Private Equity vs. Venture Capital vs. Investment Banking

By: Jane Meggitt | Reviewed by: Ashley Donohoe, MBA | Updated May 31, 2019

While all three serve as vital components of capitalism, when it comes to private equity vs. venture capital vs. investment banking, it’s easy to confuse their roles in the system. Although there is some overlap, for the most part, these entities play separate roles in the way they aid in business growth and investor returns.

Understanding Private Equity

Private equity is just that: a source of investment funds from rich investors or well-capitalized firms. Private equity firms attract the top people in the industry, because firms with billions in assets under management may include just 25 people or so as investment professionals. The money these professionals can make is astronomical. Private equity funds, as they are also known, may trade their shares publicly.

Private equity firms run the gamut when it comes to investment strategies. At one end are financiers, or individuals investing their money passively. Financiers focus on the management team of the company for which they provided financing to make decisions regarding marketing and growth. On the other end are active investors, who work in conjunction with management to grow the company.

Private Equity and Institutional Investors

Many private equity funds depend on institutional investors for their capital. Such institutional investors may include the pension funds of public-sector employees, nonprofit and university endowments, government-owned investment funds and funds contributed to by high net-worth individuals. Private equity funds often deliver superior investment performance, drawing these institutional investors.

Private equity funds might own a company and work with management for periods ranging from three to seven years. At that point, the fund decides on an exit strategy, which is either taking the company public or selling it privately for more money than was invested. The sale profits go to the fund investors.

Although private equity funds deal only with private companies, the companies in question may not start out that way. Private equity firms may obtain control over a publicly traded company and then delist it from stock exchanges. Private equity investors look for underperforming companies they can turn around. Businesses under the control of private equity funds are known as portfolio companies.

Understanding Venture Capital

Think of venture capitalists as providing the seed money that helps new businesses grow. Most startups are funded by venture capitalists, and most will fail. However, when a startup proves phenomenally successful, such as has occurred with venture capital-backed companies such as Uber, 23andMe and Airbnb, venture capitalists more than make up for losses derived from the businesses that didn’t make it. Not only are venture capitalists a crucial part of business development, but their stake in a project can make the business a target for private equity firms or investment banking services.

In exchange for providing a startup with funding, venture capitalists receive a certain percentage of equity in the company, usually less than half. Venture capitalists aren’t so-called angel investors, defined as individuals putting up their own money into an up-and-coming business. The money used to fund new companies comes from capital raised from limited partners. These funds are then pooled to make the investments.

From Seed to Maturity

New companies need funds for different purposes at different times. Venture capital firms may fund various needs or concentrate on specific stages. The seed stage, often a venture’s initial funding, provides money for product development, developing a business plan or conducting market research. The seed investment is generally relatively small.

The next stage, known as early-stage investing, focuses on companies in development. The operation possesses a feasible product or service, and this larger amount of money is intended for starting up the business. When venture capitalists invest money, each investment is designated as a letter series, starting with Series or Round A and progressing to the next letter with the following investment.

Late-stage venture capital investment involves maturing companies with a track record of growth and revenue generation, even if they do not yet prove profitable.

Understanding Investment Banking

Investment banks provide capital to corporations and governments, along with mergers and acquisition advice, asset management and stock and bond offerings. It’s the latter – the underwriting of securities and subsequent trading and selling – that truly defines investment banking. Other services include advising clients on spinoffs, designing takeover defenses and determining debt structure for acquisition financing. Investment bankers don’t deal with individual investors.

Arranging financing for a private or public entity is among the most important roles of an investment bank. For example, if a city needs money to construct a new highway, it may hire an investment bank to issue the bonds necessary for raising capital for the project. The investment bank puts together the bond issue, ensuring the bonds are priced correctly so demand results.

When a private company decides to raise money for an initial public offering, or IPO, the investment bank undertakes putting the prospectus together. Investment bankers work with the SEC to manage share issuance and make sure shares are priced correctly upon the public offering. Evaluating the right share price is an art form, as high prices keep buyers away and low prices don’t deliver the anticipated income for the client.

Investment Banking Giants and Boutiques

Goldman Sachs, one of the world’s largest investment banks, notes its work on any given day may involve refinancing an outstanding bond, creating a subsidiary’s initial public offering or “advising a company on a cross-border merger.” Goldman Sachs notes its investment bankers help clients solve critical strategic and financial challenges.

Along with investment banking giants such as Goldman Sachs, JP Morgan, Citigroup, Morgan Stanley, Credit Suisse, Deutsche Bank and others are the smaller, boutique investment banks. These boutique banks concentrate in one area of investment banking and generally work with mid-size firms, leaving huge companies to the industry behemoths. Well-known boutique investment banks include Lazard and Blackstone.

Private Equity vs. Venture Capital

The primary difference between a private equity firm and a venture capitalist is the age of their investments. Venture capitalists invest at a company’s initial stages, sometimes when an idea exists more than a business. From the concept stage, they proceed to startup, and this process alone may take many years. The bottom line is that venture capitalists look for new startups with high potential.

Private equity funds go toward different endeavors. The private equity firm concentrates on older companies with a history behind them. Often, these companies are acquired via buyouts. The aim of the fund is boosting efficiency and growth in these businesses. Interestingly, private equity firms are increasingly investing in venture capital firms.

While venture capital firms seldom acquire more than 50 percent of a company, remaining minority stakeholders, private equity funds might own 100 percent of a business. At the least, they own the majority percentage. Private equity firms direct attention to one company at a time, while venture capital firms spread their risk around, putting smaller amounts of money in lots of new enterprises.

Some Industry Differentials

There’s also a difference in the kinds of industries in which private equity funds and venture capitalists invest. Private equity firms may invest in virtually any industry. The venture capitalist, limited to startups, invests primarily in newer technologies, such as IT, biotechnology and green tech.

Investment type isn’t the same between venture capitalists and private equity. Venture capitalists receive equity only when they invest, while private equity funds might use cash and debt to purchase companies. When it comes to the difference between private equity and venture capital, there are always exceptions that prove the rule, but the crucial capital heads to contrasting companies.

Private Equity vs. Investment Banking

Raising capital is the purpose of both private equity and investment banking, but these two entities go about it in different ways. The private equity fund turns to institutional investors and high net-worth individuals for money. When a private equity firm buys a business, it does so on behalf of investors who have already provided the capital. It’s not at all unusual for the private equity firm to become involved in the company’s management.

The investment bank looks to the capital markets for its funding. An investment banker sells investors a business interest, but their investors are private companies or publicly-traded corporations.

Private equity firms do not face the same regulatory environment as investment banks. While the latter is highly regulated, that is not true of the former. While the SEC does hold some control over private equity funds, much of that relates to private equity taxation and advisory fees.

Private Equity vs. Investment Banking vs. Hedge Fund

What’s the difference between private equity and hedge funds? A private equity firm invests in companies held privately, so there is no public trading of shares. These firms receive a certain percentage of ownership in these companies. As noted, private equity funds usually work with the management to increase company value over the long-term.

Hedge funds consist of limited investor partnerships seeking to pool capital for obtaining returns in the short-term. No controlling or majority ownership in the companies in which they invest is sought, and the investment is made through bonds, stock and commodities. The trading strategies used by hedge funds are often complicated, since money is made in minute market movements.

As noted, the investment bank seeks capital from different sources than private equity funds and is bound by more stringent regulations. While the investment bank finds investment capital for businesses in need of such funding, hedge funds invest in anything the managers believe will prove profitable. Keep in mind that while hedge funds routinely earn their managers and partners billions, the term basically refers to a limited investor partnership.

The Money They Make

Inquiring minds want to know. When considering private equity vs. venture capital vs. investment banking, who makes the most money? All of the major positions in these fields are very well compensated, but some members of these exclusive professions bring home more income than others.

Investment bankers earn salaries and bonuses, with the bonus a percentage of the salary. Even entry-level salaries start near six figures, but while the pay is good, the hours are grueling. New associates should expect to put in 60 to 80 hours per week, which makes their initial large salaries less impressive when divided into hourly wages. Of course, as investment bankers move up the ladder, they may earn hundreds of thousands to millions of dollars annually.

Investment Bankers Lured to Private Equity

Investment banks are large corporations. Private equity firms are small, and hours aren’t as extreme. Many private equity firms are staffed by former investment bankers, as this is a fairly common career path.

While a private equity associate earns a salary and bonus like an investment banker, they may also receive a portion of the fund’s return on investment. However, the bulk of the return goes to the private equity fund partners, and they may rake in millions.

Venture capitalists also receive salaries and bonuses. Associates in this field usually make more money than those in investment banking or private equity, with salaries of $150,000 or more common in the first few years. When deals near the closing stage, associates work very long hours. General partners in the venture capital firm receive most of the investment profits, generating millions of dollars, but associates may receive a small percentage.

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About the Author

A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Financial Advisor, Sapling, nj.com and The Nest.

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