Lately, private equity has gotten a lot more attention than it probably wants. That’s because most of the attention has been negative as reporters and political pundits have gone all out to expose their lack of
knowledge on the subject including confusing venture capital with private equity and making wildly unsubstantiated claims about the “vulture” nature of private equity.
Let’s set the record straight about what private equity is and what it does. In private equity firms, equity capital (cash) comes from institutional investors like pension funds and wealthy investors and is invested conservatively in private companies for a variety of reasons: to grow a company, to restructure a failing company and make it an operational success, or to buy a company outright. Whatever the goal, the bottom line is PE firms are putting their money at significant risk in hopes of making the return they need to satisfy the investors in their fund. This investment is not liquid like public equity (the stock markets) so the PE firm typically maintains a relatively long relationship with the company. Clearly, they don’t get their hoped for return unless the company does well. No surprise here.
Venture capital is often referred to as a subset of private equity; however, depending on the economic environment and the quality of the deals available, the two may overlap in what they’ll consider a good investment. Venture capital typically involves smaller amounts of capital (although that’s not a requirement), earlier stage companies, and the VC generally has an ongoing relationship with the company to insure that it will achieve its return on investment. VCs expect that several of the companies in their portfolio will either fail or not deliver a good return; that’s why they invest in a number of companies.
The news sources seem to be knocking private equity because it doesn’t always create jobs; in fact, often the number of jobs in a firm that receives private equity is cut to make the company lean enough to survive. I have a real problem with making job creation the metric for success in any kind of equity investment. Anyone who knows anything about entrepreneurship and starting and growing companies knows that employees are the single biggest expense and headache a company can have. Early stage companies usually hire as few people as possible to get the job done so they can keep their burn rate down and survive. So making job creation the primary metric doesn’t make sense.
Private equity and venture capital are essential to the launch of new ventures and the growth of existing companies. Not every company can access the public markets, but every company needs capital to grow and compete. Before we start demonizing PEs and VCs for being successful at what they do, let’s think about how many companies wouldn’t exist today if they hadn’t had access to equity capital. How about the Viking Range Corp., Spectrum Athletic Clubs, Stanley tools, and US Robotics to name a few who received private equity funding. And how about
Zynga,
Groupon,
Legalzoom, and
Twitter that received venture capital? Yes, there will always be investment firms that make decisions that turn out badly, but they wouldn’t be in business if their overall upside didn’t exceed the downside. And we wouldn't be the entrepreneurial capital of the world without access to their capital.
