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P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton CHAPTER 19 Returns to Venture Capital MIKE WRIGHT Professor of Financial Studies, Centre for Management Buy-Out Research, Nottingham University Business School RIYA CHOPRAA Researcher, Centre for Management Buy-Out Research, Nottingham University Business School INTRODUCTION The returns to private equity investment have become a vexed issue, attracting widespread debate in the media, government, and among researchers. Much of the attention has focused on later-stage buyout investments, but there is a general move towards greater transparency and disclosure of the returns to both early and late-stage venture capital (VC) investments. Shortcomings in the information provided to investors may mean that limited partners are restricted in their ability to judge the investment record of the VC funds in which they seek to invest. In this chapter, returns are examined at two levels. First, we examine returns at the level of VC funds. Second, returns at the investee firm level are discussed. The literature on returns to venture capital is, unsurprisingly, mainly concentrated in finance and economics journals, but a stream of studies has also appeared in entrepreneurship journals. Reviews of the literature relating to the different stages of the venture capital investment process, from deal sourcing through to exit, are available in Wright and Robbie (1998) and Wright, Sapienza, and Busenitz, (2003). In this review, we focus specifically on the earlier venture capital stage of the private equity market. Comparisons are made with the later management buyout stage of this market where appropriate and where studies are available. Detailed surveys of the later buyout stage of the private equity market are available in Wright (2007); Cumming, Siegel, and Wright (2007); and Bruining and Wright (2008). The main findings from the studies reviewed are summarized in Exhibit 19.1. STRUCTURE OF VC FUND RETURNS The venture capital fund manager receives a fee for the management of the funds and a share in the profits of the fund (Gilligan and Wright 2008). However, the fees received are typically an advance on carried interest, not in addition to the share 407 408 30 London-based specialist UK venture capital companies, all listed on Stoy Hayward and represented approximately 20% of the total number of UK funds 74 UK venture capital institutions listed as full-time members of the British Venture Capital Association (BVCA) Dixon (1991) Wright and Robbie (1996) Summary of Findings Multivariate regression Compensation of established funds is analysis, including significantly more sensitive to performance Ordinary Least and more variable than that of other funds. Square (OLS) analysis Older and larger funds have lower base compensation, and performance and pay sensitivity do not appear to be related. Mean scores, The most important factor venture capitalists percentages of total look for in a proposed investment is the sample mentioning it experience of the management team, over the and standard projected returns and turnover. The project’s deviations financing stage determines the risk premium, as the required rate of return is an arbitrary IRR to the proposal, not calculated through theoretical pricing models. Mean scores, Standard Venture capitalists make greater use of Deviation, and discounted cash flow approaches and less use Mann-Whitney U test of asset-based methods, reflecting the use of of differences IRRs as an important indicator of investment performance. They also use wide nonfinancial information to test the robustness of the accounting and financial projections. Correlation analysis The most widely used valuation method in the UK is multiplication of past/future earnings with some price-earning ratio. In the Netherlands and Belgium it is the discounting of future cash flows, and in France it is the book value of net worth. Method of Analysis 21:46 Mail questionnaires to chief executives of the venture capital firms or senior colleagues Partnership agreements collected by three organisations: Aeneas Group, Kemper Financial Services, and Venture Economics Interviews with the executives constructed around a questionnaire Data Source December 11, 2009 Manigart et al. 136 venture capital firms from Questionnaires filled by the (1997) UK, France, Netherlands, senior managers of the and Belgium. venture capital firms 419 U.S. venture capital partnership agreements and offering memoranda for funds formed between 1978 and 1992 Sample Description Gompers and Lerner (1999) Author Exhibit 19.1 Summary of Studies of Returns to Venture Capital P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 21:46 (Continued ) December 11, 2009 Robbie et al. (1997) Karsai et al. (1999) Chi-square analyses, Stage diversification is associated with lower limited dependent required returns for early-stage ventures. variable (LDV) Being lead investor more often is associated technique and with lower required returns for early-stage ordinary least square investments and fewer investments per VC (OLS) regressions manager associated with higher required returns. The required returns for independent VCCs are significantly higher than for captive and publicly supported firms for early-stage and expansion-stage investments. 18 venture capital firms Questionnaire surveys and Mean scores on the Hungary and Poland have experienced marked (9 from Hungary, 6 from interviews administered to basis of 1 = not growth in their venture capital markets, with Poland and 3 from the managers in the VC important through to the VC firms exhibiting greater involvement Slovakia) firms 5 = very important in the monitoring of their investees, while Slovakia remains underdeveloped, and VC firms in all three countries have less involvement in strategic decisions and more involvement in operational decisions, with major infrastructural impediments. 77 UK venture capital firms, A series of in-depth Chi-square test of There exists a shift towards target IRRs set in which were full-time face-to-face interviews independence to relation to returns on other asset classes or members of the British based on a structured analyze the difference returns for outperformers in the venture Venture Capital Association questionnaire checklist, between independent capital sector. An increased amount of (BVCA) in 1996 followed by a mailed and nonindependent performance targets are expressed in terms of questionnaire survey to the venture capital firms. target IRRs and cash amounts generated. remaining UK venture capital firms (which were members of BVCA) not covered in the first stage Manigart et al. 209 venture capital companies Questionnaire survey (2002) (66 from UK, 73 from U.S., 32 from France, 24 from Netherlands and 14 from Belgium) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 409 410 Sample Description Data Source Lockett, 60 VC firms, which were full Telephone interviews Murray, and (investing) members of the conducted with the Wright British Venture Capital representatives of the (2002) Association (BVCA) in venture capital firms 1999–2000 Bygrave (1994) All U.S. funds formed from Venture Economics’ 1969 through 1985 Investment Benchmarks Report. Kleiman and 14 Small Business Investment Venture Capital Journal, Shulman Companies (SBICs) and 12 publicly available stock (1992) Business Development prices and NASDAQ Corporations (BDCs), that monthly returns started after 1980 or dissolved before 1990 Huntsman and Returns generated by 110 Three well-known venture Hoban private equity investments capital firms (a (1980) between 1960 and 1975, publicly-held Small with investment size Business Investment ranging from $1000 to Company, a partnership $1.1 million. and a wholly-owned SBIC subsidiary of a large bank holding company), each representing a different type of institution Brophy and 12 publicly traded venture Compuserve Executive Data Guthner capital funds in existence Service and S&P Daily (1988) during the time period Price Index from May 1981 to February 1985 and 12 open-ended mutual funds Author Exhibit 19.1 (Continued) Summary of Findings December 11, 2009 21:46 Scholes and Williamson Superior results are realized on publicly traded (1977) beta estimation venture capital funds when compared with technique portfolios of growth-oriented mutual funds and with the S&P 500 index. Market model using From 1980 to 1986, SBICs demonstrate Scholes and William significantly greater and unsystematic risk (1977) technique and but significantly less systematic risk than computing BDCs. SBICs experience much higher returns, cumulative return of on a risk adjusted basis, than either the the funds market proxy and BDCs. Algorithm developed An attractive rate of return can be generated by Lawrence Fisher over time by well-diversified venture portfolios. Adequate diversification requires greater minimal capital levels than may be the case for portfolios containing securities of more mature enterprises with readily marketable securities. Z-tests of proportions, More generalist firms are now making more Mann-Whitney Z-test investments in technology-based companies. statistics and Target IRRs for technology-based investments Wilcoxon signed are higher than the non–technology-based ranks test Z statistics. ones at the same stage. Weighted averages The median IRR peaked in 1982 at 27%, with weighted average at 32%. Method of Analysis P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton Ljungqvist and 73 mature private equity Records of one of the largest Regression analysis, Richardson funds started between 1981 institutional investors in calculation of IRRs (2003a) and 1993 with aggregate private equity in the U.S., and their weighted commitment of $36.7 billion referred to as the “Limited averages thereof and 8539 funds started Partner” in the study between 1981 and 2001 with an aggregate commitment of $ 207 billion (in nominal terms) Ljungqvist and 73 mature private equity Records of one of the largest Regression analysis Richardson funds started between 1981 institutional investors in (2003b) and 1993 with aggregate private equity in the US, commitment of $36.7 referred to as the “Limited billion. These funds include Partner” in the study both venture capital and buyout funds. Cochrane 16,613 financing rounds with VentureOne database, SDC (2005) 7765 companies and a total Platinum Corporate New of $112,613 million raised Issues and Mergers and Acquisition (M&A) databases, Market-Guide, and other online resources. Phalippou NA NA LiterAture review of (2007) issues faced by private equity investors 21:46 (Continued ) December 11, 2009 The average investor has obtained poor returns from investments in private equity funds, potentially because of excessive fees. Investors need to gain familiarity with actual risk, past returns, and specific features of private equity funds. Existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow and private equity fund managers respond by cutting their investment spending. The smallest Nasdaq stocks have similar large means, volatilities, and arithmetic alphas, confirming that the remaining puzzles are not special to venture capital. Private equity generates excess returns on the order to 5% to 8% per annum relative to the aggregate public equity market. Source of outperformance of IRRs is not necessarily compensation for systematic risk, but it may be related to the type and the timing of the fund. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 411 412 Data Source 5607 unique firms with Sand Hill Econometrics financing data for a total of database 12,553 rounds of funding, including 9706 rounds of private equity financing, plus 1307 IPOs, 896 acquisitions and 644 shutdowns, covering the period from January 1, 1987 to March 31, 2000 Two samples of funds Venture Economics covering the period from 1980 to 1997, excluding one with less than $5 million of committed capital. The first sample consists of 746 funds, officially liquidated or started before 1995. The second sample consists of 1090 funds, officially liquidated or started before 1997 Sample Description Summary of Findings Average fund returns (net of fees) approximately equal the S&P 500 although substantial heterogeneity across funds exists. Returns persist strongly across subsequent funds of a partnership. Better performing partnerships are more likely to raise follow-on funds and larger funds. This relationship is concave, so top performing partnerships grow proportionally less than average performers. 21:46 Regression analysis Repeat valuation model The authors report a method for building an plus a correction for index for venture capital that can be used in selection bias much the same manner that the NASDAQ and S&P 500 are used as indices of prices of common stock. Method of Analysis December 11, 2009 Kaplan and Schoar (2005) Hwang et al. (2005) Author Exhibit 19.1 (Continued) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton Phalippou and Base sample comprising 852 VentureXpert Regression analysis. Gottschalg funds raised between 1980 (2009) and 1993, which are older than 10 years with size more than $5 million. The additional sample contains 476 different funds raised between 1980 and 1993 with more than 5 investments in the “investment dataset.” Merged together, the base and the additional sample make what is called the “extended sample” in the study. Metrick and 238 funds, of which 94 are Data from one of the largest Regression analysis. Yasuda venture capital funds and private equity limited (2007) 144 are buyout funds, partners in the world, raised between 1993 and referred to as “the Investor” 2006. These funds represent in the study. Other sources all prospective funds that of data are Galante’s the Investor considered Venture Capital and Private investing in, not just the Equity Directory (Asset funds it ended up Alternatives, 2006), Private investing in. Equity. Performance Monitor 2006 (Private Equity. Intelligence, 2006), and Investment Benchmarks Report published by Venture Economics (2006a and 2006b). 21:46 (Continued ) December 11, 2009 Buyout (BO) fund mangers build on their prior experience by increasing the size of their funds faster than venture capital (VC) managers do, leading to significantly higher revenue per partner and per professional in later BO funds. BO business is more scalable than the VC business, and past success has a differential impact on the terms of their future funds. Average performance (net-of-fees) of funds is lower than that of S&P 500 by 3% per year, but gross-of-fees performance is above that of the S&P 500 by 3% per year. Newly raised funds have a performance similar to that of sample funds at the same age. It is also important to keep in mind that there is wide dispersion in performance and that performance is predictable to a certain extent only. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 413 414 Sample Description Hellmann and 149 start-up companies, with Puri (2000) legal age no older than 10 years and with more than 10 employees, that are located in California’s Silicon Valley. Engel and 21375 non–venture-funded Keilbach and 142 venture-funded (2007) firms, founded between 1995 and 1998, with at least one patent application and at least two entries with respect to their firm size to enable computation of a growth rate Burgel et al. 362 and 232 firms from UK (2000) and Germany, respectively. These firms were formed between 1987 and 1996 and had at least 3 employees in 1997 and were primarily engaged in the production and development of new products, services, and processes. Jain and Kini 136 VC-backed and 136 (1995) non–VC-backed IPOs. Author Exhibit 19.1 (Continued) Method of Analysis VC-backed IPOs exhibit relatively superior postissue operating performance compared to non–VC-backed IPO firms. Capital markets appear to recognise the value-added potential of VC monitoring, as reflectedd in the higher valuations at the time of IPOs. Cross-sectional regression analysis Going Public: The IPO Reporter and Investment Dealers Digest’s Five-year Directory of Corporate Financing 21:46 Firms with international sales have higher sales growth than firms that sell domestically. Technological sophistication of products and the experience of entrepreneurs has a positive impact on growth. Firms with higher innovative output and with a highly educated management have a larger probability of getting venture capital. Venture-funded firms display significantly higher growth rates and larger numbers of patent applications, compared to their non–venture-funded counterparts. Innovator firms are more likely to obtain venture capital than imitator firms. Venture capital is associated with a significant reduction in the time to bring a product to market, especially for innovators. Summary of Findings December 11, 2009 Mail survey using a four-page OLS and probit identical questionnaire for regression models both countries An assortments of surveys, Cox proportional publicly available hazard regression information, and model commercial databases (VentureOne and Venture Economics) Microlevel database on Probit estimation of German firms developed propensity scores and maintained by ZEW in Mannheim, Germany and DPA database (PATDPA) Data Source P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton December 11, 2009 21:46 415 (Continued ) Audretsch and 341 firms that are/were listed Individual balance sheet data Probit approach and Venture capital and debt provided by banks are Lehmann on Neuer Markt in from IPO prospectuses, two-limit tobit model not complements but substitutes. Banks play (2004) Germany between 1997 and publicly available only a minor role in financing and controlling 2002 information from online innovative firms. data sources: German Patent Office and Deutsche Boerse Bottazzi and 511 companies that went Listing prospectuses, annual Probit regression Venture capital in Europe is not systematically Da Rin public on Euro.nm from reports of the companies analysis associated with particularly dynamic (2002) their inception to December and financing information companies, whether in terms of sales growth, 2000 from the venture capitalists new employment, or stock market performance. Colombo and 439 Italian New 2004 release of Research Endogenous switching Founders’ human capital has a direct positive Grilli (2008) Technology-Based Firms Entrepreneurship in regression model effect on firm growth. VC investments are (NTBFs) operating in high Advanced Technologies attracted by the perceived management tech sectors, established (RITA) database competence of firms’ founding team. The joint between 1/1/1980 and consideration of human capital variables and 1/1/2000 VC financing has the additional advantage of helping disentangle the relative importance of “scout” and “coach” functions performed by VC investors to the advantage of portfolio NTBFs. Bertoni et al. 550 Italian New Technology Hand collected longitudinal Augmented Gibrat-law VC financing has a positive effect on the (2008) Based Firms (NTBFs), dataset drawn from the type panel data subsequent growth of sales and employment observed over a 10-year 2004 release of the RITA model with of portfolio companies. The magnitude of this period (1994–2003). (Research on distributed lags and effect differs according to the type of investor, Entrepreneurship in GMM-system with the benefits of FVCs considerably Advanced Technologies) estimation exceeding those of CVCs. Alemany and 323 Spanish firms that are SABI database (Bureau Van chi-squared test of There exists a significant positive relation Marti (2005) fully identified and for Dirk) difference between between the cumulative VC investment in a whom separate financial proportions and firm and the growth in employment, sales, accounts exist nonparametric test of gross margin, total assets, net intangible Kruskal-Wallis for assets, and corporate taxes over time. different firm characteristics. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton Summary of Findings 416 December 11, 2009 Heirman and Clarysse (2005) Lee et al. (2001) 494 start-up firms, of which Several proprietary databases: Auxiliary regression Companies that receive venture capital grow 193 are venture-backed and Trivet (leading professional model faster than the ones that did not have this 301 are employer organisation), type of financing non–venture-backed VentureOne (Reuters), and start-up firms. Venture Source (Venture Economics) 137 Korean technological Survey questionnaires, Lagged dependent Technological capabilities and financial start-up companies telephone interviews and variable model, using resources invested during the development Korean Small and Medium identical fixed lag period are positively associated with the Business Administration period start-ups’s performance. Entrepreneurial (KSMBA) web site. orientation has a positive and marginally statistically significant effect on performance. 171 Resource Based Start-Ups Structured questionnaires Uni (t-test, F-tests, Raising large amounts of VC is a key driver for (RBSUs) in Flanders Mann-Whitney early employment and revenue growth. (Belgium) founded U-tests) and While most RBSUs are founded by pure between 1991 and 2000. multivariate (General technical founding teams, R&D experience Least Square) has no effect on growth. Founding teams with analysis commercial experience, on the other hand, grow significantly more in employees, revenues, and total assets. RBSUs, which are internationally oriented from the start, grow significantly faster in terms of revenues and total assets but not in employees. Firms that are closer to a market-ready product at founding do not grow significantly more in terms of revenues and employees, but firms that are earlier in the product development cycle grow more in total assets during the early growth path. Method of Analysis Davila et al. (2003) Data Source Sample Description Author Exhibit 19.1 (Continued) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming 21:46 Printer Name: Hamilton 384 SMEs representing 23 Survey methodology, Moderated regression different industries, each complemented with analysis with 500 or fewer full-time information gathered from employees secondary sources (SMEs’ web sites, newsletters, and publications) 340 European VC-backed investments Zahra et al. (2007) Lockett et al. (2008) 21:46 (Continued ) Internal owners (CEOs and other senior executives) tend to be risk averse and have a lower proclivity to increase scale and scope of internationalization than external owners (venture capitalists and institutional investors). Top management team (TMT) ownership is strongly and positively associated with SMEs’ investment in building the knowledge-based resources devoted to internationalization. A positive relationship exists between ownership by VCs and SMEs’ investments in building two types of knowledge-based resources: human capital and proprietary. Outside directors serving on SMEs’ boards fulfill a valuable enterprise role in the governance of these firms by offering new perspectives and ideas, and focusing managers’ attention on the importance of building knowledge-based resources. External VC value-added resources have a greater impact on export intensity for early-stage ventures than late-stage ventures. External VC monitoring resources have a significant effect for late-stage MBO/I firms; however, no significant effect exists for early-stage firms. December 11, 2009 Questionnaires targeted at Heckman Selection senior management of the estimates VC-backed firms, EVCA, Europe Unlimited and CMBOR databases, ONESOURCE, export-intensity online database EVCA directories 889 Swedish SMEs, with data Statistics Sweden (the Bureau Heckman correlation from 1997 to 2000 of Census) model, hierarchical OLS regression and negative binomial regression models. George et al. (2005) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 417 418 Method of Analysis Summary of Findings December 11, 2009 21:46 Jones and RhodesKropf (2003) 838 funds raised between 1991 and 1998 with 4618 investments by 352 LPs in these funds Lerner et al. (2007) Data Source Asset Alternatives fund Pooled regression, Endowments (and to a lesser extent, public database (included as part Heckit sample pensions) are better than other investors at of their Galante’s Venture selection regression predicting whether follow-on funds will have Capital and Private Equity and probit regression high returns. Directory), supplemented models from Venture Economics’ online fund database, Private Equity Intelligence’s 2004 Private Equity Monitor, Annual reports to written request forms mailed directly to the investors, confidential listing of investments by private investors, with whom the authors have personal relationships. 1245 U.S. venture capital and Thomson venture Economics Time-series regression VC investments have positive alphas while private equity funds, analysis investors in VC funds earn zero alpha. Even formed between 1980 to though fund investors expect zero alphas, 1999, with at least $5 funds that have more idiosyncratic risk ex million of committed post will earn higher returns. capital. These funds exclude mezzanine and funds-of-funds Sample Description Author Exhibit 19.1 (Continued) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 4069 professional U.S. venture VentureOne financings of privately held firms taking place between January 1987 and December 1995, for which VentureOne was able to determine the valuation of the financing round December 11, 2009 21:46 419 (Continued ) Hedonic regression The impact of venture capital inflows on prices approach, employing is greatest in states with the most venture OLS specifications, capital activity and segments with the log-log framework, greatest growth in venture inflows. Changes Heckman sample in valuation do not appear to be related to the selection regression ultimate success of the firms. analysis and instrumental variable regression analysis Gompers et al. 2179 venture capital firms Thomson Venture Economics Regression-based Venture capitalists with the most industry (2005) investing in 16354 portfolio (Venture Economics) analysis experience increase their investments the companies, resulting in most when industry investment activity 42559 unique observations accelerates. of VC firms-portfolio company pairs. These investments were made between 1975 and 1998. Cumming and 221 PE funds managed by 72 Dataset collected by Center of Multivariate analysis of Less experienced PE managers as well as those Walz (2007) PE managers, including Private Equity Research IRR performance involved in early-stage investments are more 5038 observations of (CEPRES) in Frankfurt, based upon previous inclined to overvalue. Syndication proves to Portfolio firms (3824 are VC Germany work (Cochrane 2005; lower the incentives of PE funds to overstate and 1214 late-stage Nikoskelainen and the value of unrealized investments. mezzanine and buyout) Wright 2007), Robustness and impact of accounting spanning a time period of multistep standards and legal framework are negatively 33 years (1971–2003) Heckman-like sample related to the reporting behaviour of PE dispersed over 39 countries selection correction managers. from North and South on America to Europe and realized/unrealized Asia. The observations exits and full/partial represent 2419 fully exits realized investments, 1665 unrealized investments, and 954 partially realized investments. Gompers and Lerner (1999) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton Summary of Findings 420 21:46 Bottazi, Da Rin, and Hellmann (2008) December 11, 2009 Dimov and Shepherd (2005) 318 first-time U.S. based VC VentureXpert and Regression analysis Fund management teams with more funds, which are classified hand-collected dataset task-specific human capital manage funds as “Private Equity Firms describing the with greater fractions of portfolio company Investing Own Capital.” work/educational histories exits. Fund management teams with more These funds were raised of the venture capitalists industry-specific human capital manage between 1980 and 1998. managing the VC firms funds with greater fractions of portfolio These funds have selected from VentureXpert company exits. Fund management teams that nonmissing size have more general human capital in business information and have administration manage funds with lower invested in five or more fractions of portfolio company exits. portfolio companies. 112 independent venture VentureXpert Hierarchical regression General human capital had a positive capital firms in the U.S. that analysis and association with the proportion of portfolio have made at least one canonical correlation companies that went public (IPO), whereas investment in the wireless analysis are used to specific human capital did not. However, communication industry. analyse the data. specific human capital was negatively associated with the proportion of portfolio companies that went bankrupt. 119 venture capital firms from Survey conducted between Univariate Prior business experience is an important 17 countries, with 503 February 2002 and nonparametric tests predictor of investor activism. There exists a venture partners and 1652 November 2003, and multivariate positive relationship between investor portfolio companies. The commercially available regression analysis activism and the success of the portfolio venture firms are included databases, Amadeus, including: probit companies, emphasizing the economic were full time members of Worldscope and models, conditional importance of human capital for financial European Venture Capital VenturExpert, and trade logit models, intermediation. Association (EVCA) or of a publications like directories IV-Cum-Mills model, national venture capital of venture capital instrumental variable organisation in 2001, associations and web sites regression, actively engaged in venture of the respondents and Sorensen-Heckman capital, and operational in their portfolio companies. model, and 2002. Ackenberg-Botticni model. Method of Analysis Zarutskie (2008) Data Source Sample Description Author Exhibit 19.1 (Continued) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton Sample 1 and Sample 2 Mail questionnaires to the Mann-Whitney consisted of 58 and 56 representatives of the non-parametric tests venture capital firms in the venture capital firms listed statistics. UK, respectively. in the BVCA directories of 1998–99 and 1999–2000 for Sample 1 and Sample 2, respectively. 200 randomly selected VentureXpert Ordered logit U.S.-based independent focal venture capital firms, with 14,129 initial investments of which 8,162 were first-round investments. These venture capital investments were made from 1962 to 2002. 3,469 venture capital funds Thomson Financial’s Venture Graph theory and managed by 1974 venture Economics database multivariate capital firms that regression analysis participated, in 47,705 investment rounds involving 16,315 portfolio companies. The sample considers all investments made by venture capital funds raised between 1980 and 1999, concentrating solely on investments by U.S. based venture capital funds, excluding those made by angels and buyout funds. (Continued ) 21:46 Better networked venture capital firms experience significantly better fund performance. Similarly, portfolio companies of better networked venture capital firms are significantly more likely to survive to subsequent financing and eventual exit. Reputation is highly important in encouraging other parties to continue to syndicate with a venture capital firm both for further investment rounds of a particular deal and for subsequent deals. The finance/risk-sharing motivation for syndication is stronger than the resource-based argument. Investing in industries in which the venture capital firm has more knowledge or investing with more or familiar partners enhances performance. Access to external knowledge is more effective when an incongruity exists between what the firm knows and what it intends to know. December 11, 2009 Hochberg, Ljungqvist, and Yang (2007) De Clerq and Dimov (2008) Wright and Lockett (2003) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 421 422 Kaplan and Stromberg (2009) U.S. VC firms show a significantly higher performance on average than their European counterparts, both in terms of exit and rate of return. U.S. venture capitalists more often assert contingent control rights, indicated by convertible and decisions to replace entrepreneurs and have better capacity to screen projects and ensure their success in the early stages, than European venture capitalists. Summary of Findings Trend analysis and regression analysis On average, private equity creates economic value and therefore, has a substantial permanent component. Private equity activity is subject to boom and bust cycles, driven by recent returns as well as level of interest rates relative to earnings and stock market values, particularly for larger public-to-private transactions. 21:46 Multivariate regression Investments in nations with effective legal enforcement are more likely to employ preferred stock and to have more contractual protections for the private equity group, such as supermajority voting rights and antidilution provisions. Tobit regression and OLS regression techniques Method of Analysis Au: Missing word December 11, 2009 Lerner and Schoar (2005) Sample 1 consisted of 171 VC Questionnaire survey and firms, 67 from U.S. and 104 data derived from the from 6 countries in Europe. Thomson Financial’s Sample 2 comprises 274 VentureXpert database observations from the EU—15 countries and 234 observations from the U.S. of portfolio companies that have at least one valuation observation in the VentureXpert and of which there is a financing round round defined as “seed” or “early-stage” funding. 210 transactions from 28 Survey in the private equity private equity groups groups that invest in occurring between 1987 developing nations and 2003, with the bulk of investments between 1996 and 2002. The transactions represent 30 distinct countries. 17,171 private-equity CapitalIQ database sponsored buyout transactions, which occurred between January 1, 1970, and June 30, 2007. The transactions that had been announced but not completed by November 30, 2007 are excluded. Hege et al. (2004) Data Source Sample Description Author Exhibit 19.1 (Continued) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton Kruskal-Wallis test and VC firms in Europe and Asia are significantly multivariate analysis less likely than U.S. VC firms to use using OLS regression. liquidation value methods but more likely to use PE comparators. European firms are significantly less likely to adopt DCF methods compared to U.S. VC firms. VC firms operating under German legal system are less likely to utilize information from financial press but significantly more likely to use interviews with entrepreneurs. VC firms operating under French legal system are more likely to utilise interviews with company personnel as well as sales and marketing information. VC firms in Europe and Asia are significantly more likely than U.S. VC firms to use financial press. VC firms in Asia are significantly less likely to make use of interviews with entrepreneurs or business plan data. VC firms in Europe are significantly more likely to utilize sales and marketing information. Literature review of Under-researched areas concern the influence of international venture institutional context, especially the role of capital studies social networks and cultures. There exists major research gap in relation to work dealing with crossing of country borders by venture capital firms. 21:46 NA 357 venture capital firms from Multicountry data collected 9 countries in Europe, U.S. through mailing and Asia; covering a range questionnaires and of different legal systems conducting face-to-face or telephone interviews December 11, 2009 Wright, Pruthi NA and Lockett (2005) Wright et al. (2004) P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming Printer Name: Hamilton 423 P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming 424 December 11, 2009 21:46 Printer Name: Hamilton Venture Capital Exits and Returns in capital growth. During the investment phase, the management fee will typically be 1.5 to 2.0 percent of the committed fund size. The management fee was originally intended to pay for the operating costs of employing staff and other expenses associated with the fund manager’s business, plus the reasonable salaries of the partners. Any excess over these costs is retained by the management company and may be paid to its partners/shareholders. Fund managers have to balance the use of fee income to reinvest in growing the personnel, infrastructure, and assets of the business with the requirement to recruit and retain their best partners by offering industry-competitive remuneration. The share of capital profits (“carried interest” or “carry”) is shared among the fund managers and their staff according to whatever arrangement they have agreed among themselves and their limited partners. The share is typically 20 percent once the investors have received an agreed minimum hurdle rate return (currently around 8 percent, but variable from fund to fund), less fees received. Gompers and Lerner (1999) find from a study of over 400 VC funds in the United States that the fixed element of compensation is higher for funds that are smaller, younger, and focused on early-stage and high tech deals. Over four-fifths of funds had a carry in the range 20 to 21 percent. In addition to these fees and profit share that are common to most funds, other fees may be receivable by the fund managers. Monitoring and/or non-executive fees are widely payable by individual investee companies to defray some of the costs of employees and partners of PE managers monitoring the investment. These fees may be payable to the PE fund or to the manager, or split between them in a predetermined proportion. They are not usually material in a large fund. Transaction costs incurred by the PE fund in making an investment are usually payable by the company being bought out and not by the PE fund. Abort costs of transactions that fail to complete may be borne by the fund or the manager or shared in a preagreed ratio. PE fund managers may charge an arrangement fee to the investee company expressed as a proportion of the amount of money invested in a deal. These may be up to 3.0 percent of the equity invested (although less in larger deals). Usually these fees are credited to the fund but they may be split on a preagreed basis with the manager. Typically the net of all these fees would be included in the calculation of the management fee and do not increase the overall rewards of the PE fund managers. All of these individually negotiated arrangements within a fund manager’s business impact the individual returns of investors over the long term. TARGET RATES OF RETURN ON INVESTMENTS UK studies of the target IRRs expected by UK VCs for portfolio firms for the 1980s (Dixon 1991) and early 1990s (Wright and Robbie 1996) show a benchmark of around 30 percent IRR. Target rates of return vary across countries. Manigart et al. (1997, 2002) find higher required rates of return by VCs located in the United States and UK compared with those located in France, Belgium, and the Netherlands. They infer that these differences are related to differences in institutional, legal, and cultural contexts. They suggest that the relative development of capital markets in P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 425 a particular country is important, with the more developed U.S. and UK markets perhaps requiring more frequent valuation of companies. Consistent with the resource-based view of the firm (RBV), Manigart and colleagues (2002) find that specialist early-stage VCs require a significantly higher return than other VCs when they invest in late-stage ventures. However, consistent with financial theory, they find that buy-out-stage specialists require a significantly lower rate of return than other VCs when investing in later-stage firms. The target rate of return sought also appears to be related to the VCs’ organizational form. Independent VCs tend to seek significantly higher rates of return than captive or public sector VCs (Manigart et al. 2002). In developed markets, target rates of return are generally based upon the characteristics of a specific investment. However, in transition economies, there is a lack of a clear relationship between return and investment stage (as a proxy for risk) (Karsai et al. 1999). Funds providers (limited partners) have been found to adopt a variety of rate of return measures to judge the performance of VC funds. Robbie, Chiplin, and Wright (1997) find significant differences between the type of performance targets used by independent venture capital firms and other types of VC. While VCs tended to be set target IRRs expressed either as raw returns or percentage outperformance above other asset classes, captive VCs were also significantly more likely to be set an annual return on capital target. Robbie, Chiplin, and Wright (1997) also suggest an increase in performance target that is expressed in terms of target IRRs and cash amounts generated. Interestingly, this study found a generally low level of monitoring of VCs by the investors. Lockett, Murray, and Wright (2002) also find a variety of valuation practices among UK VC firms investing in technology-based ventures. Mostly, different target IRRs were set for each investment stage separately within technology and nontechnology categories, but in other cases the approach adopted was to set higher target IRRs for technology proposals generally or to determine target IRRs on a deal-by-deal basis. VC FUND RETURNS EVIDENCE Venture capital associations worldwide have published analyses of the returns to venture capital funds for many years. Fund-level data published by national venture capital associations and the European Private Equity & Venture Capital Association (EVCA) consistently show that the internal rates of return (IRRs) on buyout funds outperform any other form of private equity/venture capital investment. Exhibit 19.2, for example, shows the extent of returns for the upper quartile of funds. However, overall IRRs on early-stage investments for funds formed since 1980 were negative at the end of 2007 at a pooled IRR of –0.8 percent. VC industry comparisons with other benchmarks generally show that VC-stage investments underperform other indices such as the Morgan Stanley Euro Index and the HSBC Small Company Index but that buyout-stage investments on average outperform these indices (EVCA 2008). There is a long history of academic studies that have sought to provide deeper analysis of the rates of return to VC investments. These studies mostly relate to the United States and have attempted to estimate risk-adjusted rates of return and to identify whether venture capital deals generate better or worse returns than P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 426 21:46 Printer Name: Hamilton Venture Capital Exits and Returns Exhibit 19.2 Pan European IRRs (European Venture Capital Association) Data Upper Quartile Funds (Net Pooled IRR) Investment Stage 1999 2000 2001 2002* 2003 2004 2005 2006 Early Development Balanced All Venture Capital Buyout Generalist All Private Equity 21.6 13.7 19.0 17.6 23.9 14.3 19.4 21.9 13.8 16.8 16.8 21.0 13.9 18.3 15.7 13.4 20.5 15.8 19.8 11.1 17.2 8.0 10.0 12.8 9.5 17.8 6.7 12.2 5.4 8.5 11.2 7.4 17.0 6.9 10.9 4.2 7.4 10.7 6.7 16.5 6.4 10.6 2.3 9.0 8.5 6.2 17.8 8.8 10.6 2.2 8.9 7.7 5.7 16.7 8.7 10.4 Source: EVCA/Thomson Venture Economics. investing in listed securities gross and net of fees. Various approaches have been used to adjusting for risk and survivor bias. There are differences between those studies that analyze early-stage venture capital as well as later-stage deals and those that only analyse the former or the latter. Some studies use data from single funds or single limited partners (LPs) while others involve large numbers of funds. A review of nine early studies up to 1987 by Bygrave (1994) found that VC returns were substantially below the commonly held view of 30 to 50 percent IRRs. Rather, actual VC returns were generally in the tens with occasional periods in the 20 to 30 percent range and with rare highs above 30 percent. For funds raised in the period from 1969 to 1985, Bygrave (1994) finds that the median IRR reached a peak of 27 percent in 1982, with early-stage funds generating higher returns than later-stage funds. An examination of the performance of publicly traded VC firms versus the performance of government-sponsored small business investment companies for the period from 1980 to 1986 by Kleiman and Shulman (1992) showed that the latter funds experienced greater returns on a risk-adjusted basis, but while having greater unsystematic risk had less systematic risk than publicly traded VC firms. These differences became insignificant in later years. Manigart and colleagues’ (1993) analysis of 33 listed European VC firms for the period from 1977 to1991 showed that only eight had returns higher than the market return, although systematic risk was lower than the market risk. They also noted that VC firms specializing in a particular investment stage had a higher return. Studies have noted that most, if not all, of the returns are earned by the top decile or quartile. Huntsman and Hoban (1980) show that by excluding the top decile the average return dropped from 18.9 to –0.28 percent. Brophy and Gunther (1988), in the first study to look at the benefits from pursuing a fund of funds strategy for investors, distinguish between firm-specific and market-related risk in VC funds’ returns. Their study examines weekly total returns over the five-year period from 1981 to 1985 for 12 listed VC funds compared with 12 randomly selected open mutual funds with the objective of maximizing capital gains. VC portfolios showed systematic risk below the S&P 500 and the sample of mutual funds and higher returns than both benchmarks. The study provides support for a fund of funds portfolio strategy by institutional investors P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 427 as the correlation between VC fund returns is low, suggesting that firm-specific risk characteristics may be reduced by diversification. Ljungqvist and Richardson (2003a,b) find that mature funds started in the period from 1981 to 1993 generate IRRs in excess of S&P 500 returns net of fees. These returns are robust to assumptions about timing of investment and portfolio company risk. They find that buyout funds generally outperform venture funds; these differences partially reflect differences in leverage used in investments. However, the sample in this study was from one LP with a disproportionate share of (larger) buyout funds. Cochrane (2005) found that the gross returns of VC firms were high and that their log returns had negative alphas. Cochrane adjusted for the problem that missing financing rounds could bias returns upwards. Using the same dataset but with missing data issues addressed (Phalippou 2007), Hwang, Quigley, and Woodward (2005) find that gross of fees returns were lower. Using data from funds raised during the period from 1980 to 1997, Kaplan and Schoar (2005) show average fund returns gross of fees outperform the S&P 500. However, net of fees returns are overall in line with returns on the S&P 500. Comparing VC funds and buyout funds, they show that on a weighted capital basis only the former outperform the S&P 500. However, on an equal weighted basis, VC funds returns are lower than the S&P 500. Early and later-stage funds have higher returns than buyout funds in funds raised during the period from 1991 to 1998 (Lerner, Schoar, and Wongsunwai (2007). However, in an updated dataset covering U.S. funds raised from 1980 to 2003, Phalippou and Gottschalg (forthcoming) found that, after adjusting for sample bias and overstated accounting values for nonexited investments (many of which appeared to be living dead investments that had not been revalued), average fund performance changes from slight overperformance to underperformance of 3 percent per annum with respect to S&P 500. Venture funds underperform more than buyout funds. They find that while there was a substantial gross of fees returns, this was not the case net of fees. Metrick and Yasuda (2007) find that buyout fund managers earn lower revenue per managed dollar than managers of VC funds. They also show that buyout managers have substantially higher present values for revenue per partner and revenue per professional than VC managers. Buyout managers build on prior experience by raising larger funds, which leads to significantly higher revenue per partner despite funds having lower revenue per dollar. Buyout managers build on prior experience by raising larger funds, which leads to significantly higher revenue per partner despite funds have lower revenue per dollar. A major reason that private equity firm managers are able to raise larger funds is their prior expertise (Metrick and Yasuda 2007) and the nature of management fees earned likely reflects the bargaining power arising from this experience. Metrick and Yasuda also find that there is variation between funds in the percentage management fee charged (over half of their sample had management fees of less than 2 percent, while 8 percent had fees above 2 percent) and that management fees decline significantly during the life of the fund. PE firms may also charge monitoring fees relating to the investments they make, which are substantially proportionately higher in smaller companies than in larger companies. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming 428 December 11, 2009 21:46 Printer Name: Hamilton Venture Capital Exits and Returns VENTURE CAPITAL AND INVESTEE PERFORMANCE In addition to the literature on funds-level returns, a parallel literature has developed that examines firm level returns to venture capital investment. Hellmann and Puri (2000) analyze whether the choice of investor impacts outcomes in the product market. The study is the first to examine the interrelationship between type of investor and aspects of market behaviour of start-ups, specifically whether investee firms follow innovator or imitator strategies. They examine a stratified random sample of 149 VC and non–VC-backed firms in Silicon Valley during the period from 1994 to 1997. Using interviews and archival data they find that innovators are more likely to be financed by VCs than are imitators. Innovators were also faster in obtaining VC finance. VC-backed firms, especially innovators had a faster time to market. This study therefore highlights that VCs play different roles in different companies. Other studies present mixed evidence regarding the relationship between VC backing and firm performance, particularly in terms of growth. Manigart and Van Hyfte (1999) find that VC-backed firms have higher asset growth than non–VCbacked firms in Belgium. Engel and Keilbach (2007) use propensity score matching to identify a control sample of non–VC-backed in Germany and find that VC-backed firms generate faster employment growth. In contrast, Burgel and colleagues (2000) find that VC backing has no impact on the growth of firms in Germany and the UK. Other studies of the growth of VC and non–VC-backed firms that went to IPO also show mixed results, with Jain and Kini (1995) and Audretsch and Lehmann (2004) finding positive effects of VC on growth, while Botazzi and Da Rin (2002) find no effect. Colombo and Grilli (2008) examine the influence of human capital and VC backing on the growth of VC-backed new technology based firms (NTBFs). Using a sample of 439 Italian NTBFs and after controlling for survivor bias and the endogeneity of VC funding, they find that once a NTBF receives VC backing the role of founders’ skills becomes less important and the coaching skills of VCs become more important in contributing to firm growth. Important problems with these studies include their often cross-sectional nature and a typical failure to address the issue of endogeneity in VC backing. Bertoni, Colombo, and Grilli (2008) using a 10-year panel study of 550 Italian NTBFs show that VC backing, especially by financial VCs rather than corporate VCs, strongly spurs employment and sales revenue growth. A Spanish study of firms by Alemany and Marti (2005) using panel data analysis of VC-backed start-ups shows that both VC backing and its amount are associated with higher performance. Davila, Foster, and Gupta (2003) show that VC-backed firms have faster employment growth Lee, Lee, and Pennings (2001) found that the involvement of a VC in combination with the amount of financial resources invested in the first year after founding spurred the start-up’s performance during the first two years. Heirman and Clarysse (2005) further refine this observation and add that VC involvement only makes sense if they invest significant amounts of money in the company at start-up, ranging from €1 to €5 million depending on the technology. They find that companies in which VCs only invested a small amount of money at start-up perform worse than those companies that start without any VC money at all. This suggests that venture capitalists in the first place invest money, and this might be the foremost important resource for start-ups. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 429 Internationalization activities provide a further dimension of performance where the role of VCs may be important. George, Wiklund, and Zahra (2005) find that internal owners tend to be risk averse and have a lower tendency to increase scale and scope of internationalization than VC owners. Zahra, Neubaum, and Naldi (2007) find a positive relationship between the equity-holdings of VC firms and the development of knowledge-based resources for internationalization using a U.S. sample of firms. Lockett and colleagues (2008) dig more deeply into what VC firms actually do to influence the performance of their investees. In contrast to Zahra, Neubaum, and Naldi (2007) they study VC investments in Europe that encompass both early-stage and late-stage management buyout or buy-in (MBO/I) transactions. Their findings emphasize that the nature of the VC’s involvement, monitoring versus added value, in influencing internationalization may vary between stages of investment. Employing a sample of 340 VC-backed firms, they show that monitoring resources are most effective in promoting export behavior for late-stage ventures and valueadded resources in promoting export behavior in early-stage venture. INFLUENCES ON RETURNS Fund-level studies have suggested that the buildup of expertise through learning contributes to higher returns. Kaplan and Schoar (2005) find that experience matters: performance in one fund predicts performance in subsequent funds. In contrast, mutual funds do not show persistence. Phalippou and Gottschalg (forthcoming) also show that previous past performance was most important in explaining fund performance. However, Lerner, Schoar, and Wan (2007) find that there is considerable variation in returns by type of institution. The presence of unsophisticated performance-insensitive LPs allows poorly performing GPs to raise new funds. A number of other influences on fund performance have been identified. Fund size, public market returns during a fund’s life, fund sequence, having a VC objective, idiosyncratic risk, and level of investment opportunities appear to generate higher net of fee returns while competition for deal flow reduces returns (Kaplan and Schoar 2005; Jones and Rhodes-Kropf 2003; Ljungqvist and Richardson 2003a,b). There is mixed evidence concerning the influence of the nature of competition in the market on fund returns. Ljungqvist and Richardson (2003a,b) find that competition for deal flow reduces VC fund performance. They also distinguish supply and demand conditions in the market and show that higher demand increases performance while higher supply decreases it. However, while the authors focus on demand side shock, supply may be driven by returns, not by demand for deals. Demand may not grow exogenously but be endogenously determined depending on the experience of GPs in being able to create quality deals or find diamonds in the rough. Moreover, apparent overpayment may differ between VCs depending on their level of experience. Deals that are riskier for young GPs may not be so risky for experienced GPs because they have the skills to select and add value. Hence experienced GPs may be able to pay more as they can find better deals and add more value. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming 430 December 11, 2009 21:46 Printer Name: Hamilton Venture Capital Exits and Returns Gompers and Lerner (2000) show that investments made during periods of high funds inflow do not generate greater success, while Cumming and Walz (2007) find that a positive relationship between fund inflows and performance after correcting for sample selection bias. Gompers and colleagues (2005) using U.S. data show that prior experience helps VC firms to increase investments when deal opportunities improve and that this can lead to improved exit performance. The literature on the effects of venture capital has developed from a simple examination of the presence or absence of venture capital investors to recognize their heterogeneity. A particularly important aspect of this heterogeneity concerns the role of the general and specific human capital of venture capital executives in generating returns as well as the role of social capital. Fund-level analysis based on 318 U.S.-based VC funds raised between 1980 and 1998 shows that fund management teams with more task-specific human capital manage funds with proportions of portfolio company exits (Zarutskie forthcoming). Task-specific human capital was measured as having executives with past experience as VCs and as executives at start-ups. Fund management teams with more industry-specific human capital in strategy and management consulting manage funds with greater proportions of portfolio company exits. In contrast, fund management teams that have more general human capital in business administration have lower proportions of portfolio company exits. Dimov and Shepherd (2005) provide an important contribution as they show that it is not simply the amount of human capital that is important but rather its nature. They use a human capital perspective to investigate the relationship between the general and specific human capital of executives in larger and more experienced VC firms and the performance of investee firms in the wireless communications industry. They find that although general human capital has a positive association with the proportion of portfolio firms that went public, specific human capital did not. However, specific human capital was associated with the proportion of investee firms that went bankrupt. Richer insights are provided from a European study involving 119 VC firms and 1,652 portfolio companies, Bottazzi, Da Rin, and Hellman (forthcoming) explore the role of investor activism and its impact on portfolio firm performance. VC firms whose partners have prior business experience are significantly more active in investee firms. VC experience of the firm’s partners is not significant, while the influence of a science background for executives is weak. Private independent VC firms are more involved in investees than other types of VC. The authors find that having more venture experience increases the likelihood that an executive will be put in charge of supervising portfolio firms. Examining whether investees made a successful exit or not, Bottazzi, Da Rin, and Hellman (forthcoming) find that, after using an instrumental variables approach to address endogeneity issues, there is a positive relationship between investor activism and exit performance that is both statistically and economically significant. This study is particularly interesting in terms of the nature and extent of the data collected. Data are based on a survey of VC firms in 17 countries augmented with data from VC firm web sites, commercially available databases, and VC directories. The study also distinguishes different investment stages. The authors collect data that comprises direct measures about the human capital of different partners and their roles inside VC firms. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 431 VC firms engage in extensive syndication with other VCs for reasons of access to deal flow, access to greater expertise, and for risk spreading (Wright and Lockett 2003). These syndication networks both help identify better deals but also can provide access to resources that may help generate superior returns. De Clerq and Dimov (2008) examine the performance effects on 200 U.S. venture capital–backed firms of two knowledge-driven strategies, internal knowledge development and external knowledge access through syndication. Performance is measured in terms of whether the investee firm went public, was sold, failed, and remained private. In an interesting longitudinal study they find that investing in industries in which a VC firm has more knowledge and investing with more or familiar syndicated partners increases the performance of investees. Access to external knowledge through syndication is most important when there is an incongruity between what the firm knows and what it intends to do. Cumming and Walz (2007) find that syndication is positively related to gross of fees fund performance. Hochberg, Ljungqvist, and Lu (2007) also provide evidence of the linkage between the expertise that can be accessed through syndication and VC performance in their study of 16,315 companies that received their first VC funding in the period from 1980 to 1999. After controlling for other determinants of VC fund performance, such as fund size and the funding environment, they find that VCs that are better networked at the time a fund is raised subsequently report significantly better fund performance as measured by the rate of successful portfolio exits over a 10-year period. The most important influences on performance were found to be the size of the VC firm’s networks, the tendency to be invited into other VCs’ syndicates, and access to the best networked VCs. A one standard deviation increase in network centrality increased exit rates by approximately 2.5 percentage points from the 34.2 percent sample average. At the portfolio company level, a VC’s network centrality had a significant positive effect on the probability that a portfolio firm survived to a subsequent funding round. Interestingly, Hochberg, Ljungqvist, and Lu (2007) find that when VC networks are controlled for, the beneficial effects of VC experience are reduced. Moreover, even when persistence in performance from one fund to the next is controlled for, network centrality continues to have a significant positive effect on performance. Institutional context appears to play an important role in returns generation. Hege, Palomino, and Schwienbacher (2004) find that VC returns in Europe are below those for the United States. Cumming and Walz (2007) find, however, that less stringent accounting rules and weak legal systems are associated with overvaluation and misreporting of returns. Using a detailed dataset comprising individual investment details on over 5,000 portfolio firms and 221 PE funds spanning the period from 1971 to 2003 in 39 countries, they analyze potential reporting biases regarding current fund holdings using information from former fund holdings to construct benchmarks. They find systematic biases in the reporting of unrealized IRRs relative to forecast IRRs. Their research provides evidence that the reputational costs of misreporting are negatively related to the valuations of unrealized investments. Experienced PE managers tend to report significantly lower valuations than their younger counterparts. Specifically focusing on early-stage high tech unrealized investments, they find that these deals are on average of higher value than would be predicted based on realized early-stage high tech investments. Lerner and Schoar (2005) also find that both VC and buyout funds in common law P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming 432 December 11, 2009 21:46 Printer Name: Hamilton Venture Capital Exits and Returns countries generate higher returns than these types of funds in other institutional environments. SOME CAVEATS Data availability has long created problems for the analysis of venture capital returns. Accessing proprietary datasets may provide important access to otherwise difficult to obtain information but suffers from potential for selection bias since those selected may be better funds than those not included. Phalippou and Gottschalg (forthcoming), for example, attempt to address the potential selection bias in Kaplan and Schoar (2005) by using a fraction of a fund’s successful exits as a proxy for performance as this is available for both selected funds and a subset of nonselected funds in the performance database used (Phalippou 2007). Kaplan and Stromberg (2009) comment, however, that the results obtained are qualitatively identical to those in Kaplan and Schoar (2005). Proprietary datasets also typically relate to independent VC funds and thus accessing performance data on captive and public sector funds may be more problematical. These problems are also present in industry returns data. For example, Leleux (2007) notes that in compiling its European performance data the EVCA achieved only a 73 percent response rate to its request for performance information from all companies that participated in private equity activities in 2002. The extent to which this degree of nonresponse leads to bias in performance returns figures is, however, unknown. In analyzing fund returns it is important to take account of whether returns are based on deals that have exited or on all investments in the fund. Focusing analysis on exited deals may inflate returns if the exited deals are the more successful ones. Alternatively, analyses based on all investments in a fund face the problem of valuing unexited deals. A potentially important problem however with non–legally binding guidelines is that underperforming VC funds may be reluctant to write down the value of unrealized investments, which may serve to hide their true performance (Phalippou and Gottschalg forthcoming). Moreover, heterogeneity in the nature of self-reported information may make comparisons of performance between VC funds difficult. A further factor that needs to be taken into account is the difference between committed and drawn down funds. An investor making a $Xm commitment to a VC fund has very different risks and rewards than one investing $Xm in a unit trust (or similar fund) even if the underlying assets of the funds are the same. When comparing returns, a VC commitment should be viewed as providing a facility of up to $Xm not an investment (or stream of investments) of $Xm. The investors will have a return on the commitment in excess of the fees on committed investment if they receive interest in excess of the fee percentage. If the fee is 2 percent and the cash is deposited and undrawn at 3 percent, there is a positive 1 percent return even if the funds are not drawn down. This is clearly a negative NPV investment. The return on the commitment is therefore the sum of: Return on drawn down cash + Return on undrawn commitment. This contrasts with a direct investment in a quoted fund whereby the return = Return on drawn down funds + 0. Similarly, both the commitment and the fees of funds vary over the P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 433 life of the fund. Typically there is an investment period and a “harvesting period” that may overlap in the middle of the fund’s life. Fees decline after the investing period. This is an important distinction. Furthermore, there is no evidence in the academic body of work of the actual life of the funds and the variation over time. Valuing early-stage firms poses major issues for VC firms and for assessing financial returns. Lack of objective information is particularly problematical. Various venture capital associations have attempted to promulgate recommendations for the valuation of investee companies. In Europe, guidelines produced by EVCA emphasize the reporting of Fair Values of investments (EVCA 2005), that is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arms-length transaction. The Guidelines recognize the subjectivity of the process but caution against VC firms being too cautious in their approaches to valuation. A central issue concerns what methodology to use to arrive at a fair valuation given its subjective nature. The EVCA guidelines suggest that valuers should exercise judgement in the selection of the appropriate valuation method for a particular investment. Valuation methods adopted by VC firms vary between institutional environments. There is some tendency for more developed capital markets to use valuation methods that are more in line with standard corporate finance theory but even here, informational restrictions limited the extent to which the most sophisticated discounted cash flow (DCF) or options methods were used, with other methods such as P/E multiples and comparator transaction prices or industry benchmarks being used either alongside or instead of these methods (Wright and Robbie 1996; Manigart et al. 1997; 2002). A nine-country study covering the United States, Europe, and Asia by Wright and colleagues (2004) finds that the legal system and its implications for capital markets is especially important in explaining the information used in valuation methods. Cultural factors play an important role in the relative importance placed on information provided by entrepreneurs and in the business plan. This finding suggests that information sources are not easily transferred between different contexts. They also find that information sources may vary both between and within legal systems and geographic regions, emphasizing the heterogeneity of different environments and the need for fine-grained approaches. CONCLUSION In this review we have shown that an extensive and increasingly sophisticated literature has now developed to examine the returns to venture capital. Nevertheless, a number of areas for further research remain. Further research continually needs to assess the returns to venture capital funds raised during different time periods. For example, if there is a learning effect in the VC industry over time, do returns increase over time, or are these competed away through increased competition for deals? Are the returns on funds raised in the boom period up to 2007 likely to be lower than in previous periods? Further analysis may be required of the motives to invest in first-time funds if experienced funds generate greater returns. Naı̈ve LPs may invest in first-time funds to gain experience, and a shortage of allocation from established funds may mean that new entrants cannot gain access to established funds. However, it is P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 434 21:46 Printer Name: Hamilton Venture Capital Exits and Returns important to distinguish between first-time funds that are managed by inexperienced managers and those that are managed by experienced executives who have spun out of established funds. Further research may usefully examine this issue by obtaining data from web sites or fund documents on previous affiliations of executives, number of prior deals, successes versus failures, and so on. Finally, further research may usefully be focused on the nature of the human and social capital resources VC firms bring to foreign markets that can enable them to enhance performance in those markets and overcome the liability of foreignness. There is some evidence that VCs adapt when they enter foreign markets in terms of their information, valuation, and monitoring behavior (Wright, Pruthi, and Lockett 2005), but there is an absence of evidence regarding the relative success of foreign VCs in aiding firms to internationalize. REFERENCES Alemany, Luisa, and Jose Marti. 2005. Unbiased estimation of economic impact of venture capital backed firms. Working Paper. ESADE Business School. Audretsch, David, and Erik Lehmann. 2004. Financing high tech growth: The role of banks and venture capitalists. Schmalenbach Economic Review 56:340–357. Baden-Fuller, Charles, Alison Dean, Peter McNamara, and Bill Hilliard. 2006. Raising the returns to venture finance. Journal of Business Venturing, 21:265–285. Bertoni, Fabio, Massimo Colombo, and Luca Grilli. 2008. Venture capital financing and the growth of new technology based firms. WP Politechnico di Milano. Botazzi, Laura, and Marco Da Rin. 2002. 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P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 435 Engel, Dirk, and Max Keilbach. 2007. Firm level implications of early stage venture capital investment: An empirical investigation. Journal of Empirical Finance 14:150–167 EVCA. 2005. International private equity and venture capital valuation guidelines. Brussels: EVCA. George, Gerry, Johan Wiklund, and Shaker Zahra. 2005. Ownership and the internationalization of small firms. Journal of Management 31:210–233. Gompers, Paul, and Josh Lerner. 1999. An analysis of compensation in the U.S. venture capital partnership. Journal of Financial Economics 51:3–44. . 2000. Money chasing deals? The impact of fund inflows on private equity valuations. Journal of Financial Economics 55:281–325. Gompers, Paul, Anna Kovner, Josh Lerner, and David Scharfstein. 2005. Venture capital investment cycles: The role of experience and specialization. Journal of Financial Economics 81:649–679. 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P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton RETURNS TO VENTURE CAPITAL 437 ABOUT THE AUTHORS Mike Wright received his Ph.D. from the University of Nottingham. He is Director of the Centre for Management Buy-out Research (CMBOR), the first centre for the study of private equity and buyouts, which he founded in 1986. He was Research Director of NUBS from 1991–2001. He has published widely on academic entrepreneurship, venture capital, private equity and related topics in journals such as Academy of Management Review, Academy of Management Journal, Strategic Management Journal, Journal of Corporate Finance, Review of Economics and Statistics, Economic Journal, Journal of Management Studies, and so on. He was an editor of Journal of Management Studies from 2003 to 2008 and is currently an associate editor of Strategic Entrepreneurship Journal. He was ranked #1 worldwide for publications in academic entrepreneurship 1981–2005. His latest books include Academic Entrepreneurship in Europe (2007), Private Equity and Management Buy-outs (2008) and Private Equity Demystified (2008). Riya Chopraa recently completed here M.Sc. in finance at Nottingham University Business School and is now a researcher at CMBOR. P1: OTA/XYZ P2: ABC c19 JWBT218-Cumming December 11, 2009 21:46 Printer Name: Hamilton