With investing being more popular than ever, starting an investment journey has become one of the top discussion topics. Making things even more difficult, there are different investment vehicles with their unique characteristics, making it hard to choose an investment approach. In this piece we decided to tackle the topic of three very popular alternative investments and how they fair against each other - private equity vs venture capital vs hedge fund firms.
Private equity firms invest directly into private companies or are taking public companies private. Venture capitalists provide funding to start-ups and early-stage companies in different phases of their lives with a focus on those with a potential for a high-profit generation. Hedge funds utilize a wide array of strategies that can include private firms, startup companies, and a diverse specter of assets like commodities, public equity, debt, and real estate.
While regular investors usually choose to invest in ETFs or Mutual Funds, these three investment options are always highly relevant on the market. It is difficult to keep a piece like this short if we would want to provide an adequate explanation. So stay with us, and by the end of the article, you will know if some of these investment opportunities are the right option for achieving your goals.
Key Takeaways
- All three investment vehicles are reserved for accredited investors. Becoming an accredited investor demands either a high net worth or proven experience in investing.
- Hedge funds in some of their forms can encompass both private equity and venture capital strategies. This depends on the strategy the fund is employing when using pooled capital.
- All three investment options are deemed risky. Private equity is highly illiquid, venture capital comes with a risk of investing in unproven companies, while hedge funds often use high-risk strategies to beat the market.
Private Equity Firms
Definition
Private equity firms pool capital from investors to invest in private companies. The goal of the investing process is to raise the value of the target company and later on exit from it with a profit.
PE Firms utilize several approaches, with the most popular being buyouts, and growth equity approaches.
PE companies with a focus on buyouts aim to buy a controlling stake in companies. This way they are entering the board of the company and have the chance to influence its operations. From there they mold the company to their liking, with the ultimate goal of raising its value, and later selling it for a higher price.
Growth equity PE firms invest in mature companies with a solid background. Mature companies often have more than enough space for growth and just yearn for more capital to achieve it. PE firms offer them expanding cash which allows them to grow and increase in value.
All PE firms in its core work together with the companies and management teams they invested in. Together with top executives they work on developing successful strategies that can create excess value, and drive the company gains upwards.
Besides working on the operations of the company, private equity firms also often opt to restructure companies finances. Debt is a frequent drive that can significantly increase returns on equity.
In specific cases, target companies may aim for strategic mergers (M&A) as a mean to enhance value and create a stronger market presence.
Strategies
From all this, it is not difficult to guess that private equity investments are almost exclusively focused on the long term. Making changes and improvements from the inside is not an easy or quick task, and setting a company on a new route is often a long and tedious process. Usually, the exit from the company happens after five to seven years.
A good exit strategy is a crucial part of the investment thesis, and without it, the firm can just pour capital in without any clear goal. When the timing is deemed right there are several options to exit from an investment. Initial public offerings (IPO), recapitalization, and sale to another company are just the most common exit strategies that PE companies use.
IPO is the process of making a private company public. This is a way to realize gains on investment by selling their initial shares on the market. IPO offers a great opportunity for the once-private company to acquire more capital needed for growth.
The exit strategy doesn't need to end by going public. PE firms can sell the company to another PE firm to continue or reevaluate their work. By doing so the private company can find a strategic buyer that can offer fresh capital while remaining private.
The third way that offers a partial exit from the investment is recapitalization. Essentially by choosing this approach the PE company enters into a restructuring process of companies debt or equity. In this process, some part of the capital is returned to the investors while the company still holds the ownership stake.
Risk
Investing in often troubled companies that need a helping hand to grow is not a low-risk task. When you add to the mix that PEs buy a significant part of the company opting to change it from within, that adds another dimension of risk.
However, while PEs come with great risk, they can also bring high returns. If the firm succeeds in turning around the investment and making it a successful company, the payout can be substantial.
Adding another difficulty level to this already complex situation is the question of liquidity. Private equity is characterized by low liquidity, meaning that it is difficult to sell it. If the company is facing losses, it may not manage to find a buyer, until the price drops so low, that the losses are enormous.
Potential Gains
One of the key characteristics of the private companies that are bought by PEs is their low valuation. In most cases, these are troubled companies trading at a significant discount. This scenario offers a great return potential if played out well.
By relying on leveraged buyouts (LBOs) PE companies are amplifying their investments with borrowed capital. In the case of a success story, this factor can significantly increase gains.
Experts in Private equity firms conduct due diligence and asses which company can be turned around and made into a profitable story. A low valuation is not enough to make a sound move. Only an undervalued company with potential can bring gains. That is why it is necessary to conduct all the necessary analysis to avoid any potential pitfalls that can blow back up their faces.
To achieve success PE firms prefer an active management approach. Taking part in crucial operations of the company can significantly boost their chances of success.
Regulatory Environment
Private equity firms under the Dodd-Frank Act must register with the Securities and Exchange Commission when they break a threshold of $150 million in managed assets. Also, they must file Form ADV with the SEC, showing information about their business practices, fees, and potential conflicts of interest.
Venture Capitalists
Definition
Like hedge funds and private equity firms, venture capitalists also pool capital. It can come from individual or institutional investors with a high net worth. Once acquired VCs invest the capital into startups and early-stage companies. Usually, investments are made in exchange for equity stakes in these young companies.
VC managers conduct due diligence to identify potentially good long-term opportunities. Sectors that can provide high gains are those with the most innovations like tech, healthcare, biotechnology, fintech, and clean energy. In the early stages, it is difficult to assess the profitability of the company's operations, but that is a risk that VCs take. In case of a good selection of investments, they can be solidly reimbursed.
Investment Strategies
Venture Capital firms invest in four stages of company life, depending on their preference.
The seed stage is the stage where the company is just an idea or a prototype of a product or a service. VCs that offer capital in this stage are providing companies with the starting capital that allows them to create something viable, that can be offered to the market.
Early-stage (Series A and B) investments are capital infusions to companies that already created something with potential, but need additional capital to scale their operations. In this stage, the company is growing its structure and creating a solid foundation for the future.
In the growth stage (Class C and after) VCs partake in later funding rounds for companies that have laid the groundwork and are generating solid returns. With this strong potential, they need cash to move onto new markets or develop new products. Also, from this stage companies can be prepared for their initial public offering.
Late-stage investments are those that come just before the company goes IPO. Companies are already robust with a solid customer base but still need a little bulking before attempting to be sold. This is the phase that carries the least risk, but also usually generates thin gains.
Investment Process
It all starts with identifying a suitable company to invest in. VCs can get to them through incubators, other investors, accelerators, or a network of entrepreneurs. Also, there are VCs that have dedicated teams for finding the best companies that align with their strategy and approach.
Identifying a potential investment target is only the first step. The next one comes with a greater responsibility and that is to conduct due diligence. That includes analyzing the fundamentals of the company, market landscape, competition, and potential competitive advantages. All this information fits into the risk/reward ratio which is crucial when making these types of investments.
The next step in the investment process is for the venture capital firm to issue the term sheet. By doing so the firm outlines the terms and conditions of the investment.
Depending on the terms of the investment the VC provides capital to the startup, while in the return they get convertible preferred stock or the common stock.
Participation In Operations
As a part of the investment deal, venture capital firms get member board spots allowing them to make a direct impact on the company's operations.
VCs are usually experts in specific industry sectors they invest in, allowing them to provide companies with the necessary expertise to grow. Also, they typically possess a strong network of business contacts, potential investors, customers, and partners which can provide crucial resources in the process of company growth.
Exit Strategies
One of the best exit scenarios from venture capital investments is an IPO. When a portfolio company is ready to go public, the VC gets a chance to sell their shares in the open market. In the case of a well-timed IPO, shares can be worth much more than an initial investment.
Another frequent scenario especially in the tech sector is acquisition. A larger company buys a startup from the venture capital company providing it with liquidity. This is a common strategy when a big player in the sector wants to cover more ground and offer diverse products and service supplies to the market.
In case the venture capital firm is looking for an early exit, it can be done through a secondary sale. In this case, the original investor sells their share to other private equity firms.
When the startup wants to buy out existing investors they resort to recapitalization. These young companies go into debt providing another exit opportunity for the VC company.
Risk and Reward
Running a venture capital business is a high-risk and high-reward operation. The majority of startups and young companies do not manage to sell their business, leaving the investor with nothing but losses. However, in that large pool of failure, when all the pieces fit the plan can bring 10 or even 50 times more than the initial investment.
To be successful in this business, VC companies are focused on running a highly diversified portfolio. That way they are all over the market, and they have a much higher chance of picking a good investment than in the case of a concentrated portfolio.
Since the investment targets are young companies, investors need to be prepared to wait for a longer period to see benefits from their invested capital. Usually, VC companies set their goals in a range between five and ten years.
Regulatory Environment
Due to a provision in the Dodd-Frank Act, most venture capital firms are exempt from registering with the SEC. The only requirement they need to check is to maintain their operation within the boundaries of a venture capital firm. These boundaries include investing in private firms, providing significant managerial assistance to companies invested in, and avoiding using leverage.
Impact Of Venture Capital On the Economy
Venture capital is one of the rare investment vehicles with enough courage to solely focus on the high risk startup market. Their impact on the economy cannot be measured, because they are fueling the firms while they are just small teams with a lot of ideas. With proper guidance and capital influx, these can later grow into innovative powerhouses with new solutions to old problems.
Besides growing ideas, VCs are financing the creation of new jobs. When small companies that are focused on innovation grow they are in demand for highly specialized personnel. In case of success, these companies can push the growth of the entire economy which can be seen from the examples including Israel.
Hedge Funds
Definition Of Hedge Funds
Like Private equity firms and Venture capital counterparts, hedge funds pool capital from investors with the aim of investing it into a pool of diverse asset classes. Hedge funds are reserved for high net worth institutional and individual accredited investors. This comes as a result of often high-risk strategies that funds employ to generate gains.
Hedge funds are a popular investment vehicle because they offer a way to diversify the portfolio through investing in numerous assets with an overall low correlation. By doing so, the investors avoid losing large chunks of investments if one asset class is in problem, or a specific industry sector is going through a downturn.
Investment Strategies
Hedge funds provide an opportunity for almost every investor to have a unique approach to investing. Depending on the goals that the investor has, he can choose where he will place his capital. Hedge funds invest in long and short-term horizons, they use almost every strategy known to the investing world, and sometimes they can customize their approach to make it more suitable to the investor.
Some funds are specialized in using one strategy, while others rely on a more diversified approach offering several options to their investors.
Amongst the strategies that hedge fund managers frequently rely on are long/short equity, global macro, event-driven, activist investing, high-frequency trading, and market-neutral approach.
Long/short equity strategy aims to win from both ends of the market spectrum by betting both on the winning companies in the long term, and companies in trouble in the short term.
Global macro funds are focused on following global or regional events that can trigger a massive impact on a global scale. Elections in a country finished against all ads, and the new government has other plans for the economy? That is one scenario that these funds can exploit to generate high returns. To be successful in this approach hedge fund managers must have extensive knowledge about political, economic, and social elements of the markets and how they can trigger a disbalance in the market.
Event-driven funds are masters of anticipating corporate events that have an impact on a specific company or a sector. Mergers, bankruptcies, restructurings, spin-offs, and acquisitions are just a few that can be put into this category. All these events are usually followed by price volatility, and if the fund manages to place itself on the right side of the investment it can earn a solid gain.
Activist investing is a strategy that involves hedge funds buying a significant stake in a target company to change it from the inside. That involves securing one or more places on the board of the company which grants them voting rights allowing them to steer the company in a specific direction. As a result, the hedge fund can help a company bypass a bad patch and become profitable once again. By doing so the stock price rises, allowing the fund to exit from the position with a significant gain.
The implementation of innovative technologies brought hedge funds a number of new strategies, including high-frequency trading. Funds in this case use powerful computer programs to conduct a large number of orders in very short time frames. To accomplish this, programs use complex algorithms to analyze multiple markets and carry out orders based on market conditions. Execution speed is essential, and traders who carry out orders faster can generate higher gains.
Funds that use a neutral strategy create portfolios that can create consistent returns with minimal market risk. They achieve this by hedging long positions with paired short positions. Investors are exposed to low-volatility gains coupled with minimal correlation to broad asset classes like equity, bond, or credit.
Risk Management
Managing investment risk is one of the fundamentals of hedge fund operations. While investing in hedge funds can bring significant gains, without a planned risk mitigation strategy it can all end in massive losses.
Diversification is regarded as one of the pinnacles of risk management. When the portfolio is invested in different asset classes, geographies, and industry sectors, potential drawbacks can cause less harm.
Hedging strategies are another line of defense of the portfolio. The hedging technique is utilized to offset losses in investments by taking opposite positions in the closely related asset class. A typical hedging strategy involves derivatives like options and futures.
Another common risk-mitigating strategy is placing stop/loss orders. A hedge fund manager sets a limit to an asset value after which it is sold automatically. This approach is highly useful because it can limit potential losses in the case of a sudden market downturn. While stop/loss order is commonly used to exit from long-term positions, it can also be used to buy short-term holdings.
How To Choose The Investment Vehicle
If you are eligible to gain the status of an accredited investor, choosing between these three can be a tough decision. All of them have their pluses and potential pitfalls. Venture capital is essentially betting on a young firm that will manage to break into the market and have a revolutionary idea. Exiting from private equity investments is difficult due to their low liquidity. Hedge funds with their array of complex strategies and lower transparency can be overwhelming.
In any case, before you decide to place your capital conduct deep due diligence of the company you are handling your cash. Check their corporate culture, track record, manager approach, and fees, and try to gather information from credible sources. Once you have enough info, compare it with your goals and see if these are a match. Investing is a serious business, and tread carefully - you can be one step away from losing your entire investment or multiplying it.