Last week, we recapped some of the more recent literature on the performance of private equity, and venture capital (VC) in particular. The cumulative body of evidence, we found, was damning with regard to venture capital’s ability to provide better returns than comparable—and less risky—publicly traded equities.
We left off with a review of a study by Michael Ewens and Matthew Rhodes-Kropf, “Is a VC Partnership Greater Than the Sum of Its Partners?” The paper, which appears in the June 2015 issue of The Journal of Finance, seems to offer some hope, although not for the VC industry as a whole.
The authors were able to find evidence of skill and exit-style differences among VC firms. While this finding is certainly important, skill in selecting investments is only one plausible explanation for persistence of outperformance achieved by successful VC firms. Another explanation is that successful firms (such as Kleiner Perkins Caufield & Byers) are able to charge a premium for their capital.
The Importance Of Reputation
David Hsu—author of a 2004 Journal of Finance study, “What Do Entrepreneurs Pay for Venture Capital Affiliation?”—analyzed the financing offers made by competing VC firms at the first professional round of startup funding.
Hsu found that offers made by VCs with a high reputation are three times more likely to be accepted. Moreover, high-reputation VCs acquire startup equity at a 10 to 14 percent discount. This evidence suggests that venture capitalists’ “extra financial” value may be more distinctive than their functionally equivalent financial capital.
Hsu explained that if a company borrows from a bank and the terms are similar, it doesn’t matter what bank it gets the money from. However, the situation is different when the company is seeking VC investment. The company is likely seeking not just cash, but also the venture capital firm’s “reputation and access to a network of relationships—with customers, suppliers, investments bankers and other important constituents in the universe that the entrepreneur cares about.”
A VC firm can also add value by bringing to bear its human capital, providing guidance on strategic planning as well as help in attracting top-caliber employees and lining up the best IPO underwriters. Thus, a startup may not always choose the best “pre-money” offer when it raises private equity.
Offers Involve More Than Money
Hsu’s study covered 51 small companies that received at least two offers. The total number of offers he evaluated was 148. The companies in his sample were among about 300 that had participated in the Entrepreneurship Laboratory at MIT. He found that “a lot of money is left on the table” by the companies, both in absolute terms and as a percentage of the pre-money valuation they accepted. In fact:
- Less than half of the firms surveyed accepted their best financial offer.
- For the group of multiple-offer firms that declined their best financial offer, the foregone pre-money value as a fraction of the accepted offer ranged from a low of 3.6 percent to a high of 217 percent, with an average of 33.2 percent.
Hsu explains what makes the venture capitalist’s reputation valuable: “As a venture capitalist gains more investment experience in a particular industrial sector, he or she is more likely to gain the expertise needed to help startups in their portfolio acquire resources for successful development, which is a powerful contributor to VC reputation. Each additional investment extends the VC’s information network, either acquiring important social contacts and/or gaining experience in effectively structuring deals or monitoring entrepreneurs in the industrial sector.”
Hsu goes on to note: “Outsiders may say, ‘I don’t know the entrepreneur, but I know the venture capital firm through its prior deals’ and make inferences about the quality of the company they are looking at.” In other words, “When the quality of a start-up cannot be directly observed, external actors rely on the quality of the start-up’s affiliates as a signal of the start-up’s own quality.”
In short, entrepreneurs raising equity capital know that “it is far more important whose money you get than how much you get or how much you pay for it.” This knowledge allows successful venture capitalists as well as successful partners to charge a higher cost for their capital. And that in turn helps explain the persistence in outperformance.
Swensen Warns Investors
If you are thinking about investing in venture capital/private equity, before moving forward, I recommend considering the following warning from David Swensen, chief investment officer of Yale University’s $22 billion endowment fund.
In his book, “Unconventional Success,” Swensen writes: “Understanding the difficulty of identifying superior hedge fund, venture capital and leveraged buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating, active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection poses grave risks to portfolio assets.”
Those who choose to ignore Swensen’s warning still need to understand that, due to the extreme volatility and skewness of returns, it’s important to diversify the risks of venture capital. This is best achieved by investing indirectly through a private equity fund, rather than through direct investments in individual companies.
Because most such funds typically limit their investments to a relatively small number, it’s also prudent to diversify by investing in more than one fund. And you now know to make sure the firm’s track record is both long and strong, and that the partners who were responsible for that record are still around. Finally, you should remember that the top-notch funds are likely closed to most individual investors. They get all the capital they need from the Yales of the world.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.