Private equity and venture capital have much in common, and The Economist is partly correct to characterize VC as “private equity for fledglings”.
Like their counterparts in PE, VC funds have long lifespans, which allows partners to cultivate long-term growth in portfolio companies rather than focusing on quarterly showings. And like private equity firms, the modern VC is actively involved in coaching and advising its portfolio companies (though ironically, PE is often more hands-on and entrepreneurial than VC because the latter has the more limited discretion of a minority shareholder).
Jim Coulter of TPG noted that whereas VC is in the business of mutation, PE is in the business of evolution. Where VCs fund “mutant” start-ups that offer completely novel technological innovations, private equity firms facilitate the process of natural selection to ensure that only the “fittest” companies survive. This is an important distinction between the two industries, and there are other technical differences. But broadly speaking, you can’t believe in the fundamental value proposition of the venture capital industry unless you believe in the basic paradigm of investment, assistance, and economic repair pioneered by PE.
We believe that in the coming decade, segments of the private equity and venture capital industries will converge and adopt similar strategies. Returns will disproportionately accrue to firms that combine the best of each. In the 1980s – the heyday of the private equity industry – firms such as KKR, Blackstone, Carlyle and Apollo tapped the under-deployed resources of banks to purchase, restructure, and resell corporations.
But leveraged buyout (LBO) techniques are now “commoditized,” and the industry is extremely saturated: PE backs 23% of America’s midsized companies, and 11% of its large companies. The private equity industry remains valuable, but in order to generate unusual returns it must “evolve” itself.
PE firms have always tried to harness new innovations, but a surge of new information technologies has made it increasingly valuable for some private equity firms to partner with leading entrepreneurs and technologists – many of whom are located in Silicon Valley. Commercial data is exploding in volume and variety, and metrics are becoming much more precise. Private investors of the future will use technology platforms to evaluate formerly uninteresting assets as hidden stores of data, which will make their businesses and industries more efficient. New information will allow top investors to better assess consumer demand, supply chain logistics, and industry-level shifts, as well as determine where to open channels of communication and dedicate resources. Data-driven PE firms will save resources, increase their margins, and become more valuable to their partners.
Venture capitalists able to draw on the top networks of talented leaders and builders in Silicon Valley were among the first to develop an armamentarium of data-driven procedural improvements for their portfolio companies. Hybrid groups such as Vista were among the first to pioneer these techniques in the buyout space. Private equity firms working closely with venture capitalists and technologists may be able to unlock assets that others have not leveraged and build technology cultures to iterate on solutions that make these assets more productive. Some may even reclaim 1980s or 1990s-level returns.
At the same time, the best VCs will begin to imitate and adopt PE strategies. Scaling major technological breakthroughs in certain industries requires armies of people and significant resources – private equity’s bread and butter. VCs may also begin to increase their return on equity capital of late-stage portfolio companies with debt financing, drawing on the private credit divisions of investment banks, PE firms and more.
There is still a large cultural rift between the two worlds; the culture of Silicon Valley is very different from the “Wall Street” mentality of the American financial establishment.
Fortunately, open-minded individuals in each field are establishing rapport and exchanging insights. We have been lucky to add luminaries including Henry Kravis and Geoff Rehnert as investors and advisors to 8VC, and Sir Deryck Maughan as a board partner. Communication and cooperation between our industries will only continue to improve as the distinction between elite private equity and venture capital investors becomes less meaningful.