The risk and return of venture capital Historical return, alpha, beta and individual performance drivers (1983-2009) Stéphane Koch1 April 2014 Abstract We analyse the returns and the risk profile of venture capital based on a sample of 1,953 funds raised between 1983 and 2009. In a historical perspective, we first show that the strong returns during the dotcom era are followed by a decrease and a convergence of returns. However, we find strong evidence of outperformance compared to public markets, with a PME of 1. In a second time and in order to assess the risk profile and the risk-adjusted returns of venture capital, we focus on the beta and alpha of this asset class.
Beta stands between 1.8 and the quarterly CAPM alpha between 0.1%, revealing a clear positive risk-adjusted performance. Lastly, we focus on individual fund characteristics as potential drivers of performance. If we find no evidence of size driving overall returns, we show that location (US) is a strong determinant of performance. Stage-focus does not influence returns, unless the fund is a general fund, in which case returns are driven downwards.
Finally, we confirm the negative relationship between IRR and duration, and show that funds whose payback period is shorter are likely to outperform. Keywords: venture capital, private equity, performance, return. Acknowledgements: I would like to first thank Mr. Christophe Spaenjers for supervising this research paper.
I am also very grateful to Mr. Amaury Bouvet for helping me to understand the different databases and collect data. in International Finance, HEC Paris, stephane. 1 TABLE OF CONTENTS 1 Introduction 3 1.1 Why the performance of venture capital funds matters 4 1.2 Overview of the research paper 5 2 Theoretical background on venture capital 7 2.1 The emergence of venture capital 7 2.2 Types of private equity investments 7 2.3 Private equity investment structure and definition of terms 8 2.4 Overview of venture capital funds 9 3 Literature review 10 3.1 How to measure the performance of a private equity investment 11 3.2 Understanding the risk-return profile of VC: historical performance, comparison with public markets, alpha and beta 15 3.3 Individual performance drivers 18 3.4 Is there persistence in performance? 20 3.5 Selection biases 21 4 Research questions and hypotheses 23 5 Dataset, variables and potential sample biases 24 5.1 Presentation of VentureXpert and potential sample biases 24 5.2 Dataset and variables 27 6 Empirical analysis: results and findings 35 6.1 Historical performance and comparison with public markets 35 6.2 The alpha and beta of venture capital 42 6.3 Individual performance drivers 45 7 Conclusion 51 References 53 Appendix 56 2 1 Introduction This paper examines the performance of venture capital as an asset class.
By definition, venture capital is a component of private equity, the act of investing in the equity of a private, non-listed, company. Among private equity, venture capital funds seek returns by investing in young companies whereas buyout funds target mature and established companies. Despite the dramatic growth in private equity investments over the last twenty years, the very basic characteristics of venture capital remain controversial: if an extensive research already exists on the subject, the studies have reached different findings and no consensus exists on questions such as the risk and return of this asset class. For Gompers and Lerner (2000), the risk-return profile is precisely “what we don’t know about venture capital”.
The main goal of this paper is therefore to get a better understanding of the returns of the venture capital asset class. First, what is the historical performance of venture capital investments, and how this performance compares to public equities? Do they yield larger risk- adjusted returns than publicly traded securities? The existing research emphasizes the different cycles in the performance of venture capital, with increasing returns for funds raised in the 80s and the 90s (Ljungqvist and Richardson (2003)) and a reversed pattern after 1999 and the Internet bubble (Harris, Jenkinson and Kaplan (2013)), however the average return during these cycles and whether or not funds have outperformed public markets remains controversial. Second, we would like to understand the specificity of venture capital investments and therefore estimate the alpha and beta of such investments1. From a theoretical standpoint, the illiquidity of such investments in private companies should lead to a premium and consequently to high returns in comparison to the overall market.
Moreover, venture capital firms often keep around two percent of the invested capital (see Gompers and Lerner (1999), Lerner, Schoar and Wongsunwai (2007)) to compensate for their monitoring role within portfolio companies, which should normally result in a high performance (Admati and Pfleiderer (1994)). Finally, we would like to characterize the type of fund which outperforms and underperforms in terms of size, geography and stage specialisation. This will be the last focus of this paper. 1 The beta, defined more precisely later in this paper, represents the degree of correlation between an asset and the overall market.
The alpha measures how effectively an asset has outperformed or underperformed the theoretical performance. It depends on the model used to forecast asset returns.1 Why the performance of venture capital funds matters The private equity asset class, made mainly of buyout and venture capital funds, has grown importantly since 1990, with institutional investors dedicating more and more capital to private equity in their tactical allocation. A good example is given by the Harvard endowment, allocating 0% to private equity in 1980, 7% in 1984 and 16% in 20131. Within this asset class, venture capital has increased significantly as well, from $3bn flowing into venture funds in 1990 to around $100bn in 2012.
Venture capital has consequently been the fastest growing segment among private equity, with a 1995-2011 CAGR of 20%. Figure 1: Global private equity capital raised by fund type ($bn) 1600 Other Distressed PE 1400 Real estate Venture 1200 Buyout 1000 800 668 679 600 543 358 400 306 253 275 268 220 210 200 163 92 142 141 104 33 44 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: “Global Private Equity Report”, Bain & Company, p. One of the reasons of the success of the private equity segment among asset managers is probably its hedging property. Many invest heavily in private equity with the belief that the returns of private equity investments are largely uncorrelated with public markets and business cycles.
As an example, the Yale endowment reports that such funds “can generate incremental returns independent of how the broader market will be performing2”, something interesting given the current context in public markets. This belief, discussed later in this paper, has already received attention from previous research. According to Gottschalg, Phalippou and Zollo (2003), the performance of venture funds strictly follows business cycles and consequently the beta for such investments should be around one, as documented by Lerner and Schoar (2005). 1 “Harvard Management Company”, An evolving view of asset classes: Creating the optimal mix of investments.
2 The Yale Endowment 2010. 4 Moreover, venture capital is interesting from a macro perspective. It enables young and innovative companies to receive financing from outside investors to finance their growth. Given the uncertain prospects, it is difficult for start-ups to receive bank financing and venture capital can often be an efficient way to grow and professionalize young companies, as evidenced by Hellman and Puri (2002).
A company like Sequoia Capital, one of the biggest venture capital firms specialized in technology companies, has helped Cisco, Nvidia, Apple or Youtube grow and become strong established companies. According to Hege and Palomino (2003), the strong economic growth in the US in comparison to Europe can partly be attributable to the emphasis put on venture capital and contractual differences such as the greater use of control rights. It is therefore clear that venture capital plays an important role as a catalyst for economic growth and knowing more about the risk and return of these investments is of primary importance.2 Overview of the research paper In this paper, we analyse the performance of funds based on the IRR measure traditionally used in private equity. However, this measure is imperfect for at least two reasons, described into more details in section 3.
Firstly, it assumes that all the proceeds are reinvested at the IRR, which of course is not the case. Secondly, it does not take into account the return on public markets. Bradley, Mulcahy and Weeks (2012) recommend “rejecting performance marketing narratives that anchor on internal rate of return” and “adopt public market equivalent as a consistent standard for VC performance reporting” instead. This is why we build another measure, the public market equivalent (PME), based on the methodology developed by Kaplan and Schoar (2005).
This metric compares the return one gets by investing all the money into the fund, basically the IRR, and the return obtained by investing everything into public markets, using for example the return of the S&P500. This paper answers three questions that previous research has not answered yet or for which there is not a clear consensus: firstly, whether venture capital funds have historically outperformed public equities and whether its performance help justify the dramatic growth of this asset class; secondly, define the alpha and beta of this asset class; finally, whether size, geography and stage specialisation are explanatory variables of a fund performance. We show that historically venture capital funds have yielded an average IRR of 9% and have significantly outperformed public markets, with a PME of 1.26 using the S&P500 and 1.08 using the Nasdaq Composite index. Especially, funds raised between 1993 and 1996 5 have had a very strong performance.
However, it seems that the overall performance of VC funds is being less and less volatile and is converging both in the US and Europe, because of a maturing market. Using three different venture capital indices from VentureXpert, Cambridge Associates and Sand Hill Econometrics, we estimate the beta and alpha of venture capital. We also test for sensitivities using two benchmarks: the S&P500 index and the Nasdaq Composite Index. We find that the beta lies between 1.8, close to the findings of previous literature.
This result is consistent with both the S&P500 and the Nasdaq Composite Index and proves that venture capital tends to overreact to public markets. However, this beta is calculated using lagging market returns, which shows that venture capital returns are linked to current and past market returns. We document a positive quarterly alpha between 0.1% revealing a strong risk-adjusted return for venture capital. Finally, we find evidence that location can be considered as a performance driver.
Funds in the US significantly outperform European funds. Additionally, we confirm the theoretical negative relationship between the lifetime of a fund and its return, suggesting for practitioners to focus on general partners showing a strong ability to exit investments quickly. However, this conclusion is to be mitigated by the difference between US and Europe, where this relationship is weaker. Eventually, if non-specialized funds slightly underperform the venture capital industry, stage specialisation and size have little explanatory power over the return of a fund.
The rest of the paper proceeds as follow. Section 2 provides some theoretical background on venture capital, describing the typical structure of a private equity investment. Section 3 surveys and summarizes the relevant literature. In section 4, we present our research questions and lay out our hypotheses.
Section 5 presents the dataset obtained from VentureXpert and warns the reader about potential biases. It also describes the variables that will be used in our empirical analysis. Section 6 presents the key findings of the empirical analysis. 6 2 Theoretical background on venture capital 2.1 The emergence of venture capital Gompers (2004) situates the emergence of venture capital in the early 80s in the US, after changes in the Employee Retirement Income Security Act (ERISA).
Before, this act largely prohibited pension funds from allocating large amounts of money to high-risk assets including venture capital.