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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
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(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)
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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
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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
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(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.
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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)
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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).
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(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.
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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
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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.
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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
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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
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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
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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.
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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.
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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.
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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.
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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
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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
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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
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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.
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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.
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