Private Equity vs Venture Capital Returns

The prior comments are a bit too reductive on their own. Together they provide a decent picture which I will elaborate on.

RyRy's is astute but misses the nuance of how 'venture proper' works.

Venture funds have a wider standard deviation in their returns than buyout funds do. This is the single important takeaway.

There are three primary factors that contribute to the difference in returns between these two subsets of the private equity asset class.

One: Target investment

Buyout targets mature, cash flow-heavy businesses who offer predictable growth prospects. Venture targets immature, as-yet-unproven businesses who offer dynamic growth prospects.

As such, when you "miss" in buyouts, the business generally suffers flatter EBITDA growth than you'd like, or less frequently, minor EBITDA contraction. The fund exits the business at a price barely higher, the same, or slightly lower than it entered. When you "miss" in venture, the business collapses. The fund suffers complete capital loss or a fractional return of capital thanks to an acquihire or fire sale at a depressed price.

When you win in buyouts, the business outperforms your EBITDA growth predictions. (e.g. Instead of 8% YoY EBITDA, you enjoyed 12%.) The fund exits for a price even higher than the price higher than it paid that it was targeting. When you win in venture, the business turns into a (maybe multi-) billion-dollar juggernaut. (e.g. You invested at a $50m post-money valuation at the Series B and it is acquired or does an IPO at a $2b valuation.) The fund enjoys a gaudy multiple on capital.

Two: Concentration

Buyout funds maintain fewer active portfolio companies than venture funds do.

A $250m buyout fund probably has 6-10 portfolio companies, each of which it invested something like $20-50m in equity into (along with 3-6x leverage, depending on the financial strength of the company and accordingly the debt load it can support).

A $250m venture fund probably has 30 or more startups in its portfolio. Depending on their strategy, a fund may choose to allocate some portion of the assets to reserves (capital set aside to invest in later financing rounds that occur at hopefully higher prices as the startup succeeds and continues to grow).

Touching on my prior post, the buyout shop is looking for stable businesses. It expects none of them to entirely fail. The venture shop is expecting 50-75% of its businesses to simply die and disappear.

(This mentality does not always hold true outside the venture epicenters of the Bay Area, New York, and Boston. A lot of regional guys who call themselves "VCs" act way more like private equity investors and refuse to 'write off' a deal. Correspondingly, the deals they invest in tend to be way less of a potential rocket ship and way more of a traditional SME that just so happens to be 'starting up' from scratch and therefore they term it a "startup". Paul Graham would dispute that type of business deserving that label, but a ton of people outside the proper venture community think this way.)

You can easily see how much this affects returns. Buyout fund returns are going to be less volatile because one 'bad' deal in relative terms does not weigh down performance terribly. Venture fund returns can be volatile because a venture firm might think based on its track record across three prior funds over the previous decade that the failure rate in its portfolio will continue to be 55%, but on their fourth fund, the failure rate winds up being 85% and the survivors weren't 20x home runs.

Three: Power law

Actual returns in venture are incredibly skewed. Over two-thirds of venture funds fail to return investor capital net of fees. That means that after a decade, if you put $10m into someone's venture fund, you get back less than $10m. The second uppermost fifth gives you decent returns (1.5-3x on capital), the second uppermost decile gives you really nice returns (3-6x), and the top-decile guys give you 10-30x on capital.

Contrast this to buyout, where the differentiation between top-quartile (24% IRR) and third-quartile managers (4% IRR) is not that wide. You may point out that as a Limited Partner you very much would like to receive 26% IRR on your fund commitment than 4%, and that is entirely correct, but the point remains that the spread between them is nowhere near as wide as the spread between an elite venture manager and a sucky venture manager.

In venture, a great manager (historically: Sequioa, Accel, Kleiner ... lately: A16Z, Benchmark ...) sees a higher proportion of what has proven to be a fairly steady number of top-caliber deals.

It isn't that the guys inside Andreessen are that much smarter than the guys next door on Sand Hill Road. It's that there's a recursive effect where having invested in the best deals of the past few years means the best founders try the hardest to get in front of them, and that access means they continue to invest in the best deals, and the cycle continues. (They are fairly open about this phenomenon, by the way. It was an explicit part of their pitch to the LP community.)

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So, if you add all this up, if you had to pick which subset of the private equity asset class you had to divvy up a $1b commitment within, you'd be smarter to pick buyout. However, if you are a top-flight LP and enjoy access to top-tier managers, you would be smarter dividing that allocation among the best venture managers.

Most of the massive institutional LPs find themselves with more capital to deploy than access to top managers. It's a crummy conundrum. Most GPs recognize this and in the past five years have notably upsized their fundraise targets. This then started a 'flight to quality' where LPs gladly dedicated more capital to the Blackstones, Carlyles, Vistas, NEAs, and Andreessens of the world because overall it seemed a safer bet than diligencing some unknown newer or smaller guy who couldn't even accommodate the check size they wanted to write.