An Analysis of the Performance of Publicly Traded Venture Capital Companies, Journal of Financial and Quantitative Analysis,by Martin, J. and Petty, J.

No comments

 This research work was conducted in furtherance of the authors intellectual content; in order to  provide a lead-way for anyone that will conduct further or similar research on the topic.
The study focuses on the Analysis of the Performance of Publicly Traded Venture Capital Companies. The observation shows that Venture capital companies can be likened to mutual funds that make investments in small, new businesses. However, investments made by venture capitalists are unique in several ways: Firstly usually five or more years are required for a new firm to become well enough established that a venture capitalist can liquidate an investment;
also during the early years of an investment, there is no organized secondary market for its shares; Furthermore the new firm characteristically faces a high risk of failure; and lastly several infusions of capital are usually required before the new enterprise becomes a going concern. Consequently, the investments made by the venture capital firm have long been considered to carry high risks as well as the potential for high returns. For this reason, venture capital firms actively diversify, investing in a portfolio of individual projects. Thus, the risk and return attributes of the venture capitalist's diversified portfolio will not totally mirror those of its individual investments. The objective of this paper is to assess empirically the risk-return profiles of a group of publicly traded venture capital firms. Specifically, they compare the performance of investment in venture capital firms with two benchmarks: a sample of 20 mutual funds with a stated objective of maximum growth potential; and the Standard and Poor's (S&P) 500 stock market index. 
Two methods were used to compare investor preferences for venture capital firms, mutual funds, and the market portfolio index: mean-standard deviation comparisons; and a generalized form of stochastic dominance. The mean- standard deviation comparison methodology is well known in the finance literature and its strengths and weaknesses as a tool for evaluating performance have been well documented. Thus, a review of this method is unnecessary. However, the general stochastic dominance method is relatively new to financial applications and will be presented informally. Meyer provides a method for evaluating the preferences of a "group" of investors defined by the upper and lower bounds on their Pratt-Arrow on absolute risk-aversion coefficients. An investor group is defined using the notation, Ui (rL (x), ra (x)), where Ui is the set of all investors whose absolute risk-aversion coefficients fall between the lower bound on risk aversion, rL(x)y and the upper bound, rv(x). Meyer shows that if the expected utility of investment A” is greater than the expected utility of investment “B” for investors of rL(x) and of r^x), then “A” is preferred to “B” by all investors in Uj(rL(x), rv(x)). This conclusion is true of an individual where risk aversion varies as long as it remains between rL and rv within the range of outcomes that x may assume.
The selection of venture capital firms was severely restricted by the unavailability of data. Of 37 firms that appeared at some time during 1970-1980, only 17 firms had price data available spanning the test years, 1974-1979. These 17 firms were reduced to the final 11-firm sample because of inactive trading. Trading inactivity was evidenced both by an absence of prices for some months and by consecutive months for which no price change was recorded. The necessity for eliminating 26 of 37 companies and the short observation period means that our results are quite sample-specific. That is, they are totally reliant on the time period studied and on the firms for which data were available. This condition introduces two potential sources of bias into the results. First, the firms studied were those that were in existence for the entire 1974-1979 period. Hence, a survivorship bias is necessarily inherent in the test sample. To reduce the impact on the performance comparisons resulting from months without price changes, the analysis was based on the compound annual rates of return. Thus, annual rates of return for the period 1974-1979 (six observations per company) provide the basis for the tests that are described in the next section.

The objective of this study has been to compare the return distributions of publicly traded venture-capital companies to mutual funds (with a maximum capital gains objective) and the S&P's 500 Index. The findings indicate that venture capital firms are indeed more risky than either of the two standards of comparison. However, this risk did not preclude even risk-averse investors from preferring the return distributions of one or more venture capital firms over some of the mutual funds or the stock index. In addition, portfolios of venture capital firms in combination with mutual funds and individual stocks offer yet another potential source of improved performance. In the tests performed in the present research the performance of the venture capital firms was compared to that of a sample of 20 maximum capital-gains mutual funds and the S&P 500. These comparisons were made using both mean-standard deviation analysis and general stochastic dominance. The results of the first of these two analyses are contained in Table 3 where mean annual rates of return, standard deviations, and Sharpe's (reward-to-variability) ratio are presented. In contrast, there was only one mutual fund with a mean return-standard deviation combination that dominated the market and one case where the market dominated a mutual fund. Both the venture capital firms and the mutual funds were ranked using Sharpe's reward-to-variability ratio. These results indicate that seven of the top ten firms were venture capital firms; however, two of the venture capital firms were ranked at the bottom (30th and 31st). In addition, the S&P 500 ranked between the 23rd and 24th firms.
The results of the venture capital firm versus mutual fund comparisons are summarized in Table 4. These results can be interpreted as follows. When venture capital firm number one was compared to each of the 20 mutual funds by the strong risk-seeking group (group 1), there were six mutual funds that were preferred to this venture capital firm. On the other hand, in the 14 remaining mutual fund comparisons, venture capital firm number one was preferred in 12 instances. The two mutual find comparisons not reflected in these reported results represent comparisons where neither venture capital firm number one nor the respective mutual funds were unanimously preferred by those investors contained in the strong risk-seeking group. Therefore, it is necessary that we report the "prefer mutual fund" and the "prefer venture capital firm" columns since a third possibility (no unanimous preference) also exists.
The results presented in Table 4 provide the basis for two important observations. First, the predominance of the preferences of the risk-seeking investor groups for venture capital firms (an average of 70 percent preferred venture capital firms versus 20 percent who preferred mutual funds) suggests that venture capital firms are indeed more risky investments than the mutual funds. It noted that venture capital firms were preferred over mutual funds by the strong risk-seeking investor group in 73 percent of the comparisons. In contrast, when the preferences of the strong risk-averse group are analyzed only 41 percent of the comparisons produced an unambiguous preference for the venture capital firms (with 44 percent preferring mutual funds). Second, it also should be emphasized that risk-averse investors at times preferred venture capital investments to the mutual funds analyzed. In fact, across all groups of risk-averse investors, venture capital firms were preferred over mutual funds in 51 percent of the comparisons. Perhaps even more informative is the fact that investors in the "slight" risk-averse group preferred the mutual funds in only 29 percent of the cases, while preferring the venture capital firms in 67 percent of the comparisons. These results may well explain the increased propensity for pension funds to invest in venture capital firms. The last phase of the research compared the venture capital firms with the S&P's 500 Stock Index. The objective was to compare the return and risk attributes of a well-diversified portfolio of publicly traded equity securities with that of venture capital companies. The results of these comparisons are presented in Table 5. The results are notably similar to the venture capital-mutual fund comparisons with risk-seeking agents exhibiting a preference for the venture capital firms. As the degree of risk aversion increased, preferences switched to the market portfolio.

No comments :

Post a Comment