Private equity deep dive

Today’s private equity markets offer an increasingly wide range of potential investment opportunities with a similarly broad set of characteristics. In this paper, we explore four key questions to help investors better understand how these strategies compare and complement each other in a portfolio.

• What is private equity? 
• How do venture capital and buyout opportunity sets differ?
• What is private equity’s risk-return profile?
• Where does private equity fit in a portfolio? 

In particular, we compare two popular private equity investment strategies — venture capital and buyout — highlighting their distinct opportunity sets, risk-return characteristics, and portfolio roles.

What is private equity?

Investments in the global financial landscape can broadly be divided into public and private markets. The most prominent difference between these markets is that private investments involve financing nonpublic companies in negotiated transactions, unlike the easily accessible exchanges on which the public market primarily operates.

There are a multitude of different private market asset classes but the five most common are private equity, private debt, real estate, infrastructure, and natural resources. Each asset class provides a distinct investment profile due to different exposures, risks, structures, and target returns.

Private equity funds invest in the equity of companies that are not publicly traded, or in the equity of publicly traded firms that the fund intends to take private. They are generally structured in the form of partnerships that consist of investments in individual private companies. 

Private equity opportunities

The characteristics of the companies that venture capital invests in vary significantly from those of buyouts. Generally speaking, venture capital target companies are high growth but unprofitable, while buyout target companies are profitable with stable reoccurring revenue but have more moderate growth.

The venture capital opportunity set
Venture capital is itself a broad strategy that is most frequently divided into the substrategies of seed-stage venture capital, early-stage venture capital, growth-stage venture capital, and late-stage growth (also known as late-stage venture capital).

Seed-stage companies typically require financing to research business ideas, develop prototype products, or conduct market research. Early-stage companies generally have well-articulated business and marketing plans but are pre-revenue. Growth-stage companies have started their selling efforts and need capital to expand production capacity, product development, and/or fund working capital. Late-stage growth companies typically have a product or service that has achieved relative maturity and are raising additional capital to fuel further expansion or accelerate growth before a liquidity event, either through an IPO, strategic buyer (M&A), or financial buyer (commonly buyout funds).

Venture capital firms generally raise funds that focus on one of these exit substrategies, although it is also common to raise diversified funds that invest across two or more.

Private equity’s risk-return profiles

Investors allocate to private equity in pursuit of higher returns and diversification. This is for good reason, as over the last 25 years, the Cambridge Associates Venture Capital and Buyout Indices returned pooled net returns of 19.35% and 12.82% respectively, compared with annualized returns of 6.73% and 7.39% for the Russell 2000 and the S&P 500 indices, respectively.¹ Importantly, private equity investments, as noted in our previous piece on Understanding private equity performance, are typically measured using performance metrics that are unique to these funds.

While the historical premium to public markets is attractive, allocators to early-stage venture capital, late-stage growth, and buyout should consider the distinct risks associated with these investments.

• Early-stage venture capital’s most prominent risk is “operational risk,” which is the possibility that the companies they invest in could fail due to an inability to execute their business plans.
• Late-stage growth’s operational risk is mitigated at this stage due to the size of the companies, which now instead face “valuation risk.” This is the risk of overpaying for an investment and being unable to make a profit in liquidation.
• The buyout strategy’s biggest risk is the very same leverage that can result in strong returns. The resulting “financial risk” for buyout is the risk that the company will not be able to service or pay back the debt used for the investment, which may result in a partial or complete loss of investment.

Early-stage venture capital and late-stage growth funds rarely lever their investments, making them less vulnerable to financial risk and higher interest rates. All three strategies bear illiquidity risk as they cannot exit their investments when it may be most convenient and instead require a liquidity event. Despite these risks, investments in these strategies can yield important diversification benefits that can help “de-risk” a portfolio. Figure 2 shows the potential risk-return profile for each strategy.

Bottom line: Where does private equity fit in a portfolio?

Early-stage venture capital, late-stage growth, and buyout are three of the most common strategies in private equity. Many investors in this asset class allocate to buyout as a core holding given its moderate risk level and relatively stable returns, while investments in early-stage venture capital are frequently smaller and seeking outsized returns. Late-stage growth is relatively new compared to the other two strategies, but its risk profile and potential for quicker return of capital may be attractive to investors implementing exposure to venture capital at scale, building a new private investment program, or as an alternative to public equity small-cap strategies.

The combination of early-stage venture capital, late-stage growth, and buyout allows investors to allocate across a business’s life cycle (Figure 3), improving exposure and diversification. In addition, private equity investments historically have not been as correlated to downturns in the public market, so they have the potential to stabilize a well-diversified portfolio during these times.

Potential return, risk, and liquidity expectations are critical considerations for investors allocating to private equity, with the best diversification benefits historically having been achieved by investing across strategies. For this reason, many institutional investors have separate allocations to each substrategy.

¹ Source: Cambridge Associates US Private Benchmarks Q1 2023 Report. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Please refer to the end of the document for additional disclosures.