Tuesday, April 24, 2012

Zero Risk Premium in Venture Funds

Noahpinion had a neat story on a paper by Harris, Jenkinson and Kaplan, which finds:
Average U.S. buyout fund performance has exceeded that of public markets for most vintages for a long period of time. The outperformance versus the S&P 500 averages 20% to 27% over the life of the fund and more than 3% per year. Average U.S. venture capital funds, on the other hand, outperformed public equities in the 1990s, but have underperformed public equities in the 2000s.
These strategies should have higher 'operational risk', and thus higher risk from tail events, Knightian/Keynesian uncertainty. It highlights that merely noting an asset class is opaque and illiquid does not mean it generates an above-average return.  This is especially important because many pension funds are stretching to alternative assets (read: hedge funds) under the illusion that these areas have less clear data, so are riskier, therefore generate higher returns.

Most interesting are the data issues, which are very complex. If you read the paper, you see it is all about what data to include, which to exclude, etc. It has very little to do with asymptotic standard errors, or overidentifying restrictions that are presented as the really important tool for empirical financial researchers in graduate school.

 I mean, consider this graph, and you can see there's something obvious going on, and that data prior to 2000 was probably not the same as that afterward. That isn't an abstruse statistical issue.


Mercury said...

VC firms just happened to have been perfectly positioned to take advantage of the 90’s tech bubble (junk bonds, mortgages, silver – not so much) so, the stars would really have to align again for them to be able to reprise anywhere near that kind of performance. Certainly “green tech” isn’t panning out as hoped.

But here is yet another asset class where the risk premium does not seem to be as sizable as perceived and the (management) cream rises to the top and outperforms.

Although, determining actual net returns of PE funds in general (to individual investors/LPs) is probably only slightly less difficult than figuring out how much of a “profit” a Hollywood movie has made.

Anonymous said...

Does the study adjust for leverage? Aren't most PE funds leveraged about eight times? I believe most of them underperform a similar strategy executed with S&P futures. It has always seemed to me that pension funds love PE because it is sneaky leverage with a MTM that displays huge inertia. i.e., they get the leverage without having to worry about the fund being marked down too drastically.

Venture funds don't get that kind of leverage, unless you believe that they are able to secure more equity than they are actually paying for (i.e. hoodwinking the techies).

Anonymous said...

Why do these studies continually use the S&P 500 as the bmark. The average buyout is under $1B. So lets look at comparing buyout to small cap value and the 3% premium disappears quickly.

Ben said...

In 2000, the community of investors became aware of the investment opportunity. So they all piled in and bid down the price until the anomalous margin was no more.