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(This was extracted from a log of the same name by Victor Hwang, http://www.forbes.com/sites/victorhwang/2012/10/01/presidential-debate-primer-whats-the-difference-between-private-equity-and-venture-capital/)

Venture capital (VC) and private equity (PE) often overlap in practice, so the distinction is frequently confusing to practitioners, too.

So, let me try to clarify things.  While both VC and PE are in the business of buying low and selling high, they come at this challenge from fundamentally different directions.

I was chatting with the former CEO of a billion-dollar company a few weeks ago, and he described it like this: “I consider private equity and venture capital as opposites.  In private equity, you start with the numbers, and then you try to fit everything into the numbers.  In venture capital, you start with people, and then you try to figure out what numbers you can make.”

In other words, private equity is usually about taking an existing company with existing products and existing cash flows, then restructuring that company to optimize its financial performance.  When private equity works right, it can save poorly-performing companies from bankruptcy and turn them into profitable enterprises.

So, while PE usually starts with existing but under-optimized companies, VC often starts with crazy people.  Here’s a little table I put together to show the contrasting worldviews of PE and VC:

 

Private Equity Venture Capital
Environment Control Chaos
Medium Numbers Human Beings
Primary Hard Tool Buying and selling stock Buying and selling stock
Primary Soft Tool Operational Efficiency Human Motivation
Primary Lever Optimized Structure Disruptive Innovation
Primary Investment Trigger Underutilized Assets Team
Direction of Value Creation Top-down Bottom-up
Economic Philosophy Neoclassical Economics Innovation Ecosystems (“Rainforests”)
Assumption Rational Actors Irrational Actors
Role of Probability Precision Serendipity
Model Deming/TQM, Six Sigma Silicon Valley
Parallels Classical music,
Fine arts,
Farms,
Assembly lines
Jazz,
Street art,
Rainforests,
Design thinking

 

Of course, I realize that the characterizations above are huge oversimplifications.  Capital happens in shades of gray, just like most things in life.  We can think of the interplay between venture capital and private equity as the tension between two mindsets, rather than between two types of capital.  These two mindsets reflect fundamentally polar methods of value generation: bottom-up creation versus top-down optimization.  In the middle is where they overlap.

Confusion happens because, on the visible surface, both types of investing often appear to be the same.  They often utilize the same legal contracts, deal with the same financial terminology, serve the same institutional investor clients, and exit investments in the same way.  So the differences can be largely invisible, rather than visible.

Victor W. Hwang is a venture capitalist, entrepreneur, and co-author of the book The Rainforest: The Secret to Building the Next Silicon Valley.

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