The author explores determinants of the risk premium inherent in venture capital investments.
What’s Inside?
Venture capital is opaque relative to its public market counterparts, and as an asset class, it possesses risk and return characteristics that derive from its illiquidity and high failure rate. Control features may afford investors the ability to enhance the return potential of venture capital and offset these risks to some degree. The author proposes a more accurate model for determining the risk premium for venture capital.
How Is This Research Useful to Practitioners?
The features unique to venture capital call for a proper determination of its risk premium. Illiquidity and high failure rates increase its risk as an asset, whereas the availability of investor control compensates to some extent. The CAPM variants applied to venture capital fail to account for these characteristics and are unable to distinguish between managerial ability and the risks inherent in the asset class. The author’s proposed model aggregates control, illiquidity, and failure risk into a single premium that removes the effects of managerial skill.
About one-quarter to one-third of venture capital investments fail, and a little more than one-quarter eventually become publicly traded. Accordingly, about one-third of a venture capital portfolio’s value receives a residual illiquidity discount. The author uses surveys covering various time periods since 1960 that break down average initial public offering percentages and failure rates both in the aggregate and by stage of investment. Similarly, he calculates control premium averages using numerous surveys and compares company prices when trading in public markets with those when trading privately. An average overall control premium comes to about 40% on US acquisition deals.
The required venture capital premium is a mathematical expression that captures these innate frictions of degrees of control over an asset class characterized by low liquidity and a high risk of failure. Because it uses actual survey data on these particular features and can parse out investor skill, the model allows for a more accurate computation of the premium for an investor to add to public equity returns to facilitate comparison with individual venture capital projects or portfolios. Its use should enable better investment decision making in this asset class.
Valuation practitioners in general, as well as those focused on private equity investment in particular, will welcome this valuation model for its intuitive simplicity and focus.
How Did the Author Conduct This Research?
The author proposes a scenario of investors with three different profiles to highlight the differences between public (traded equities) and private (venture capital) markets in order to address how to properly determine the appropriate risk premium to compensate for the risks of investment in venture capital.
Drawing on survey data from numerous authoritative sources and using simple mathematical formulas, the author calculates and illustrates the high degree of liquidity and failure risk to which venture capital is subject. Similarly, he reviews sources on control premiums and illustrates through formulaic expression how the premium acts as a countervailing weight to the asset class’s inherent illiquidity and high risk of failure. From there, he derives the required venture capital premium formula that calculates the risk premium for both the passive investor subject to illiquidity and failure risk and the control-type investor.
Appendices provide a more detailed explanation of the model and explore in greater depth the relationship between the equity discount—a function of illiquidity and the high risk of failure—and the risk premium. One appendix breaks down the cash flow growth rates of average US venture capital portfolios and cash flows by sector. A few end notes clarify the definition of venture capital and the CAPM and provide miscellaneous insights on venture capital investors and control issues.
For the passive venture capital investor, the appropriate risk premium is 1.29%; for the active or control-type investor, it is 0.42%. These figures represent a weighted average for all investment stages (early, middle, and late). Because control investors have input in decision making, they have a greater impact on potential outcomes than a passive investor, whose limitations would argue for a higher hurdle rate.
Abstractor’s Viewpoint
Investment outside of the public markets lends itself to more nuanced valuation specific to its unique characteristics. Such is the case with venture capital, whose risk is a function of illiquidity, failure risk, and investor control. The author’s formula represents a ready means to compute a minimum performance hurdle rate for venture capital and its risk-adjusted performance. Such a tool may allow for more accurate and less arbitrary return calculation and, by extension, help venture capital analysts and general partners achieve more accurate pricing for target portfolio companies rather than relying on the use of ad hoc, arbitrary internal rates of return. A potential caveat is that investors may use their own estimates of residual liquidity, failure risk, and control to compute the premium. The accuracy of the inputs will determine that of the output.