Swedroe: Venture Capital 'Hits' Driven By Skill

July 01, 2015

There’s a large body of sound, academic evidence (which is presented in my books, “The Only Guide to Alternative Investments You’ll Ever Need” and “The Quest for Alpha”) demonstrating that, in aggregate, private equity investments have represented the triumph of hype and hope over wisdom and experience.

 

The following is a summary of findings from some of the more recent research on the performance of private equity, and venture capital (VC) in particular:

  • A 2005 paper, “The Risk and Return of Venture Capital” by John Cochrane, revealed that the returns to venture capital were similar to those of the smallest Nasdaq stocks; specifically, illiquid, thinly traded stocks with very small market caps. Cochrane’s study—which covered the period from 1987 through June 2000 and 6,613 rounds of financing that involved 7,765 companies—further stated that such stocks exhibit traits similar to venture capital (extreme skewness and high volatility). Despite its greater risks, venture capital didn’t provide returns any higher than comparable publicly traded equities. Cochrane concluded: “The fact that we see a similar phenomenon in public and private markets suggests that there is little that is special about venture capital.”
  • Oliver Gottschalg and Ludovic Phalippou, authors of the 2007 study “The Performance of Private Equity Funds,” researched the performance of 6,000 private equity deals and about 1,000 buyout funds using data collected through investors in 852 private equity funds raised before 1993 (to ensure the funds had sold all their assets). They found that after accounting for fees, the average private equity fund underperformed the S&P 500 by 3 percent a year.
  • The study “Private Equity Performance: What Do We Know?” was published in the October 2014 issue of the Journal of Finance and covered the period from 1984 through March 2011. The authors—Robert Harris, Tim Jenkinson and Steven Kaplan—found that while the median private equity fund outperformed the S&P 500 by 3 percent a year, small-cap value stocks returned an annualized 16.0 percent, outperforming the riskier private equity by 2.2 percentage points each year.
  • Diane Mulcahy, Bill Weeks and Harold Bradley, authors of the May 2012 study “We Have Met The Enemy…And He Is Us,” examined the Kauffman Foundation’s 20-year record of investing in VC funds. They found VC returns have not significantly outperformed the public market since the late 1990s and that, since 1997, less cash has been returned to investors than has been invested. They also found that the average VC fund failed to return investor capital after fees, and that after fees, the majority of funds—62 out of 100—failed to exceed returns available from the public markets. Thus, investors were not compensated for taking the incremental risks of illiquidity and lack of diversification that are associated with VC.

 

The authors of the Kauffman Foundation study concluded: “The historic narrative of VC investing is a compelling story filled with entrepreneurial heroes, spectacular returns, and life-changing companies. The quest to invest in the next Google guarantees that VC will retain its allure and glamour, even in the face of the disappointing results we’ve just discussed.

 

Investors are still attracted to the ‘lottery ticket’ potential VC offers, where one lucky ‘hit’ investment like Zynga or Facebook can offer the potential to mitigate the damage done to a portfolio after a decade of poor risk-adjusted returns. The data suggest that such ‘hits’ are unlikely to salvage industry returns.”

 

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