VCs Eating PE with AI

We are all seeing the blurring of the lines between PE and VC lately as some PE-dominated industries are starting to adopt tech for the first time and VCs are starting to fund tech-enabled rollup strategies. I have been observing this merging of asset classes curiously and speaking to the various players in the ecosystem to understand where I will focus my energies as an investor through this shift. I haven’t made up my mind yet, but it’s clear that big things are happening. AI is allowing technology to adopt people versus the other way around, and that has some irreversible effects on the markets we are investing into. 

Traditional Value Creation in PE vs VC

According to Cambridge Associates, typical allocation for Limited Partners between venture capital and private equity is around 30/70 within their overall private market investment portfolio. LPs have traditionally allocated more capital to PE due to its more stable return profile (~15% over the past decade) and larger addressable market. In contrast, top-quartile VC funds, while higher risk, can deliver higher returns (up to ~30%) but typically are harder to access. 

While every fund pitches a different strategy around sector, geography, and process advantages - like sourcing, due diligence, and portfolio value creation - LPs across venture and PE are fundamentally investing into two core change vectors in the economy and the GPs who have mastered spotting and harvesting them.

The fundamental logic behind PE returns has remained relatively unchanged for decades. Traditionally, much of PE’s performance has been driven by the use of leverage to drive returns on equity. At the same time, PE firms can also drive operational efficiencies and create scale by merging competitors, cutting overhead, improving processes, and more recently introducing technology. The former strategy is commoditized, but as operational talent is more scarce, the latter strategy is more differentiated and sustainable.

The logic behind VC returns emerged with the onset of technology adoption. In venture,  returns are generated by the speed of change in customer behavior - and the startups that successfully capture those shifts. This is driven both by technology shifts such as the Internet, Mobile, Cloud, and AI as well as market shifts such as generational transitions, pandemics, macroeconomics, etc. VCs specialize in identifying these tech and market shifts coupled with the revolutionary entrepreneurs who fight for exponential change, working against inertia, stagnancy, and sometimes rationality.

Along Comes AI

However, the technological innovations of late — particularly AI agents capable of near-perfect labor substitution — are making these two vectors of private market value creation collide.  

A lot of the tech adoption happening now is in sectors that were previously untouched by venture-backed tech companies because it was so hard for a company so ridden with manual and offline processes to adopt technology. This is where we have spent a lot of our time as of late, investing in companies in healthcare, procurement, professional services, etc. 

Hereby lies the power of AI: historically, the burden was on users to learn complex tools, navigate outdated interfaces, or manually transfer data across disconnected systems - often using bridging solutions like Microsoft Excel rather than actual workflow products. The rate of technology adoption was always limited to the human behavior change required to make the technology work in a complex environment. When it doesn’t go as planned, many companies add layers of administrators to make the process work, and after a few layers of this, the whole thing gets gridlocked in an incentive conflict that prevents anything new from being introduced — just look at the US healthcare system. In the past few tech paradigms, it was always about people serving the tech interface, and going back to PE value creation, the only way to make it work was to send operators into the field to help improve these processes and do the change management required to drive out costs. 

AI is flipping this paradigm on its head, allowing technology to finally serve human interfaces - rather than the other way around. It can listen to our natural speech, sort through piles of piles of offline text, watch videos of our behaviors, maybe in the future even read our thoughts, all without humans having to do anything differently than they are already doing today. Instantly the barrier to adoption goes down to near 0. That is groundbreaking. The rate of change so far on how easily tech is adopting us has been staggering to most venture capitalists since the onset of Chat-GPT. 

Automation is already making major dents in administrative processes like billing, compliance, legal work, and procurement across sectors like healthcare, legal, financial services, etc. Now some of the fastest growing venture-backed startups in AI are selling to PE rollups, and of course PE firms are incentivized to be using these technologies to cut costs within portfolio companies. 

Value Capture Going Forward?

What else is happening? We are seeing VCs rolling up companies themselves to drive out costs with AI-enabled tech. We are seeing PEs hire previously venture-backed talent directly to roll this out across their portfolios. We are seeing more VC-funded business-in-a-box solutions that collapse a lot of the previously burdensome administrative tasks with automation. They sell directly to SMBs to help them realize the value without a franchisee-like value extractor overhead. We also see VCs less gun-shy about investing into tech-enabled services businesses that rebuild certain service sectors from scratch. Lastly, where PE has traditionally had the capital market advantage because of their highly scaled funds, but now venture has that too with the multi-stage mega funds.

So going forward, value capture across these two asset classes is going to be interesting. It could go three ways: 1. If the software tools completely commoditize and PEs are great at implementing the tech, the value could show up in the OPEX budget of PEs. 2. If the software tools don’t commoditize, it could go to the tech giants that will be built to serve these PE-owned offline sectors. 3. It could go directly to the venture-backed tech-enabled businesses that will completely displace the PE-owned incumbents. A mix of all three will probably happen across different sectors / market structures / geographies, etc. It will also depend on how the large publicly-held tech giants will react to these changes. 

This will be an exciting journey, as it will be our job to figure this out in the next decade or so.

Ultimately, who will capture the most value in this new paradigm? We believe it will be the builders and investors who:

• Understand technology as products, not. just businesses. 

• Deploy patient capital with longer holding periods. 

• Move quickly to transform themselves and their portfolios. 

Based on that, I would say the odds look pretty favorable for venture capitalists if they can raise scaled-enough funds. However, for VCs curious about moving into PE territory – e.g. deploying capital to consolidate businesses, I feel it will still be very important to get the product-market-fit right on the first company before considering using capital to scale the outcome. The leap of faith on this strategy can’t be the automation piece because that is our core competency, and PEs are much better at the latter part of the equation. This is where I see some funds have already made some big mistakes.