Understanding the VC to PE Continuum

I was recently asked to give a talk at UT Austin to a group of economics and finance majors about venture capital, private equity, and what we do here at BuildGroup. I jumped at the opportunity. I love mentoring college students. I was lucky enough to have mentors early in my career that helped steer me in the right direction. They gently helped redirect me when I was heading down a path that wasn’t quite right for me (they usually recognized this before I did), and celebrated as I honed in on the direction that was best for me. I love being able to pay it forward and share what I’ve learned so far. 

Most students who reach out to me are interested in a career in venture capital and/or private equity. Many of them think they know exactly where they want to be – seeding brand new startups, or doing later stage buyouts, for example. But most students only have a vague idea of what they want to do beyond working at a fund and investing in private companies. 

So much of my mentoring and speaking engagements with students is now focused on helping them better understand the industry, and where they are likely to be a good fit coming out of college. I wanted to share the talk I gave to the students of UT as a blog post – and explain the key differences between VC and PE for those going into this space, to hopefully lend some clarity. 

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First things first, VC and PE are only sort of a single industry.

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The first and most important fact to understand is that “VC and private equity” is only sort of a single industry. All VC and PE firms invest money in private companies (and in later stages of private equity, sometimes in public companies as well). They all raise money from private sources such as academic institutions, retirement plans, and family offices. But from there, the differences begin.

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The chart above roughly divides the industry into the categories of “venture capital” and “private equity”. It implies that there is a distinct line between these two industries, which is not accurate.  This chart is probably most useful for understanding the size and maturity of the companies that are being invested in, but even that is not perfect. For example, most students are familiar with buyouts of larger, more mature companies, but buyouts do occur at early stages as well.

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A better way to think about the industry is as a continuum along seven major characteristics, as illustrated below.

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The Continuum from VC to PE
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1. Stage.  VCs invest in new / young companies with less (or sometimes no) revenue, while PE invests in companies that are more mature and have more revenue. A more useful distinction might be profitability. Most VC-backed companies are not profitable until the later “ABC” or growth equity rounds, while PE invests mostly in companies that are profitable or which they believe they can get profitable quickly.

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2. Risk.  When a company is not profitable, it depends on external financing to stay alive.  I often refer to companies at this stage as “experiments” and not businesses. Because of this dependence on external capital, the risk of these companies failing is much higher.  They are not in control of their own destiny. It’s also higher because the smaller a company is, the more subject it is to disruption by other players – established or emerging – that could quickly evaporate their core market. So as companies grow their revenue base, often diversifying it with new products and markets, they get less risky.  But the real turning point is when they become profitable.  At this point, they don’t need someone like me to write them a check. They are much more in control of their own destiny. It doesn’t mean that they are risk-free. PE firms can lose money on larger, more profitable firms because of the same industry risks that early stage companies face. Or more likely, because they overpaid, they overleveraged, or they were unable to generate the financial efficiencies they assumed they could, for example.

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3. Portfolio.  One way to manage risk is “portfolio construction”. This can mean a lot of things, including investing across VC or PE stages, or investing in uncorrelated sectors.  But the most common way of doing this is by simply investing in more companies. The earlier stage at which a VC makes investments, the larger their portfolio is likely to be.  They depend on the “power law” to generate their outcomes – i.e., a small percentage of their investments will be home runs while many will be write-offs. As the risk declines, portfolios can be smaller as any one company is less likely to go out of business.  So for VCs, returns can typically have a huge range from 0 to 100 times. As you scale into PE that range will tighten to say, 2 to 4 times per company.

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4. Source of Returns.  VCs primarily depend upon a company’s growth to generate returns. They are in the business of seeding new ideas to capture new markets, or disrupt existing ones. If you look at the 10 largest companies in the world, most of them were once VC-funded. As you move into the PE realm, returns are determined more through either financial structure or operational changes, or both. Financial structure means primarily the use of leverage but could also include other structural deal terms  Operational changes mean cost-cutting and rationalization, shuttering of unprofitable operations, making acquisitions, or pivoting the company to a new market or strategic direction.

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5. Industries.  PE firms invest in a wide range of industries. Specific PE firms may have industry focuses, but across the PE sector there are firms that invest in almost every industry. VC, on the other hand, is very concentrated in a few industries, specifically technology, healthcare and consumer. And within VC, technology dominates the total amount of investment dollars. VC has become synonymous with technology.

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6. Check Size.  As you move along the continuum from VC to PE, the check sizes go from small to big. Angel or pre-seed investors often write checks in the tens of thousands of dollars, while large PE buyout funds on the other end right checks in the hundreds of millions of dollars. VCs are not typically buying shares from founders, they are providing growth capital and thus the checks can also be smaller. PE funds are often using a substantial portion of the funding to buy shares from the existing owners, in addition to putting growth capital onto the balance sheet. VC funds tend to be small and grow as they advance towards the PE stage.

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7. Ownership. VC firms work with early stage companies in which the founders and leadership are critical to the company’s success. Having them motivated financially is important. Therefore most VCs only take minority positions – less than 50% of a company’s ownership. VCs are also typically comfortable working in collaboration with other VC funds in the same company. As you get to later stage investments, PE firms often want control of a company so that they can put in their own leadership teams, make operational changes unimpeded, and put leverage on a company. Later stage PE funds essentially run these businesses through management teams and playbooks that they select.

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Understanding these seven factors on the continuum from VC to PE helps students to better understand the work they will be doing at each type of firm. It also helps them to grasp if they have the right training and interests to pursue a role in VC or PE.‍

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What do entry-level roles in VC and PE look like?

The most prominent role for undergraduates going into VC is sourcing new opportunities. This means lots of research, cold calling and cold emailing, conferences, etc. It’s essentially a business development job. You need to be good at, and like, sales. You have to find opportunities, get basic information from them, and then convince them to meet with your firm.  It’s an extra bonus if you have specialized knowledge applicable to the sector you are investing in. For example, a computer science degree is useful if you will be looking at technology, or a pre-med degree if looking at healthcare. Diligence is important, but it’s much more about technology, customer, or market diligence than it is financial modeling. These are small companies with limited financials to begin with, and depending too much on these early numbers to guide your decision making can be misleading. That doesn’t mean that financial modeling doesn’t go on, in particular around unit economics, but it is not the much more robust financial work you see at PE firms.

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PE firms are primarily looking for students who have strong analytical backgrounds, such as in finance. The primary function of new undergraduates is financial modeling of the businesses they are evaluating. These are more mature businesses with much more data to work with when making decisions.  Sourcing can be part of the role, but this often falls to more experienced investors or even partners.  Expertise can be useful here as well, depending on where a firm specializes, such as in oil and gas or retail.

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One other consideration I ask students to consider is their long-term path. 

As a career, VC is more fluid, with ongoing natural entry and exit points.  PE is much more of a career commitment.  Historically, I have seen quite a few young VCs transition into industry. In our short time at BuildGroup, two of our professionals have chosen this path. VCs love to hire experienced executives as well. Our firm was founded by entrepreneurs and executives. Net, you can go into VC and still have the options to go into industry, and vice versa. 

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I think that path is harder in PE, however. In PE, because of the focus on financial capabilities, it is much more of a committed career path. I see fewer young professionals leave PE to pursue jobs in industry. PE firms typically hire less executives from industry into their firms. It does happen, but it's not as common as in VC. PE firms often hire individuals who have honed their financial capabilities at investment banks or other PE firms.

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The last thing I’ll say here for those figuring out what they want to do after they graduate – is that like in any industry, it’s important to stay true to yourself when exploring opportunities in VC and PE. Do you thrive on identifying and nurturing innovative ideas, have a passion for tech or healthcare, and excel at business development and market research? Then venture capital could be an excellent fit for you. On the other hand, if you enjoy rigorous data analysis and modeling, and prefer working with more established companies, you may enjoy private equity.

Understand this landscape and align your opportunities with your genuine interests and abilities. You’ll be so much happier doing something that’s authentic to who you are, and probably more successful too, because you’ll be in it for the long haul.

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This content does not constitute or form part of an offer of any investment advisory services of BuildGroup Management, LLC, nor does it constitute or form part of an offer to issue or sell, or of a solicitation of an offer to subscribe or buy, any securities or other financial instruments, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.