Tuesday, June 24, 2008

The Curious Case of Entrepreneurial Returns

Entrepreneurial investment, such as in small proprietorships (S-corps and private LLCs) is generally a highly undiversified investment for most entrepreneurs. The reasons are straightforward, in that when one person has a significant effect on the business through his effort and competence, it is natural that he should have the most ‘skin in the game’. This is a classic issue of moral hazard because a business manager, who has significant upside and, without ownership, no downside, is motivated to take wild risks on the theory of heads I win, tails the banker loses. However, if the manager is the majority owner, his failure should affect his net wealth too. About 75 percent of all private equity is owned by households for whom it constitutes at least half of their total net worth. Indeed, households with entrepreneurial equity invest on average more than 70 percent of their private holdings in a single private company in which they have an active management interest.

Despite this dramatic lack of diversification, private equity returns are on average no higher than the market return on all publicly traded equity. The chart above, from Moskowitz and Vissing-Jorgensen (AER 2002) shows the basic results, that over an 8 year period, if anything returns to private business, be it partnerships, proprietorships, S corps, C corps, and two entirely different sets of data, there is no demonstrable premium. Given an investor can invest in a diversified, and liquid equity portfolio, it is puzzling why households willingly invest substantial amounts in an asset with an equivalent return, but much higher volatility, including a positive correlation with the market.


Frank said...

The goals are different. The diversified portfolio of equities is designed to make money.

I think most entrepreneurs would tell you that they would gladly give up a steady paycheck from 'the man' in exchange for a volatile set of cash flows to follow their dreams of 'building a widget factory' so long as they didn't completely lose everything.

The returns look even worse when you consider the equity portfolio is likely funded with cash, while the entrepreneur is typically highly levered (likely mortgaged his/her house and maxed out all the credit cards to start the company).

Anonymous said...

I think the key to understanding this are two motivating factors.
1. self employment. many who invest in and own their own business are not doing it for capital appreciation, but rather it is a vehicle for them to be employed and earn a salary, benefits, etc. This type of business often has little or no operational or financial leverage, little in the way of competitive advantage or growth, so naturally has little potential beyond the job it provides.
2. the other group are those who want to get rich. U have more operational leverage, possibly financial leverage, and hopefully some type of competitive advantage or intellectual property. People are motivated by the returns earned by the success stories, so the average return, kind of like with acting, singing, sports, and other star activities, may not be the relevant motivator.

Pete Sattler said...

There is a huge difference in the maximization function of these organizations:
1) Public companies want to show big profits because that makes the price of the stock go up. If this leads to higher taxes, so be it. If there is any discretion, anything that can get capitalized will be capitalized.
2) Private companies want to show no profits, or as little profit as possible, to pay as little taxes in possible.
The owner writes off his/her car, his/her home office, his/her garage (if there are some boxes in there), new tires, their cell phone, their auto-insurance, or anything else they can get away with.
If there is any discretion, anything that can get expensed will get expensed.

Pete Sattler said...

Let me put this another way:
1) If a big company CEO is going to prison, it's usually for inflating profits.
2) If a small business owner is going to prison, it's usually for deflating profits to pay no taxes.

Thus, we can see that whenever there is discretion, one number will be fudged up and the other down.
That said, the discretion has a much bigger effect on the private firms down.

Eric Falkenstein said...

Yeah, underreporting 'own' profits is quite different than for public companies. I'm sure they addressed that, but I'll have to read up, because it does seem like a big issue.

Reminds me of 'this guy' who sold his company to a public company. They got 3 times book (or something). After this deal was done, they were asked to change their accounting to maximize the profits, even though this increased the book value, and thus the asking price. He thought, fools! The buyer wanted to make his purchase look better to the public.

Pete Sattler said...

That would be interesting research. If any work has been done, it's probably been in the accounting literature. I
think you suggested a good way to look at it, if you could get access to pre-purchase financials (used for due diligance) for firms that were purchased by public firms.

As it stands now, I don't think it makes sense to compare the two.