The risk and return of veture capital
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The risk and return of veture capital
The Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital erson Graduate School of Management. UCLA. 110 Westwood Plaza. Los Angeles CA 90095-1481. john.cochrane9anderson.ucla.edu. This paper is an outgrowth of a project commissioned by OffRoad Capital. I am grateful to Susan Woodward of OffRoad Capital, who suggested the idea of a selection-bias correctio The risk and return of veture capital n for venture capital returns, and who also made many useful comments and suggestions. I gratefully acknowledge the contribution of Shawn Blosser, whoThe risk and return of veture capital
assembled all the data used in this paper. Revised versions of this paper can be found at ht t p: //gsbww w. uchicago.edu/fac/john .Cochrane/researchThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital e that corrects for selection bias. Since firms go public when they have achieved a good return, estimates that do not correct for selection bias are optimistic.The selection bias correction neatly accounts for log returns. Without a selection bias correction. I find a mean log return of about 100% The risk and return of veture capital and a log CAPM intercept of about 90%. With the selection bias correction. 1 find a mean log return of about 5% with a -2% intercept. However, returnsThe risk and return of veture capital
are very volatile, with standard deviation near 100%. Therefore, arithmetic average returns and intercepts are much higher than geometric averages. TThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital tic average return of around 700% and a CAPM alpha of nearly 500%. With the selection bias correction. I find arithmetic average returns of about 57%. and CAPM alpha of about 45%.Second, third, and fourth rounds of financing are less risky. They have progressively lower volatility, and therefore low The risk and return of veture capital er arithmetic average returns. The betas of successive rounds also decline dramatically from near 1 for the first round to near zero for fourth roundsThe risk and return of veture capital
.The maximum likelihood estimate matches many features of the data, in particular the pattern of IPO and exit as a function of project age. and the faThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital tive is to measure the expected return, standard deviation, alpha, beta and residual standard deviation of venture capital investment projects.I use lhe VentlircOnc database. The typical data point gives the investment at each round of financing and number <>r shares. ĨI’ the firm is acquired. goes The risk and return of veture capital public:. or goes out of business, we can then compute a return for the venture capital investor. These returns are the basic input to the analysis.OvThe risk and return of veture capital
ercoming adtclion bia# is the central hurdle in evaluating venture capital in vestments, and it is the focus of this paper. Most importantly, firms goThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital s, is an upward biased measure of the ex ante returns to a potential investor.Ĩ overcome this bias with a maximum-likelihood estimate that identifies and measures the increasing probability of going public or being acquired as value increases, the point at which firms go out of business, and the mea The risk and return of veture capital n, variance, alpha and beta of the underlying returns. The model captures many of the surprising features of the data, such as the fact that the returThe risk and return of veture capital
n distribution is little affected by the time to ipo. The estimate also corrects for additional selection biases due to data errors. For example. I amThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital rms out of the sample would bias the results.1 use only returns from investment to ipo or acquisition, or the information that the firm remains private or has gone out of business. 1 do not attempt to fill in valuations at intermediate dates. There are no data on market values of venture capital pro The risk and return of veture capital jects between investment and exit, so such an imputation requires assumptions and proxies. 1 also do not base the analysis on returns computed betweenThe risk and return of veture capital
financing rounds. Though each financing round does establish a valuation, and such returns are potentially interesting, venture capital investors typThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital turns to venture capital projects. Since venture funds often take 2 3% annual fees and 20 30% of profits at ipo. returns to investors in venture capital funds are often lower.Results1 verify large and volatile returns if there is an ipo or acquisition, i.e. if we do not account for selection bias. T The risk and return of veture capital he average return to ipo or acquisition is an astounding 698% with a standard deviation of 3.282%. The distribution is highly skewed: there are a fewThe risk and return of veture capital
truly outstanding returns of thousands of percent and many more modest returns of “only” 100% or so. 1 find that returns to ipo/acquisition are very wThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital on. Interestingly, these total returns are quite stable across horizons, and annualized returns are not stable across horizons. As I will explain, this is the pattern we expect of a selected sample. A CAPM in levels gives an alpha of 462%: a CAPM in logs still gives an astonishing alpha of 92%.The e The risk and return of veture capital stimates of the underlying return process with a selection bias correction are much more modest and sensible. The estimated average log return is 5.2%The risk and return of veture capital
per year. A CAPM in logs gives a beta near one and a slightly negative intercept. However. I find arithmetic average returns of 57% and an arithmeticThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital hout a sample selection correction.The difference between logs and levels results from the large standard deviation of these individual firm returns, near 100%. This large standard deviation implies an arithmetic average return of 50% or more, even if the average log return is zero. Venture capital The risk and return of veture capital investments are like options: they have a small chance of a huge payoff.issuesOne can cite many reasons why the risk and return of private equity mighThe risk and return of veture capital
t differ from the risk and return of publicly traded stocks, even holding equal their betas or characteristics such as industry, small size, and finanThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital •Poor diversification. Private equity has typically been held in large chunks, so each investment may represent a sizeable fraction of the average investors' wealth. Standard asset pricing theory assumes that every investor holds a small part of every risk, and that all assets are held in perfectly The risk and return of veture capital diversified portfolios.•Information and monitoring. Venture capital investments are often not purely financial. The VC investors often provide a "mentThe risk and return of veture capital
oring" or monitoring role to the firm, they sit on boards of directors, and may have the right to appoint or fire managers. Compensation for these actThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital ld mine, we should expect rapid entry. Many venture capital firms are large enough to effectively diversify their portfolios. The special relationship, information and monitoring stories suggesting a restricted supply of venture capital may be overblown. Private equity may be just like public equity The risk and return of veture capital .2LiteratureDue to the (lata and econometric hurdles, only a few papers have tried to estimate the risk and return of venture capital. I have found noThe risk and return of veture capital
work that tries to correct for the selection bias.Long (1999) estimates a standard deviation of 8.23% per year. However, his analysis is based on onlThe Risk and Return of Venture CapitalJohn H. Cochrane1January 4. 20011 Graduate School of Business, University of Chicago. On leave 2000-2001 to Ande The risk and return of veture capital than 1% of all private equity, which includes privately held businesses, partnerships, and so forth. They use data from the survey of consumer finances, and use selfreported valuations. They find that a portfolio of all private equity has a mean and standard deviation of return very close to that of The risk and return of veture capital the value weighted index of publicly traded stocks.A natural way to estimate venture capital returns is to examine the returns of venture capital funThe risk and return of veture capital
ds, rather than the underlying projects. This is not easy either. Most venture capital funds are organized as limited partnerships rather than as contGọi ngay
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