a statement from the firm.

A friend asked me why Vanguard is getting into startup investing. The short answer is, they’re not.

Private equity (PE), in this sense, is a totally different animal than investing in small private startups. PE refers to professional investors who buy most or all of a mature private company. PE investors then try to improve the company’s performance and eventually resell it. PE acquisitions are typically done using lots of debt (leverage).

And it looks like retail investors may soon have the chance to invest in PE funds. The Department of Labor just released a letter that hints at this. Here’s how the New York Times reported this development in an article titled “401k Plans Move a Step Closer to Pooling With Private Equity“:

The Department of Labor on Wednesday issued a letter that clarifies how, under existing rules, certain retirement plan sponsors, including 401(k)’s, can put money into private equity investments that are usually reserved for the super rich and big institutional investors.

However, there is reason to be cautious about PE investing. Private equity skeptic Dan Rasmussen highlighted the risks in his excellent 2018 piece “Private Equity: Overvalued and Overrated“.

This consensus has led institutional investors to flood private markets with capital, about $200 billion per year of new commitments. The result is soaring prices for private companies of all shapes and sizes. Just before the financial crisis, in 2007, the average purchase price for a PE deal was 8.9x ebitda (earnings before interest, taxes, depreciation, and amortization—a commonly used measure of cash profitability). Deal prices reached 8.9x again in 2013 and are now up to nearly 11x ebitda.

But asset prices are going up everywhere. What makes private equity dangerous is the use of debt—and the use of phony accounting to conceal the riskiness of these leveraged bets. The average PE deal is 65 percent debt financed, and whereas the valuations of public equities are determined by transparent, liquid public markets, PE firms determine the valuations of their own portfolio companies. Unsurprisingly, they report far lower volatility than public markets.

Dan brings up some excellent points. I strongly recommend reading the entire piece — especially if you’re thinking about investing in PE. The average price for PE deals has soared in recent years. And while PE funds have performed well on paper over recent decades, there are very real risks involved.

Investing in PE funds is actually quite a lot like investing in the stock market, but with less liquidity and more leverage (debt).

It’s utterly different from what we do — investing in private startups. Private startups have a different set of risks to consider. But I much prefer it as a growth investment. With PE, you’re depending on the fund’s managers to make the right decisions.

With startup investing, you’re spreading out your bets across a bunch of different founders and teams. Many startups will fail, but it’s possible to make 100x or more in each opportunity.

I hope that clears up the confusion between PE and startup investing. It’s a distinction that a lot of people don’t understand. Yes, startups are technically “private equity” as well. But PE has a very specific meaning among institutional investors.

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