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