TheReturns to EntrepreneurialInvestment: APrivateEquity Premium Puzzle?

By TOBIAS J. MOSKOWITZAND ANNETTE VISSING-JØRGENSEN*

Wedocument the return to investing in U.S. nonpublicly traded equity. Entrepre- neurialinvestment is extremely concentrated, yet despite its poor diversiŽ cation, we Žndthatthe returns to private equity are no higherthan the returns to public equity. Giventhe large public equity premium, it is puzzling why households willingly investsubstantial amounts in asingleprivately held Ž rm witha seeminglyfar worse risk-returntrade-off. We brie y discusshow large nonpecuniary beneŽ ts, a prefer- encefor skewness, or overestimates of theprobability of survivalcould potentially explaininvestment in private equity despite these Ž ndings. (JEL G11,G12, M13)

Assetpricing and investment theory rely crit- tionof equityreturns across nonpublicly traded icallyon our understanding of investors’ port- Žrms. We analyzeinvestment in and document foliochoices. Yet, entrepreneurial investment, thereturn to allnonpublicly traded equity in the whichrepresents a substantialfraction of many UnitedStates. The total value of privateequity investors’portfolios, is relatively understudied issimilar in magnitude to the public equity andnot well understood. SpeciŽ cally, little is marketover our sample period. Despite this, the knownabout the aggregat ereturnto entre- privateequity market has received relatively preneurs’equity investments and the distribu- littleacademic attention. 1 We providethe Ž rst setof estimatesof the returns and risks for the entiremarket of nonpublic equity. *Moskowitz:Graduate Schoolof Business, University We Žndinvestment in private equity to be ofChicago, 1101 East 58thStreet, Chicago, IL 60637 extremelyconcentrated. About 75 percent of all andNational Bureau of Economic Research (e-mail: privateequity is owned by households for [email protected]).Vissing-Jø rgensen: whomit constitutes at leasthalf of theirtotal net Department ofEconomics, University of Chicago, 1126 East 59thStreet, Chicago, IL 60637,Center forEconomic worth.Furthermore, households with entrepre- PolicyResearch, andNBER (e-mail: vissing@uchicago. neurialequity invest on average more than 70 edu).We are gratefulto several anonymousreferees, percentof their private holdings in a single RochelleAntoniewicz, Merle Erickson,Eugene Fama, Ken privatecompany in which they have an active French,Lars Hansen,John Heaton, David Ikenberry, Barry managementinterest. Despite this dramatic lack Johnson,Steve Kaplan, Deborah Lucas, Andrew Metrick, SendhilMullainathan, Ann Semer, Per Stromberg,and sem- ofdiversiŽ cation, the average annual return to inarparticipants at theUniversity of Minnesota, the Uni- allequity in privately held companies is rather versityof Chicago(Finance and Macro lunches and Money unimpressive.Private equity returns are on av- andBanking seminar), MIT,UCLA, Arizona State Univer- erageno higher than the market return on all sity,the New YorkFederal Reserve, PurdueUniversity, StanfordUniversity, University of California– Berkeley, publiclytraded equity. McGillUniversity, University of British Columbia, Ohio State University,the NBER MacroeconomicFluctuations andCorporate Finance meetings, the Berkeley Program in 1 Whilethere are paperswhich examine venturecapital Finance,the Wharton Conference on Household Portfolio Žnancingof private Ž rms, venturecapital accountsfor a Choice,and the WFA meetingsfor helpful comments and trivialfraction (less than1 percent)of the entire private suggestions.Moskowitz thanks the Center forResearch in equitymarket [accordingto thenumbers in George W. Fenn SecurityPrices andthe James S.Kemper Foundationfor et al.(1995) as well as ournumbers for total private equity]. Žnancialsupport. Vissing-Jø rgensen thanks the National Inaddition, venture capital pertainsto averyspeciŽ c typeof Science Foundationfor Ž nancialsupport. Special thanks to investmentin private equity that may notprovide much Jay Ritterfor data oninitialpublic offerings and to Taorong insightinto the typical entrepreneur’ s investmentdecision Jiangfor help with the SDC database. andreturns.

745 746 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

Usingdata for allprivate equity from boththe differentbetween investing in a portfolioof a Surveyof Consumer Finances (SCF) andthe singleprivate Ž rm, apublicequity index, and Flowof Funds Accounts and the NationalIn- T-bills,or a portfolioof just the public equity comeand Product Accounts (FFA/NIPA) over indexand T-bills. For aninvestorwith a relative theperiod 1989 to 1998 as well as proprietor risk-aversioncoefŽ cient of 2(as wellas reason- andpartnership data from theFFA/ NIPA over ableassumptions about the debt-to-asset ratio of thelonger period 1952 to 1999,we Žndthat the theprivate Ž rm andthe fraction of entrepreneur- averagereturn to allprivate equity is similar to ialwealth invested in private equity), purely thatof the public market equity index. This is idiosyncraticprivate equity risk generates a hur- surprising,since investing in the equity of a dlerate of about 10 percent above the public singleprivate company is likely to be much equityreturn. 2 MichaelJ. Brennanand Walter riskierthan investing in the public equity index. N.Torous(1999) estimate a certaintyequiva- First,survival rates of private Ž rms areonly lentwealth loss of investingin asingle(public) around34 percentover the Ž rst tenyears of the Žrm ofabout 64 percent over a ten-yearhorizon Žrm’s life.Second, even conditional on sur- for aninvestorwith a relativerisk-aversion co- vival,the distribution of equity returns across efŽcient of 2.This loss increases to 95 percent entrepreneursis wide. Third, the average entre- for aninvestorwith a relativerisk-aversion co- preneurholds most of his investment in the efŽcient of 3. Shlomo Benartzi (2000) Ž ndsthat sameprivate Ž rm inwhich he works, making areturnpremium of 20percentis neededfor an hisequity return highly correlated with his hu- individual(with relative risk-aversion coefŽ - mancapital return. Fourth, while it isdifŽcult to cientof 4) to invest 45 percent of his portfolio preciselyestimate the overall risk of private ina singlepublicly traded stock when the total equity,our estimates suggest that the index of portfoliois restricted to have 40 percent bonds privateequity is likely as volatile as thepublic and60 percent stock. When allowing the total equityindex and that aggregate private equity portfolioto contain 100 percent equity, and returnsare highly correlated with the public reducingrisk aversion to 2,therequired excess equitymarket. Finally, the amount of idiosyn- returnof the individual stock over the public craticrisk of a singleprivate Ž rm impliesthat equityindex return declines to 5 percent.There- theaggregate (index) return is likely an overes- fore,the premium required to induce investors timateof the average of the returns to each tohold equity in a single private Ž rm would individualentrepreneur, further strengthening alsohave to be large. For simplicity,we will theconclusion that private equity returns are cite10 percent as the required premium for low.Our resultsare robust to a varietyof ad- usein some of our “ back-of-the-envelope” justmentsfor thelabor component of entrepre- calculations. neurialincome, retained earnings in the Ž rm, Ofcourse,obtaining a precisemeasure of the Žrm birthsand deaths, initial public offerings meanreturn to private equity is extremely dif- andacquisitions, and potential income underre- Žcult.The notoriously difŽ cult exercise of esti- portingdue to tax evasion. Overall, the diversi- matingthe mean on a highlyvolatile return Žedportfolio of public equity seems to offer a seriesover a relativelyshort time period is well far moreattractive risk-return trade-off than that known.This difŽ culty is exacerbated when us- obtainedby the typical entrepreneur. ingfairly imprecise data on estimatesof private Toput our results into perspective, consider whattheory suggests the expected private eq- uityreturn to be. The higher risk from lackof 2 Thisnumber is basedon theaverage ofline 2 and3 in diversiŽcation of privateequity should lead to a Table4 ofHeatonand Lucas (2001).This case corresponds higherprivate equity premium than that on pub- mostclosely to the ratio of private equity to net worth licequity. How muchhigher than the average documentedbelow based on theSCF andthe ratio of debtto publicequity return would we expectthe aver- assets forproprietors and partnerships in the FFA. The authors’calculation assumes azero correlationbetween ageprivate equity return to be? JohnHeaton and privateand public equity (the private investment project in DeborahLucas (2001) model and calibrate the theirmodel has noaggregate risk). A positivecorrelation hurdlerate which would make a householdin- wouldincrease theprivate equity hurdle rate. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 747

Žrm valuesand proŽ ts. Nevertheless, the esti- Heatonand Lucas (2000) argue that the addi- matedrealized returns to private equity are sim- tionalrisk of private investment and its corre- ilarto those in the public market, and are highly lationwith public equity market returns may correlatedwith public equity returns. Hence, it helpexplain why the (public) equity premium isunlikely that private equity outperformed isso high. However, while it is standard in publicequity by 10 percent per year over our thisliterature to treat nonŽ nancial income as sampleperiod (including the longer period from exogenous,our Ž ndingsemphasiz ethata 1952to 1999). 3 Theimplication is that private completeunderstanding of investor portfolio equityreturns appear low given their risk. choicerequires private equity holdings to be Inaddition to itssheer size, it is interestingto endogenized. analyzethe private equity market to helpunder- Analternative interpretation of ourresults is standexisting asset-pricing issues. Consider the thatthey raise the question “ whydo people “equitypremium puzzle” of Lars P.Hansenand becomeentrepreneurs?” This decision is based KennethJ. Singleton(1983) and Rajnish Mehra onboth the equity return as wellas thereturn andEdward C. Prescott(1985). Resolutions of onhuman capital. Since our equity return thehigh average return on publicequity, which estimatesaccount for thelabor compone ntof relyon homogeneous agents with very large entrepreneurialactivity ,Žndinga lowequity valuesof riskaversion [e.g., John Campbell and returnmakes the decision to become an en- JohnCochrane (1999)], seem at odds with the trepreneursomewhatpuzzlin g. 4 In the Ž nal factthat many households take on much larger partof thepaper, we briey discusspossible risksin the private equity market without, on theoriesfor whatmotivate sentrepreneursto average,earning a higherreturn than the public enterinto entrepren eurshipand hold such un- equityreturn. In other words, unlike the equity diversiŽed portfolio sofprivate equity, de- premiumpuzzle documented in public markets, spitethe unattractiverisk-retu rntrade-off.We thereturns to private equity investment appear considerŽ vepossible explana tionsfor entre- far toolow given their risk. If householdsre- preneurialinvestment:high entrepren eurrisk quiresuch a highexpected return to takeon the tolerance,largeadditio nalpecunia rybeneŽ ts, risk of publicly tradedequity, why are they largenonpecu niarybeneŽ ts, a preferencefor willingto invest substantial amounts of wealth skewness,and overopti mismand misper- in a single private companywith a muchworse ceivedrisk. risk-returntrade-off? Should this be considered Themost related work to ourpaper is Barton a“privateequity premium puzzle” ? Morethe- H.Hamilton(2000), who documents that indi- oreticaland empirical work is needed to deter- vidualsin the 1984 Surveyof Income Program mineif this is the case. What we hopeto Participation (SIPP) chooseself-employment convincethe reader is that a completetheory of despitefacing a median(but not mean) stream householdportfolio choice should emphasize offuture earnings signiŽ cantly less than that bothpublic and private equity. For example, availableas a paidemployee. In addition, the cross-sectionalstandard deviatio nofself- employedearnings is substantially larger than 3 Forexample, suppose private and public equity each thatof wagesfrom paidemployment. Hamilton haveannual returns with (known) standard deviation of 0.17 (2000)interprets these results as evidence that anda correlationof 0.5, and that the sample mean return largenonpecuniary beneŽ ts to self-employment difference is zero.Then, one can reject thatthe mean return exist.Our dataallow for amorecomprehensive onprivate equity exceeds themean returnon publicequity by4.1 percent or more peryear at the5-percent signiŽ cance levelwith 47 annual observations. With zero correlation between privateand public equity, one can reject thatthe 4 Evenif the conditional return distribution for some difference exceeds 5.8percent at the5-percent level. This entrepreneursis attractive giventheir information, this doesnot account for measurement errorin our private wouldonly mean thatthe conditional distribution of returns equityreturns or uncertainty about the variance orcovari- forother entrepreneurial activities would be even less at- ance. Nonetheless,it suggests there is hopeto establish,in tractive.Hence, theunattractiveness of the unconditional astatistical sense, thatthe mean privateand public equity privateequity return distribution indicates that the motiva- returnsare closer thanpredicted by existing theory. tionfor at least some groupof entrepreneursis puzzling. 748 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 treatmentof theequity return component of the Žrms. Furthermore,characteristics of thehouse- entrepreneur’s payoffover a longertime period, holdare provided on employment status, hours includingadjustments for Žrm entryand exit. 5 workedper week, demographics, and educa- Therest of thepaper is organized as follows. tionalattainment, as well as ontheattributes of SectionI briey describesthe combination of privateŽ rms inwhich the household has own- datasources used to analyze the diversiŽ cation ership.Weighting households using the SCF ofandreturns to private equity. Section II doc- weights,about 11 percentof respondentsreport umentsthe poor diversiŽ cation of entrepreneur- tohave some ownership in anonpubliclytraded ial/privateequity investment and compares it to Žrm (28percent when not weighting). ownershipof publicly traded stock in Ž rms for Table1 reportssummary statistics on the whicha householdmember works. Section III privateequity investments in the SCF. Panel A conductsa detailedanalysis of the returns to documentsthe percent of totalprivate equity in privateequity, highlighting a seriesof issuesin variouslines of business. The set of private calculatingthese returns and Section IV exam- equityinvestments span a varietyof industries. inesthe idiosyncratic risks of private equity Our computationof thereturns to private equity investment.Based on this risk-return trade-off, encompassesall of these entrepreneurial activ- theobserved concentration of wealthin private ities.However, note that the data is not domi- Žrms appearspuzzling. Section V considers natedby any particular industry. A signiŽcant variousexplanations for whyinvestors may be- fractionof entrepreneurs are in manufacturing comeentrepreneurs and willingly hold so much (21.4percent) and service industries (30 per- undiversiŽed privateequity. Finally, Section VI cent)as wellas retail/ wholesale(21.8 percent). concludeswith a discussionof the results. Likewise,activities that may be moreconsistent withconsumption or hobbies rather than invest- I.DataSources ment(e.g., restaurants, bars, weekend ranches, etc.)represent a smallfraction of our data. Inorder to analyze private equity holdings PanelB reportsthe distribution of entrepre- andreturns, we usedata from severalsources. neursacross various household and Ž rm char- acteristicsusing data for theŽ rm inwhich the A. TheSurvey of Consumer Finances householdhas its largest actively managed eq- uityshare. Most of the entrepreneurs are male, TheŽ rst isthe 1989, 1992, 1995, and 1998 and40.3 percent have a collegedegree. The Surveyof Consumer Finances (SCF). These averageage of our entrepreneurs is 46.5, with surveysare nationally representative samples of 90percentof thesample below 65 yearsof age. about4,000 households per survey year. Thus,the majority of private equity investors Weightsare provided to allow aggregation to withactive management interests in oursample U.S. totals.A highwealth sample is included, arebelow retirement age and therefore are not whichimproves the accuracy of estimates of individualslooking for a“hobby”in retirement. aggregatewealth and its components. The re- Finally,there is a widerange of Žrm sizesin the spondentsprovide information on individual sample(measured by equity, sales, proŽ ts, and householdportfolio composition, including in- numberof employees) with signiŽ cant right vestmentin both private and publicly traded skewness.

B. Flowof Funds and National Income and ProductAccounts 5 Hamilton(2000) employs various income measures to captureboth the labor component of earnings and the pri- vate equityreturn. His resultson the mean payoffare As anadditional supplement to our private sensitiveto the measure used,while the median payoff is equitydata, we alsoemploy equity data from substantiallybelow the outside option irrespective ofthe theFederal Reserve Board’ s Flowof Funds incomemeasure used.Given the limited amount of equity informationin his sample (onlyone year ofequity return Accounts (FFA) andincome data from the Na- data fora fractionof thesample), hefocuses onthemedian tionalIncome and Product Accounts (NIPA) entrepreneurrather thanthe mean. overthe 1952 to 1999 time period. This data VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 749

TABLE 1—SUMMARY STATISTICSON ENTREPRENEURSFROM THE SURVEY OF CONSUMER FINANCES

A. Percentageof Private Equity in Each Industry (Average 1989and 1992): Industry Percentage ofprivateequity Agriculture 13.02 Farm; nursery;forest management; agriculturalservices; landscaping 13.02 Retail,wholesale 21.84 Restaurant;bar 2.76 Direct sales: Amway; Avon;Mary Kay; Tupperware; Stanley Home products 0.03 Gas station 0.08 Food/liquorstore 1.70 Otherretail and/orwholesale business 17.27 Professionals 11.72 Professionalpractice: law, medicine,architecture, accounting 9.96 Businessmanagement andconsulting services 1.76 Manufacturing 21.40 Manufacturing,printing/ publishing;oil Ž eldservices 13.96 Contracting;construction services; plastering;painting; plumbing 6.32 Trucking;moving and storage; warehousing 1.12 Services 29.98 Beautyshop; barber shop 0.14 Personalservices: hotel,dry cleaners, funeralhome 5.04 Entertainmentservices, dance studio,theater 1.00 Communications;(cable) TVorradiostations 0.45 Autorepair; car wash 1.49 Repair services: appliances,TV, upholstery, furniture, shoes 0.24 Real estate; insurance 15.38 Variousbusiness services: advertising,equipment rental, computer programming 4.62 Banksand brokerage Ž rms; mortgage/Žnance company 1.63 Other 2.04

B. DistributionAcross Individualand Firm Characteristics(Average 1989–1998): Standard Percentile Characteristic Mean deviation 10th25th Median 75th 90th Entrepreneurage 46.5 12.9 31 37 45 55 65 Firm age 10.7 10.7 1 3 7 15 25 Marketequity 186,8881,647,228 0 4,00025,000 100,000 300,000 Sales 4,027,681130,509,000 700 6,500 40,000 186,000 900,000 ProŽ ts 344,1278,790,767 0 1,00010,000 50,000 160,000 Employees(including entrepreneur) 18.7 337.9 1 1 2 5 12 Percentage male 81.1 Education(percentages) Less thanhigh school 9.5 High school 50.1 Collegegraduate 40.3

Notes: Summarystatistics forhouseholds who own private equity are reportedfrom the 1989, 1992, 1995, and 1998 SCF. PanelA containssummary statistics onthe percent of equity each industrycategory accounted for in the 1989 and 1992 surveys.Industry statistics pertainto the largest three activelyheld private equity positions of each household.Private equity valueis netequity if business were soldtoday, plus loans from household to business, minus loans from business to household.Panel B reportsthe distribution of entrepreneursacross demographiccategories as well as thedistribution of Ž rm age (since founded/acquired)and size. PanelB uses informationfor the Ž rm inwhich the household has thelargest actively managedposition. The calculations include all Žrms withnonzero proŽ ts ornonzeromarket equity.For the entrepreneur-level data,the entrepreneur is deŽned as therespondent (the male incouples) if he/ she is self-employedand the self-employed spouseotherwise. All statistics reporteduse averages across all ŽveSCFimputations. 750 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 sourceprovides aggregate statistics on thevalue laterin thepaper.) We accountfor entrepreneur- andincome of corporateand noncorporate Ž rms ialleverage in the Ž rm byaddingloans from the onan annual basis. We employthis data to householdto thebusiness and subtracting loans generateadditional evidence on private equity from thebusiness to the household. We exclude returns. thevalue of personal assets used as collateral for businessloans. This is done to beconserva- C. OtherData Sources tive,but does not materially affect the results. Summarystatistics are reported for eachsurvey We alsosupplement our return calculations year(1989, 1992, 1995, and 1998) as well as the withadjustments for IPOs (providedby Jay averageacross years. All Ž guresare calculated Ritter),merger and acquisition activity in pri- usingSCF weights,and are thus representative vateand public markets [from the Securities ofthepopulation of U.S. households.We aver- DataCorporation (SDC)], aswell as public agedollar values across the Ž veSCF stockreturn information from theCenter for imputations. Researchin Security Prices (CRSP), andac- TheŽ rst threerows ofPanel A reportthe countinginformation on public Ž rms from percentof total private equity owned by house- Compustat.Data from the1993 NationalSurvey holdswith various degrees of networth devoted ofSmall Business Finances (NSSBF) arealso toprivate equity. A littlemore than 75 percent usedto supplement our calculations. 6 ofall private equity was heldby households whohad 50 percent or more of their net worth II.EntrepreneurialEquity Concentration devotedto private equity. A moredirect mea- sureof the poor diversiŽ cation caused by in- Westartby comparing the level of diversiŽ - vestmentin private equity is captured by the cationof private equity investors to that of nexttwo rows ofPanelA. Therows reportthe publicequity investors, focusing on ownership averagepercent of networth invested in private inpublicly traded corporations for whicha equityacross all households with some private householdmember is or hasbeen employed as equityholdings and positive net worth. The themost severe candidate for poordiversiŽ ca- averagehousehold in thisgroup invests 41 per- tion.We Žndthat private equity investors are centof its wealth (45 percent when weighting dramaticallyless diversiŽ ed than public equity bynet worth) in private equity, consistent with investors. theŽ ndingsof WilliamM. Gentryand R. Glenn Hubbard(2001a). This Ž guredoes not account A. Ownershipin Privately Held Firms for humancapital and the fraction of this de- rivedfrom laborincome in the Ž rm. Moreover, Usingdata from theSCF, Panel A ofTable thisinvestment is typically devoted to a single 2documentsthe poor diversiŽ cation of house- privateŽ rm inwhich the household has an holdportfolios in private equity. The value of activemanagement interest. The next two rows privateequity for agivenhousehold is theself- ofPanel A reportthe mean percent of private reportedvalue of the household’ s shareof net equityheld in the Ž rm representingthe house- equityin the business if it were soldtoday. hold’s largestactively managed equity position. (Possiblereporting bias issues are addressed Theaverage household who owns private eq- uityhas 82 percent (73 percent when weighted byamount of private equity invested) of its privateequity investment in sucha Žrm. More- 6 The1993 NSSBF is aŽrm-based surveyof small over,more than 86 percent of total private eq- businessessponsored by the Federal Reserve Boardto pro- uityis held by investors with an active videdetailed information on a representativesample of managementrole in the company in each year private,nonŽ nancial, nonfarm businesses with less than500 ofthe SCF. Overall, these results indicate that employees.The sample represents thepopulation of about5 millionsmall businessesin the United States inoperation as notonly is private equity investment substantial ofDecember, 1992.The sample covers4,637 small relativeto networth, it isalso poorly diversiŽ ed companies. andconcentrated in the hands of managers. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 751

TABLE 2—PRIVATE EQUITY AND OWN-COMPANY STOCK OWNERSHIP

A. PrivateEquity Ownership: Measure 1989 1992b 19951998 Average Percentage oftotalprivate equity owned by households with: a $ 25percentnet worth in privateequity 92.2 92.4 93.2 91.7 92.4 $ 50percentnet worth in privateequity 76.2 73.3 77.2 74.7 75.4 $ 75percentnet worth in privateequity 40.8 46.9 50.3 47.9 46.5 Meanpercentage ofnetworth invested in private equity for households with positive private equity and net worth: SCFweightsonly 42.3 45.0 37.2 39.9 41.1 Weightedby networth 45.4 45.6 45.7 44.0 45.2 Meanpercentage ofprivateequity held in one actively managed Ž rm forhouseholds with positive private equity: SCFweightsonly 77.9 82.9 82.5 84.8 82.0 Weightedby amountof privateequity 72.8 70.7 74.0 73.5 72.8

B. Own-CompanyStock Ownership in Public Firms: Measure 1989 1992 19951998 Average Percentage oftotalpublic equity owned by households with: $ 25percentof their public equity in own company 13.4 12.5 10.9 12.5 12.3 $ 50percentof their public equity in own company 10.4 9.0 6.7 6.2 8.1 $ 75percentof their public equity in own company 5.6 4.3 3.7 3.6 4.3 Meanpercentage ofnetworth invested in own-company stock for households with positive own-company stock and net worth: SCFweightsonly 8.7 6.9 10.8 10.4 9.2 Weightedby networth 7.7 8.9 10.2 12.7 9.9 Meanpercentage ofdirectlyheld public equity in own-companystock for households with positive own-company stock c: SCFweightsonly 77.7 77.5 69.1 71.0 73.8 Weightedby amountof directlyheld public equity 54.7 49.1 47.7 49.2 50.2 Meanpercentage ofdirectlyand indirectly held public equity in own-companystock for households with positive own- companystock d SCFweightsonly 67.0 55.6 46.9 40.2 52.4 Weightedby totalpublic equity held 43.6 31.8 30.8 30.3 34.1

Notes: Privateand own-company stock ownership for households are reportedfrom the 1989, 1992, 1995, and 1998 SCF, as well as theaverage across all foursurvey years. PanelA containsinformation on private equity ownership and Panel B containsinformation on own-company stock holdings in public corporations, deŽ ned as ownershipin a publicŽ rm forwhich ahouseholdmember is orhas beenemployed. All statistics reportedare averages across all ŽveSCFimputations. a Ownershipby households with negative net worth included. b For1992, data fortwo households with very small valuesof net worth for one of the imputations were deleted. c Ineach year afew householdsreport holding more directlyheld own-company stock than their total direct stock holdings. Forthese, we set thepercent of own-companystock in directlyheld equity to 100. d Ineach year afew householdsreport holding more directlyheld own-company stock than their total direct and indirect stockholdings. For these, we set thepercent of own-companystock in directly and indirectly held equity to 100.

B. Own-CompanyStock Ownership in stitutethe majority of the households’ direct PubliclyTraded Firms equityinvestment, averaging 73.8 percent (50.2 percentwhen weighted by amount of directly For comparisonto the concentration of heldpublic equity). As afractionof all public wealthin private equity, we documentthe prev- equityheld, both directly and indirectly through alenceof holdings in public Ž rms inwhich a mutualfunds, IRAs, pensionplans, and annu- householdmember is or has been employed. itiesand trusts, own-company stock accounts PanelB ofTable2 reportsthat for households for about52.4 percent (34.1 percent when withown-company stock holdings, these con- weightedby amount of total public equity 752 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

TABLE 3—THE SIZE OF PRIVATE AND PUBLIC EQUITY MARKETS

1989 1992 1995 1998 A. PrivateEquity ($ billion), SCF: Proprietorsand partnerships (market value) 2,026 1,977 1,991 2,511 SandC corporations a (market value) 1,661 1,780 2,302 3,226 Totalprivate equity (market value) 3,687 3,757 4,293 5,737 Public equity(market value) 1,587 2,102 3,439 7,256 Ratio:private/ publicequity 2.32 1.79 1.25 0.79 ProŽts ($ billion) Pretax,proprietors and partnerships 335 430 458j 534 After-tax, SandC corporations b 267 288 341 496 ProŽ ts 2 retainedearnings, P&P (20percent retained) 268 344 367 427 ProŽ ts 2 retainedearnings, S&C (20/ 40percentretained) 175 194 244 355 Laborincome ($ billion) Totalsalary paid to self-employed managers 141 191 159 300 (Hoursworked) 3 (estimated wagerate) c for entrepreneurs withno self-employment salary 175 193 229 232 Proprietorsand partnerships 152 155 200 172 SandC corporations 23 38 30 60 Price-to-earningsratio 6.1 5.2 5.4 5.6 Price-to-dividendsratio d 13.8 10.9 11.2 10.4

B. PrivateEquity ($ billion), FFA/ NIPA: Equityin noncorporate business e 3,102 3,127 3,599 4,394 2 Valueof 1– 4 family rentalproperties 942 1,003 1,135 1,272

5 Proprietorsand partnerships (market value) 2,160 2,124 2,463 3,122 SandC corporations(market value)(estate multiplier 5 2) 1,412 1,220 1,585 2,067 SandC corporations(market value)(estate multiplier 5 3) 2,117 1,830 2,377 3,101 Totalprivate equity (market value)(estate multiplier 2) 3,571 3,344 4,048 5,190 Totalprivate equity (market value)(estate multiplier 3) 4,277 3,954 4,841 6,223

Ratio:private/ publicequity (estate multiplier 2) 1.08 0.76 0.60 0.39 Ratio:private/ (0.70 public)equity 1.55 1.09 0.86 0.56

Income anddividends ($ billion) Proprietors’income 362 434 498 624 Adjustedproprietor’ s income 2 retainedearnings f 209 247 336 519 Dividends,S andC corporations g 147 176 236 376

C. PublicEquity ($ billion), Center for Research in Security Prices: Marketvalue 3,292 4,376 6,734 13,217 New issuesand takeovers, three-year total($ billion) h New issues 42 76 110 SDCM&A adjustmentto private equity i 55 129 421 SDCprivate acquisitions of publicŽ rms 34 31 58

Notes: Theaggregate market valuesof all privateand public equity as well asvarious proŽ t measures are reported.Estimates are obtainedfrom twosources. Panel A containsdata from the1989, 1992, 1995, and 1998 SCF, averaging over all Žveimputations.Panel B containsdata from theFFA/ NIPA overthe same years.Panel C containsdata on publicly traded equity (NYSE, AMEX, andNASDAQ) from theCenter for Researchin SecurityPrices (CRSP)over the same period. a Includedin this category are Žrms ofunknowntype and other types of corporations. b After-tax proŽts assume a 30-percentcorporate tax rate whichonly applies to C andother corporations and type unknown Ž rms. ProŽts from Scorporationsare includedpretax. c Hoursworked by head and/ orspouse for self-employedpersons with positive equity in a businessin which they have an active managementrole and who did not report receiving a salary.Estimated wagerates are determinedby Ž rst regressinghourly wage rates of householdmembers whoare notself-employed on educationaland demographic attributes, and then using the regression equation to predict wagerates ofself-employed household members withno salaryreported. d “Dividends”refer toproŽ ts minus retained earnings minus the labor adjustment for self-employedindividuals who do notreport a salary. e Equityin noncorporate business is deŽ ned as (tangible assets 1 Žnancialassets) 2 liabilities.Tangible assets consist of real estate(at estimatedmarket value)and equipment, software, and inventories (at estimatedreplacement cost). f WeadjustP&P incomein three ways.First, we changethe adjustment for misreportingof proŽts on incometax returns to be 75percent ineach year from 1959onward, implying that for every$1 ofproŽ ts reported to the IRS, adjusted proŽ ts are $1.75.Second, we subtractthe capitalconsumption adjustment included in NIPA proŽts from earningsto get a measure oftheactual proŽ t owsto proprietors. Third, as a measure ofactual retained earnings in the Ž rm, we addcapital expenditures plus net acquisition of Ž nancialassets minus net increase in liabilities(excluding “ proprietors’net investment” ). Thismeasures theamount owners must have invested to cover Ž rm investment,whether from proŽts or additionalpaid-in funds. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 753

TABLE 3—Continued.

g Weestimate dividendspaid out by private S andC corporationsas total dividends paid by all corporations(from NIPA) minusdividends paid bypublic corporations (from CRSP).In addition, we add20 percent of the NIPA incomeunderreporting adjustment made tototal corporate proŽ ts. h Resultsin the three columnsreported are for 1990– 1992,1993– 1995, and 1996 – 1998. i Thetotal change to private equity totals from merger andacquisition activity obtained from SDCand Table 5.Table5 describesthe various adjustmentsto the private equity totals. j TheSCF proŽt totalfor P&P in1995 is very sensitive to one outlier (household number 1921). The ownership share of this respondent isimputed and generates a veryimplausible value for thedollar amount of Žrm proŽts which are attributableto the respondent. We use instead asour SCF P&P proŽt totalfor 1995a weightedaverage of the1992 and 1998 SCF P&P proŽt totals.The weights re ect thepercentage of SCFS&C proŽ t growthfrom 1992to 1998 that occured between 1992 and 1995. invested)of a household’s totalpublic equity moreof their equity holdings in indirect form holdings.Relative to net worth, however, invest- (e.g.,mutual funds, retirement plans, etc.). mentin own-company stock for publicŽ rms isfar Thisundersco res theimportance of analyzing lessimportant. As afractionof househo ldnet andunderstanding investment in private equity. worth,investme ntin own-company stock is only10 percent, compared to 45 percent for III.The Returnsto Private Equity Investment privateŽ rms. Furthermore,households with over25 percentor moreof theirequity holdings Dueto the lack of a comprehensivepanel inown-company stock own only about 12 per- dataset on entrepreneurinvestments, we exam- centof total equity investment in public Ž rms. inethe returns to an index of allprivate equity Householdswith at least 50 percent and 75 byaggregating all the private Ž rm valuesand percentof their equity holdings in own-com- proŽts to U.S. totals.Only by aggregation can panystock comprise only 8 and4 percent,re- we accountfor Žrm entryand exit over time and spectively,of total public equity investment. assignthe proper returns. In the next section we Hence,owners of own-companystock in public arguethat the private “ index”return is likelyto companiesare not as poorly diversiŽ ed as own- bean upward-biased estimate of the average ers ofprivate equity and own only a small individualŽ rm return(when focusing on geo- fractionof public equity. 7 Itshould be noted metricbuy-and-hold returns). thathouseholds may hold undiversiŽ ed portfo- liosof public equity without owning any own- A. TheSize of the Private Equity Market companystock. However, Vissing-Jø rgensen (1999)shows that 91.3 percent of publicequity We beginby Ž rstcomparing the size of the heldin the 1995 SCF isowned by households privateand public equity markets. We employtwo withat least Ž vedirectly held stocks or halfor datasources for ourestimates of the size and returnsof this market. The Ž rstis the 1989, 1992, 1995,and 1998 SCF andthe second is the FFA 8 7 Thenumbers in Table 2 donotinclude own-company from 1952to 1999. PanelA ofTable 3 reports stockheld indirectly through pension plans or employee thesize of the private equity market estimated stock-ownershipplans (ESOPs). However, the Department from theSCF usingthe household weights pro- ofLabor estimates (basedon Form 5500 Ž ledwith the vided.Total market value of private equity held in InternalRevenue Service) thatof thetotal $1,024 billion in assets ofdeŽned contribution plans with 100 or more par- billionsof dollars are reported for twotypes of ticipantsin 1995, $165 billion was investedin employer Žrms: proprietorshipsand partnerships, and S and stock.ESOPs with 100 or more participantsaccount for othercorporations (with unknown Ž rm typesin- another$100 billion of investments in employer equity. cludedin the latter category). In computing the Based onthe 1995 SCF, the total dollar amount of directly heldown-company stock is $272 billion, about the same as totalamount of private equity investment (and holdingsthrough pension plans and ESOPs combined. The theirreturns) we againdeduct collateral posted by totalamount of direct and indirect holdings of publicly theentrepreneur for loansto the Ž rm. Thisis done tradedstock by households in the 1995 SCF is$3,439 billion,implying that (165 1 100 1 272)/3,439 5 15.6 percentof totalpublic equity held directly or indirectly by 8 Foracomparisonof the SCF andFFA equitynumbers, householdsis ownedby employees. This is stillconsider- as well as thenumbers for many other asset categories,see ablyless concentratedthan private equity. RochelleL. Antoniewicz(2000). 754 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 tobe conservative so that private equity values reauof EconomicAnalysis) of themarket value willnot be in ated by the inclusion of personal ofsuchproperties. assetsposted as collateral. Theresulting estimates of (noncorporate) AsTable3 shows,the market value of private proprietorshipand partnership equity are fairly equityhas risen steadily from 1989to 1998, in similarto those from theSCF inPanel A. The largepart due to an increase for Sandother FFA numbersfor equityin corporations are corporations.The total dollar amount of private moreproblematic. Equity in S andC corpora- equityis substantial, ranging from $3.7trillion tionsrefer toboth equity in publicly traded in1989 to $5.7 trillion in 1998. The SCF esti- corporationsand equity in privately held Ž rms. mateof the total holdings of public equity by TheFFA estimatesthe value of closely held householdshas similarly risen sharply over the (nonpublic)corporations from estatetax re- decadecovered by the four surveys (from $1.6 turns,but do not publish separate series for trillionto $7.3 trillion). 9 Thegrowth in public publiclytraded corporate equity and nonpublic equityvalue has outpaced that of privateequity. corporateequity. The speciŽ cs ofthe approach Theprivate market was 2.3times larger than the areproprietary and they would not release their publicmarket in 1989,but was only79 percent series.To obtain an estimate of nonpublic cor- aslarge as the public market by theend of 1998. porateequity, we consideredsubtracting from Thissuggests that the returns to public equity theFFA numberthe estimate of the market were largerthan those of privateequity over this valueof public equity from CRSP,which is timeperiod. Also reported is the average price- reportedat the bottom of Table 3 inPanel C. to-earningsratio (P/ E)andprice-to-dividends However,this produces an extremely volatile S ratio(where dividendsare proŽ ts minus re- andC privateequity series since it is the resid- tainedearnings minus a laboradjustment de- ual,which thus also captures any deŽ nitional scribedbelow), which average 5.6 and 11.6 differencesbetween the FFA andCRSP. As an overthe sample period, respectively, in thepri- alternativemeasure (that is stillindependent of vatemarket. These are signiŽ cantly smaller theSCF equitytotals), we adopta methodused thanthose in the public market. bythe IRS for estimatesof wealth that is also Wealsoestimate the size of theprivate equity basedon estate tax returns; see Barry W. Johnson marketfrom dataobtained from theFFA. For (2000).This method is useful since the vast comparisonto the SCF estimates,we showthe majority(over 90 percent) of equity in private FFA datafor 1989,1992, 1995, and 1998. FFA corporationsis owned by the population repre- noncorporateequity is deŽ ned as tangible and sentedon estate tax returns (i.e., those with Žnancialassets minus liabilities. Tangible assets assetsover $600,000). The estimation relies on consistof realestate (at estimated market value) anestate multiplier which re ects the probabil- plusequipment, software, and inventories (at itythat a givendollar of wealth shows up on replacementcost). As describedin Antoniewicz estatetax returns for agivenyear. The multi- (2000),the FFA noncorporateequity includes plierused by the IRS isaround100 from 1989 themarket value of 1– 4 familyrental proper- to1995. We reportnumbers for multipliersof ties.To obtain a numbermore comparable to 200and 300, which we argueis abettermulti- theSCF, we subtractfrom theFFA numberan plierfor privateequity-holders, who are un- estimate(based on aggregatedata from theBu- likelyto have the same mortality rates as the generalpopulation in the same age and wealth cohort.While obtaining precise multipliers is difŽcult, Appendix A providessome support for 9 These numbersinclude estimates ofhouseholds’own- ourmultipliers based on health and expected ershipof publicequity through mutual funds, deŽ ned con- life-spanquestions from theSCF. This method tributionretirement plans,and trusts. Since part of public canonly be applied to the FFA Žguresfrom equityis ownedby deŽ ned beneŽ t retirement plans,includ- 1989to 1999,but not for thelonger period 1952 ingstate andlocal government retirement plans,or by nonproŽt organizations,insurance companies, and foreign- to1999 due to data limitations. Consequently, ers, theSCF publicequity totals will be lower than the we willfocus on proprietorships and partner- CRSPtotal market valuefor public equity. shipsfrom theFFA whenexamining the longer VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 755 timeperiod. The FFA estimatesof corporate inthe Ž rm. Sincethe SCF doesnot record how privateequity obtained by this method are muchof earnings are paid out to shareholders, slightlysmaller than the estimates based on the we assumethat 40 percent are retained in C SCFwhenusing a multiplierof 200and slightly corporations.This corresponds roughly to the largerusing a multiplierof 300. ratioof retainedearnings to after-tax proŽ ts for Usingthese numbers, the total size of the Ccorporationsin the NIPA dataover the period privateequity market based on the FFA/ estate 1989to 1998. External Ž nancingis likelyto be taxreturn data is substantial, and is larger than morecostly for privateŽ rms thanfor larger thepublic equity market in the 1989 data. Ac- publicŽ rms. Therefore,it islikely that private C countingfor thefact that individuals own about corporationsretain more in theŽ rm thanlarger 70percent of corporateequity (direct and indi- publicŽ rms. Increasingthe retention rate would rectholdings), the ratio of private-to-publiceq- lowerour subsequent return estimates, hence uityheld by households is again large. the40 percentretention assumption will, if any- thing,bias our returns upward. Since S corpo- B. Returnsto an Index of All Private Equity rations,proprietorships, and partnerships are oftensmaller than C corporations,one may ex- Webeginby calculatingthe returns to a val- pectthem to face even higher costs of external ue-weightedindex of allprivate equity based on Žnancingand thus have higher retained earn- the1989 to 1998 SCF data.In order to estimate ings.On the other hand, they may have fewer thereturns to private equity holdings, we use growthopportunities, so we conservativelyas- thehousehold estimates of the market value and sumetheir retention is half that of C corpora- proŽts of the private Ž rms beingheld as re- tions(i.e., 20 percent). ProŽ ts after retained portedin Table 3. The proŽ ts reported by earningsare reported in Table 3. householdsare pretax earnings for theyear prior Usingthe market value of private equity at tothe survey. Although these numbers are self- thebeginning and end of each survey period, reportedby households, they are anonymous plusthe after-tax proŽ ts, adjusted for retained andnot subject to tax scrutiny. However, we earnings,we computethe return on private eq- willaddress later whether reporting biases are uityover the years between each survey. Table likelyto have in uenced our return calculations 4,PanelA reportsthe geometric average annual andhow we canaccount for thesepossible returnfrom investingin private equity over the distortions. threesurvey periods. From 1990to 1992, the We Žrst convertpretax earnings of Ccorpo- averagereturn is 12.3 percent per year, from rationsinto after-tax proŽ ts by subtracting an 1993to 1995, the average return is 17.0 percent, estimateof the taxes due assuming a 30-percent whileit is 22.2 percent from 1996to 1998. corporatetax rate. Table 3 reportsboth the PanelB ofTable4 reportsthe returns to the pretaxproŽ ts of proprietorships and partner- CRSPvalue-weightedindex of NYSE, AMEX, shipsand after-tax proŽ ts ofcorporations(with andNASDAQ publicequity over the same time noadjustment for Scorporationswho are ex- periodfor comparison.The geometric average emptfrom corporatetaxation). Since earnings annualreturn to publicequity is 11.0,14.6, and arereported for theyear prior to each survey 24.7percent for the1990 to 1992,1993 to 1995, (andsurveys occur only every three years), we and1996 to 1998 periods, respectively. These reportthe average of thereturns obtained using returnsare similar to those from privateequity thecurrent and the previous survey’ s earnings inthe SCF (a bitlower from 1990to 1995). estimates.Thus, the returns over the Ž rst survey Sinceprivate Ž rms aremuch smaller and riskier period1990 to 1992 are the average of the thanlarge public companies, represented by the geometricannualized returns using 1988 and CRSPvalue-weightedindex, perhaps a better 1991earnings, respectively. comparisonis to the returns on the smallest Toavoid double-counting earnings as both a decileof publicly traded Ž rms. Over thethree potentialdividend to investorsas wellas acap- surveyperiods, the geometric average annual italgain, we makean assumption about the returnson the smallest decile of CRSPŽrms is fractionof (after-tax)earnings that are retained 30.5,20.3, and 22.0, respectively. These are 756 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

TABLE 4—THE RETURNS TO PRIVATE EQUITY (1990– 1998)

A. PrivateEquity Returns Datafrom the SCF: Retainedearnings Adjustments Annualreturns (percent per year) Firm Tax P&P– CcorporationsP, P&SLabor a birthsIPOs M&A b evasion S&C1990– 1992 1993– 1995 1996– 1998 1) All 0.400.20 — ———yes 12.3 17.0 22.2 2) P&P 0.20— ———yes — 12.6 15.6 23.0 3) S&C 0.40 — — — — yes — 12.0 18.5 21.4 4) All 0.400.20 yes ———yes 8.2 12.7 18.4 5) P&P 0.20yes ———yes — 6.4 9.4 15.9 6) S&C 0.40 yes — — — yes — 10.9 16.9 20.6 7) All 0.400.20 yes yes ——yes 7.5 11.6 16.4 8) All 0.400.20 yes yes yes —yes 7.8 12.1 17.0 9) All 0.400.20 yes yes yes yes yes 8.2 13.0 19.4 10) P&P 0.20yes yes yes yes yes yes 7.4 8.9 15.4 11) S&C 0.40 yes yes yes yes yes yes 9.7 17.6 22.8 12) All 0.40 0 yes yes yes yes yes 10.3 15.4 21.7

Datafrom the FFA/ NIPA: S&C P&P 13) Alld actual actual yes ———yes 4.1 16.7 22.4 14) Alle actual actual yes ———yes 2.1 14.7 19.4 15) P&P actual yes ———yes — 1.9 12.3 19.8 16) S&Cd actual yes — — — yes — 6.5 22.6 25.5 17) S&Ce actual yes — — — yes — 2.4 17.7 19.7

B. PublicEquity Returns Source: 18)CRSP data, value-weighted index 11.0 14.6 24.7 19)CRSP data, smallest decile 30.5 20.3 22.0 20) SCF data 13.2 20.7 30.0 21)SCF data,with IPO and takeover adjustment c 13.1 20.3 29.8

Notes: PanelA reportsthe returns to all privateequity based on estimates ofthe size ofprivatelyheld equity and their earnings fromTable 3. Thereturn estimates pertainto data fromthe 1989, 1992, 1995, and 1998 SCF as well as theFFA/ NIPA.Returns are calculated usingvarious assumptions about retained earnings, the labor component of proŽts, sample compositionchanges dueto entry and exit of Žrms, andunderreported proŽ ts dueto tax evasion. When separating returns by proprietorshipsand partnerships(P&P) versus S andC corporations(S&C), we assume 2.1percent of P&Pstransfer toprivatecorporations in orderto account for the in ow and out ow of equity values to both types of Ž rms (denotedby a “yes”in the P&P– S&C column).Panel B reportsreturns to publicly traded equity over the same time periodfrom CRSP. All returns are nominal geometric average returnsover the three subperiodsfrom 1990 to 1998. a Whensalaries are notreportedfor self-employed households, the salary adjustmentis thehours worked by heador spouse forself-employed persons times theestimated hourlywage rate forthe person. Estimated wage rates are determinedby Žrst regressinghourly wage rates ofhouseholdmembers whoare notself-employed on educationaland demographic attributes, andthen using the regression equation to predict wage rates ofself-employedhousehold members whodo notreport a salary. b Obtainedfrom Securities Data Corporationfor each year overthe survey period. A summary ofthe adjustments are describedand reported in Table 5. c IPOandtakeover adjustments assume householdsown 70 percentof all publicequity. This corresponds approximately tothe share ofcorporateequity owned by households (directly and indirectly) over this period in the FFA. d Estate multiplier 5 2. e Estate multiplier 5 3. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 757 considerablyhigher than the private equity re- rateon a constant,their age, age squared, a turnsfor the1990 to 1992 period and quite dummyvariable for havinga high-schooldi- similarfor theother two periods. Other small- plomabut not a collegedegree, a dummyfor Žrm indicesperformed worse thanthe CRSP graduatingcollege, and a dummyfor theirgen- indexin the 1990’ s, however.Given the dispar- der.We runone regression for headsof house- ityin performance across various small-Ž rm holds(deŽ ned as the male in couples) and one indicesin the 1990’ s, we comparethe private regressionfor spouses.Using the regression co- equityreturns for thisperiod to the returns on efŽcients, we thenestimate the wage rate for theentire public index. self-employedindividuals who do not report a Theseare our basic private equity return es- salaryby multiplying their demographic and timates,which are likely to be biasedin several educationcharacteristics by theestimated coef- ways.In the rest of this section, we quantify Žcientsand using the predicted value as their thesebiases as bestwe can.Correcting for some hourlywage rate. This procedure does not ac- ofthe biases leads to higher private equity re- countfor anyunobserved differences between turnswhile correcting for othersleads to lower self-employedand other individuals. In fact, the privateequity returns. We willargue, however, resultsof Hamilton (2000) suggest that this thatour most accurate private equity returns are shouldlead to a laboradjustment that is too small, lowerthan those reported above. thusbiasing our private equity return estimates upward.He shows,using a sampleselection 1. Accountingfor Labor Income. —The most model,that the mean wages of employees are less importanteffect not accounted for aboveis thanthe expected wages of entrepreneurs had they thatthe private equity returns contain the part beenpaid employees. Furthermore, entrepreneurs ofproŽ ts that re ects the labor input of the returningto paid employment are found to earn a entrepreneur.This component is not return to higherwage than other employees with the same equity,but rather captures the fact that many observablecharacteristics. These Ž ndingssuggest entrepreneursdo not pay themselves a salary. thatmore talented individuals self-select into For theseentrepreneurs, part of their compa- entrepreneurship. 10 nies’proŽ ts should be viewed as payment for We thensubtract the estimated annual wage hoursworked, rather than return on equity. for thosenot reporting a salaryfrom earnings SpeciŽcally, our baseline return estimates ac- andrecompute returns. The fourth row ofTable countfor salarieswithdrawn from theprivate 4PanelA showsthat the labor adjustment re- Žrms byself-employedmanagers, since they are ducesthe estimated returns by about 4 percent alreadysubtracted from theearnings numbers peryear (6.5 percent for proprietorsand part- reported(for reference,the amount of suchsal- nershipsand 1.2 percent for SandC corpora- ariesare reported in Table 3). However, the tions),indicating its importance in these SCFprivateequity-holders include many re- calculations.With this adjustment, returns to spondentswith actively managed equity posi- privateequity are considerably smaller than tionswho do not report a salaryto themselves. thosefor publicequity. Therefore,we makean adjustment to earnings for thislabor component for individuals(head and/orspouse) who report being self-employed, 10 As acheck onour procedure, we alsocompare the haveownership in a privatecompany in which salaries takenby self-employedhouseholds who do reporta theyhave an active management interest, but salary towhat our regression approach would have pre- failto report a salarytaken. To doso,we usethe dictedtheir salary tobe. The average reportedsalary across all entrepreneurswho report a salary is1.16times thesalary reportedweeks worked per year and hours ourregression approach suggests. (For proprietorships, part- workedper week. We multiplythe annual hours nerships,and S corporationsthis ratio is 1.10; for C corpo- workedby an estimated wage rate for similar rationsit is 1.33).This likely conŽ rms theselection issues individualsin the survey who worked in paid emphasized byHamilton (2000). For C corporationsit may alternativelyre ect excessive salaries reportedby some employment.SpeciŽ cally, for respondentswho entrepreneursfor tax reasons. Using estimated, rather than reportedto work in paid employment (i.e., not actual,reported salaries forC corporationsonly has asmall self-employed),we regresstheir hourly wage effect onreturns. 758 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

2. Accountingfor Firm Entry:Births and 3. Accountingfor Firm Exit:IPOs, Mergers New Equity.—Theprevious computa tionsas- andAcquisitions, Failures and Liquidations. — sumethat the composit ionof Žrms intheSCF As willbe documentedin the next section, exit isthe same at the beginnin gofeach three- ratesfor privateŽ rms arelarge, and include sale yearsurvey period as it is at the end. While tonew owners (including acquisitions and theSCF employsthe same sampling proce- IPOs) aswell as liquidations and failures. If a dureand question sfor eachof the surveys, Žrm goespublic between two surveys, then it therewill be sample composit iondifference s willno longerbe containedin theend-of-period betweensurvey years that may distort the Žguresfor privateequity. Since IPOs aregen- returnestimate s. erallythe most successful private companies, First,a possibledistortion of the composition ignoringthese would understate the returns to ofŽ rms thatcomprise the beginning and end- privateequity. To takethis into account, we add of-periodprivate equity values occurs when thetotal market value of allinitial public offer- newprivate Ž rms are“ born”between the two ingsover the three years between surveys to the surveyyears. Since end-of-period Ž gurescon- end-of-periodvalue of privateequity. The effect tainŽ rms createdafter the previous survey, the ofIPOs israther small, increasing average re- valuesshould not be attributedto initial equity- turnsby only about 50 basis points per year. holdersfrom theprevious survey year. To take Anotherpossible distortion concerns merger thisinto account, we recomputereturns by andacquisition activity between the survey droppingŽ rms attheend of the period that were years.SpeciŽ cally, when a privateŽ rm is founded(but not those that were boughtor boughtout by a publiccompany between sur- inherited)less than three years ago. This is done veys,the value of that private Ž rm willno for theearnings estimates and labor component longerbe containedin the end-of-period private computationsas well. The returns drop by 0.7to equityvalue. Ignoring this will understate re- 2percentper year. turns.As for saleto new private owners, no Similarly,newequity invested in existing adjustmentto private equity returns is neededif Žrms shouldnot be attributedasacapitalgain thenew owners hold as much equity in the Ž rm tooriginalprivate equity-h olders.To estimate asdid the previous owners. If theprevious theaverage value of newequity injected into ownersget moreequity out than the new owners privateŽ rms eachyear, we employdata from putin (i.e.,due to increasedŽ nancingwith debt the1993 NSSBF. Inthis survey, responde nts orinternalfunds, or from foreignequity inves- areasked “ Duringthe last three years, has the tors)then our private equity returns should be Žrm obtainedadditionalequity capital from increasedby the amount of the difference. existingowners, their relatives ,orfrom new Therefore,we needto determine the extent to orexisting partners? ”Andif yes,how much? whichprivate Ž rms areacquired by publiccom- Usingthe NSSBF weights,one can aggregat e panies(whether foreign or domestic), by for- theresponse stoU.S.totalsand divide by 3to eignprivate companies (irrespective of how getannual numbers. The aggregat edannual funded),and by domestic private companies totalfor 1993was 28billion dollars, when fundedby debt or internalfunds, and add back excludingfundsraised for “businessexpan- thesecomponents to private equity values. sion,acquisit ion”(which we addressbelow) Onthe other hand, if domestic private Ž rms andexcludin gthefew publicŽ rms inthe raisenew equity to acquireforeign targets, this NSSBF.Sincethe populat ionof Žrms covered shouldbe subtracted from ourprivate equity bythe NSSBF havefewer than500 employ- totals,since the gains from suchacquisitions ees,equity raised by the biggest private Ž rms willaccrue to foreign entrepreneurs. Likewise, willnot be covered.Thus, our returns may be publicŽ rms acquiredby private Ž rms funded overstated.Aswedonothave annual data for withnewly raised equity will also overstate our thisadjustme nt,it is not included in Table returns.Hence, we needto subtract these from 3.However, this effect likely cancels with an privateequity totals. omittedeffect from Žrm exit,which we de- Toaccount for theseeffects, we examinethe scribebelow. totaldollar amount and number of transactions VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 759 ofmergerand acquisition activity in privateand TheSDC databasecovers the largest mergers publicŽ rms usingdata from SecuritiesData andacquisitions. Data on sales of small busi- Corporation(SDC) overthe period 1989 to nessesto new owners as well as equity recov- 1998.We focusonly on completedtransactions eredin liquidationsis not available annually. To andwhether the acquirer and target is a private evaluatethe impact of suchtransactions, we use orpublicŽ rm, whetherforeign or domestic,and the1993 NSSBF. Accordingto the U.S. Small whetherthe acquisition was fundedwith equity BusinessAdministration (2000) about 500,000 orwithdebt or internal funds. 11 employerŽ rms discontinuedeach year during Table5 reportsthe total dollar amount in mil- the1989 to 1998 period. The upper bound on lionsand total number of transactions involving thedecrease in Ž rm equityat saleor liquidation publicŽ rm acquisitionsof private Ž rms, private isthe amount of assetsheld by suchŽ rms. Inthe Žrm acquisitionsof other private Ž rms, andpri- 1993NSSBF themedian asset holdings for all vateacquisitions of public Ž rms overeach of the Žrms withless than 500 employees (using threesubperiods from 1990to 1998. One problem NSSBF weights)is about$70,000. Thus, if the withthe SDC datais that a signiŽcant number of typicaldiscontinued Ž rm was ofmedian size, dealshave missing values. Consequently, the total theupper bound on the total adjustment neces- valuereported only pertains to those deals with saryis 35 billion dollars per year. In reality, availableprice information, which are typically mostof the discontinued Ž rms areliquidations thelargest transactions. Rather than employing the orfailuresrather than sales to new owners (see averagevalue for themissing observations, which SectionIV). Thus,the relevant adjustment is wouldoverstate our private equity returns, we muchsmaller than 35 billion dollars and there- estimatethe value of missing deals using a pre- fore likelycancels with the 28 billiondollars of dictiveregression approach similar to that em- newlyraised equity by existingŽ rms discussed ployedfor entrepreneurswith missing salaries. inthe previous subsection. Thedetails are provided in Appendix B. These We believethe returns in line 9 ofTable 4 are estimatedvalues are added to the value of deals themost accurate returns to privateequity. The withprice information to produce a totalor followingsummarizes our computations and “scaled”value for eachsubcategory. Table 5 re- variousadjustments to earnings and private eq- portsthe sum of these values over the three uityvalues in Table 4: subperiods.The sum of all changes are added to theend-of-period total value for privateequity in AMVt 1 3 1 AE t:t 1 3 Table 3. (1) R 5 t:t 1 3 AMV As indicatedin the ninth row ofPanel A of t Table4, accounting for mergersand acquisi- tionsadds an additional 0.4 percent per year to (2) AMVt 1 3 5 MVt 1 3 1 IPO t:t 1 3 privateequity returns over the 1990 to 1992 age,3 period,about 1 percentper year from 1993to 1 M&At:t 1 3 2 MVt 1 3 1995,and 2.4 percent per year from 1996to age,3 1998.However, the modiŽ ed returns remain (3) AEt:t 1 3 5 ~Et:t 1 3 2 Et:t 1 3 !~1 2 tc ! substantiallybelow the returns to publicequity.

3 ~1 2 rRE ! 2 LCt:t 1 3

11 SDCrecords a hostof information about global tc 5 tax rate ~0.30for CCorps., merger andacquisition activity from 1983 to 2001,includ- ingpublic status of the target and acquirer, where itis located,and the source of fundsemployed in thedeal. The 0for SCorps.and P&Ps) sources offunds include borrowing from outside lenders, bridgeloans, debt issues, foreign lenders, junk bonds, credit rRE 5 earningsretention rate lines,and mezzanine Žnancing,which we codeas “debt” sources,as well as fundingfrom internal sources. We ag- gregateall deals withdebt or internalfunds sources intoone ~0.40for CCorps., category.The rest are deals fundedby common and pre- ferred equity. 0.20for SCorps.and P&Ps) 760 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

TABLE 5—MERGER AND ACQUISITION ACTIVITY IN PRIVATE AND PUBLIC FIRMS

1990–1992 1993–1995 1996–1998 Acquirer: PublicPrivate Private Public Private Private Public Private Private Target: PrivatePrivate Public Private Private Public Private Private Public AllAcquirers, All Targets Value ($million) $ 62,236$24,059 $70,989 $109,702 $32,358 $ 90,217$287,669 $ 69,727$136,736 Numberof deals 6,2904,338 2,397 10,451 5,716 3,828 18,942 8,118 3,723 Numberof deals 2,718857 1,657 5,088 1,312 2,522 8,943 1,993 2,477 w/price Scaled value $133,847$43,741 $85,275 $211,678 $85,410 $106,895 $610,613 $196,099 $158,987 AllAcquirers, Domestic Targets Value ($million) $ 30,579$11,116 $30,310 $ 67,448$14,193 $ 26,764$192,238 $ 27,519$ 50,155 Numberof deals 3,1411,181 1,221 5,737 1,535 1,814 10,711 2,467 1,787 Numberof deals 1,367268 1,021 2,960 378 1,516 5,126 558 1,367 w/price Scaled value $63,720$20,799 $33,824 $131,533 $36,593 $ 31,261$407,889 $ 77,468$ 58,073 Domestic Acquirers,Domestic Targets,Debt or Internally Funded Value ($million) $ 3,483$ 3,068$ 8,794$ 12,015$ 3,568$ 4,632$ 28,592$ 5,832$ 16,806 Numberof deals 163 88 70 391 102 57 511 84 86 Numberof deals 136 30 61 352 59 48 424 46 77 w/price Scaled value $7,342$ 5,238$ 9,250$ 23,413$ 9,756$ 5,533$ 60,403$ 13,371$ 19,198 ForeignAcquirers, Domestic Targets Value ($million) $ 6,400$ 5,919$12,574 $ 7,654$ 6,110$ 10,831$ 17,836$ 11,738$ 19,858 Numberof deals 432 239 588 425304 1,013 737 447 970 Numberof deals 265 87 520 268 133 892 454 161 760 w/price Scaled value $13,242$10,439 $14,002 $ 15,186$14,902 $ 12,937$ 37,734$ 32,293$ 23,073 Domestic Acquirers,Foreign Targets, Equity Funded Value ($million) $ 2,081$ 222$ 8,635$ 6,138$ 631$ 9,306$ 16,907$ 1,893$ 4,595 Numberof deals 374 100 84 728 195 151 1,548 299 110 Numberof deals 114 15 52 220 28 77 518 50 66 w/price Scaled value $3,869$ 295$10,909 $ 11,690$ 1,317$ 11,628$ 36,187$ 3,626$ 5,083

Domestic Acquirers,All Targets, Equity Funded Value ($million) $ 23,291$ 4,216$20,262 $ 55,227$ 6,201$ 21,784$165,406 $ 15,420$ 25,138 Numberof deals 2,938988 666 5,683 1,359 91111,054 2,258 872 Numberof deals 1,094175 510 2,590 235 667 4,801 414 623 w/price Scaled value $47,951$ 8,483$24,306 $106,954 $16,085 $ 25,938$351,533 $ 41,536$ 28,861 D Total valuea $63,720$15,381 $24,306 $131,533 $23,341 $ 25,938$407,889 $ 42,038$ 28,861 (1) (2) (3) (1) (2) (3) (1) (2) (3) Total D PrivateEquity Value (1) 1 (2) 2 (3) 5 $54,795 $128,936 $421,066

Notes: Thetotal dollar amount (in $ millions)and total number of transactionsof merger andacquisition activity in private andpublic Ž rms are reportedabove over the three subperiods1990 to 1992,1993 to 1995, and 1996 to 1998. Data are from SecuritiesData Corporation(SDC) and correspond only to completed transactions. Statistics are reportedseparately forpublic Žrm acquisitionsof privateŽ rms, privateŽ rm acquisitionsof otherprivate Ž rms, andprivate Ž rm acquisitionsof public Ž rms, each brokendown further into domestic acquirers andtargets, foreign acquirers andtargets, and acquisitions funded with debt orinternal cash andequity. Also reported are thenumber of transactions with available price informationand a scaled dollar valuefor all deals usingan estimated valuefor deals withmissing transaction value, as detailedin Appendix B. Thetotal changein privateequity value from this activity is reportedat thebottom of thetable. a Calculatedas follows:For column (1) (Private-to-Public) 5 scaled valueof all acquisitionsof domestic targets. For column(2) (Private-to-Private) 5 scaled valueof domesticacquisitions of domestictargets fundedby debtor internalfunds 1 scaled valueof foreignacquisitions of domestic targets 2 scaled valueof domestic acquisitions of foreigntargets fundedby equity.For column (3) (Public-to-Private) 5 scaled valueof domestic acquisitions of all targets fundedby equity. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 761 where Rt:t1 3 isthe return over the three-year are2.3 percent per year higher from 1990to periodbetween surveys (which is reported as a 1992,8.7 percent higher from 1993to 1995, and geometricaverage annual return). AMVt13 is 7.4percent higher from 1996to 1998 than re- theaggregate market value of all private Ž rms turnsto equityin P&P Žrms. However,even the threeyears or older at time t 1 3,plusthe value higherS&C returnsare lower than those of the ofprivateŽ rms inexistence at date t who went publicmarket in two of the three subperiods. publicor were acquiredby a publicŽ rm be- Publicequity outperformed P&P privateequity tween dates t and t 1 3. AEt:t1 3 istheadjusted inall three subperiods by between 3.6 and 9.3 aggregateearnings of all private Ž rms from date percentper year. We nowconsider further ro- t to t 1 3. IPOt:t13, M&At:t13, and LCt:t1 3 bustnesschecks on the SCF privateequity arethe total value of IPOs, acquisitionsof pri- returns. vateŽ rms, andthe labor component of proŽ ts, respectively,over the period t to t 1 3. Differ- D. Robustnessof the Return Estimates entreturn estimates in Table 4 includeor ex- cludethese various adjustments. We considerrobustness issues and possible reportingbiases in the SCF togauge whether C. ReturnsAcross Firm Type thesecould distort our return estimates.

Thereturns to private equity we havedocu- 1. RetainedEarnings Sensitivity. —For ro- mentedpertain to all Ž rms notheld publicly. bustness,and as an overestimate of the returns Whilewe wouldlike to compute private equity toprivate equity, the twelfth row ofPanel A returnsacross industries, this cannot reliably be assumesthat proprietors, partnerships, and S doneusing the SCF datagiven the fairly small corporationsdo notretain any earnings. This is numberof observationsin each of the industry anextreme assumption since it implies that ac- categories.As notedin Table 1, our sample of tualretained earnings for theseŽ rms willbe entrepreneursare not dominated by any partic- double-countedas both a dividendand capital ularindustry. gain.However, the private equity returns are Wecan,however, compute returns separately stillbelow those of thepublic market in twoof for proprietorsand partnerships and S andC thethree time periods. corporationsusing the 1993 NSSBF toestimate thepercent of proprietorand partnership equity 2. UnderstatedProŽ ts Due to Tax Evasion? — which“ migrates”to SandC corporationequity Sincethe SCF isbased on interviews and not eachyear. The NSSBF providesboth current taxreturns, it is not clear whether respondents and1992 Ž scalyear corporate status, from reporttheir true proŽ ts ortheproŽ ts asstated on whichwe canquantify the migration of Ž rms theirtax forms. However,as long as respon- from P&PtoS&C. This is important since dentstrust that the SCF willnot release infor- manyof themost successful P&P Žrms become mationto othergovernment agencies (which the SandC corporationsas they expand. We esti- SCFgoesto great lengths ensuring), households matethe migration rate from P&P toS&Ctobe haveno incentiveto hide their true proŽ ts. This 2.1percent of proprietor and partnership equity issupported by thefact that the SCF proŽts for per year.12 Usingthis rate, as well as attributing P&Ps arequite close to the corresponding NIPA allIPO andmerger activity to S andC corpo- proŽts (proprietor’ s income).The latter are rations,and employing a laboradjustment of 6.5 basedon proŽ ts as reported to the IRS witha percentfor P&P and1.2 percent for S&C,lines 75-percentadjustment for incomeunderreport- 10and 11 of Table 4 reportreturns across the ingon taxreturns (more detailbelow). The SCF twoŽ rm types.With all of the return adjust- proŽts are almost identical to theadjusted NIPA ments,returns to equityin SandC corporations proŽts in 1992 and within 15 percent of the NIPA proŽts in the other three years. Further- 12 Thismay evenbe overstated since thesurvey was more,evidence from evaluationstudies of the Želdedbetween March,1994 and January, 1995. Thus, the 1977economic censuses also suggests that twoŽ rm-typeobservations are more thanone year apart. householdsdo in fact report higher income to 762 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 surveysthan to tax authorities. For thesecen- thepublic market. Since public equity per- suses,the Census Bureau conducted additional formedremarkably well from 1989to 1998,this specialsurveys of small Ž rms for whichtax mayexplain the low SCF privateequity returns. returninformation had been used in theoriginal Likeprivate equity, owner-occupied homes are economiccensuses. The income reported in the illiquidassets that are likely to suffer from specialsurveys consistently exceeded the infor- similarreporting biases. To defend the survey mationbased on tax returns. 13 numbers,we thereforeexamine housing returns bycalculatingthe capital gain on detached sin- 3. ReportingBiases? —TheSCF isconsid- glefamily homes using the SCF dataand com- eredquite accurate and relatively free ofbi- paringit to the capital gain on such properties ases.14 Nevertheless,to addresspossible report- basedon datafrom theOfŽ ce ofFederalHous- ingbiases and potential issues involving survey ingEnterprise Oversight (OFHEO). Thetwo weightsand imputations, we calculatereturns setsof numbersdiffer in that the SCF numbers basedon data from theFFA/ NIPA inthe next arebased on households’ self-reported esti- subsectionand Ž ndreturns similar to those of matesof what they think they could sell their the SCF. housefor, whereas the OFHEO numbersare Todetermine whether there is any general basedon actual repeat-sales housing transac- reportingbias in the SCF equitynumbers, or tionsdata from FreddieMac and Fannie Mae. problemswith using survey weights or imputa- Thecomparison can be done for theperiods tions,we usethe SCF toconstruct public equity 1993to 1995 and 1996 to 1998since the 1992, returns,and then compare them to those from 1995,and 1998 SCFs provideinformation on CRSP.As PanelB ofTable 4 reports,the public thetype of property in which the respondent equityreturn numbers from theSCF are2.7– 6.1 householdsreside. 16 percenthigher than the CRSP returns.Since the Theresulting capital gains based on theSCF CRSPdataimplicitly takes into account IPOs householdsurveys are 5.3 percent per year from andmerger activity, but the SCF datamay not, 1993to 1995 and 5.9 percent per year from we makean adjustment for this(subtracting the 1996to 1998.The actual capital gains based on valueof IPOs butadding the value of public OFHEO dataare only 2.6 percent per year from Žrms takenover by private Ž rms). Thishas a 1993to 1995 and 4.3 percent per year from smalleffect. Thus, if there is a reportingor 1996to 1998. This suggests that household self- weightingbias, it seems to run in the wrong reportedestimates of the market value of their directionto reconcile our low private equity homes,if anything, leads to higher capital-gain returnnumbers. 15 estimates.If self-reportedprivate equity values However,since price information is more exhibita similarbias, it is likely our private readilyavailable in publicmarkets, it ispossible equityreturn estimates overstate the true re- thatreporting distortions may be moreprevalent turns.See also Michael Collins et al.(2001) for inthe private equity Ž gures.Respondents may asummaryof the literature on homeowners’ reportstale values of privateequity that may lag

16 One adjustmentto theSCF data isneeded. The value ofnew homessold in between surveyyears enters the 13 See RobertP. Parker(1984) and Carol S. Kingand currentSCF calculation in the same way as new Žrms EdwardK. Ricketts(1980) for information on these issues. created between surveyyears affected thecalculation of the 14 See RobertB. Averyet al.(1988), Kennickel and returnto private equity. We thereforesubtract an estimate of MarthaStarr-McCluer (1994), Kennickel et al.(1997), and thevalue of new singlefamily houses sold between survey Kennickelet al.(2000) for a discussionof the survey and years fromthe end-of-period SCF valueof single family weightingschemes, as well as theSCF codebook. housesto obtain the correct capital gain.The estimate ofthe 15 Itshould be noted that for some accounttypes in valueof new singlefamily houses is obtainedfrom the U.S. whichpublic equity is held,the SCF onlyprovides categor- Bureauof theCensus. The capital gainfor the period 1993 ical informationabout holdings, e.g. “ mostlystocks,” to1995 is thus calculated as: [(SCFbased 1995 total value “mostlybonds,” or “ acombinationof stocks and bonds.” ofsingle family houses 2 U.S.Bureau of Censusestimate Thisby itself couldlead thepublic equity returns calculated ofthe value of new singlefamily houses sold in 1993, 1994, usingthe SCF to differ a bitfrom the CRSP returns, but and1995)/ (SCFbased 1992 total value of single family shouldnot cause asystematic bias. houses)]1/3.Similarlyfor the 1996 to 1998 period. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 763 estimatesof the value of their homes. This eachyear from 1959onward, implying that for literatureŽ ndsonly small valuation biases of every$1 ofproŽts reported to theIRS, adjusted differentsign in different surveys. proŽts are $1.75. 17 Thisdiffers from theincome Anotherpossibility is that households simply underreportingadjustment made in NIPA, employa staticvaluation model or “ ruleof which uctuatesdramatically over time, from a thumb”to estimate their private equity value. lowof 33 percent in 1959 to a highof 200 For example,households may simply report the percentin 1982; see NIPA Table8.23. While bookvalue of their private equity holdings if some uctuationsin income underreporting to theyŽ ndit difŽ cult to estimate market values. theIRS ispossible, this level of volatility seems Thiswould tend to understatereturns in periods implausible.Appendix C discussesthe main whenthe market-to-book ratio is increas- sourceof information about income underre- ing.However, in the 1989 survey, both mar- portingon tax returns, which are studies per- ketand book values are reported for thethree formedby the IRS underthe Tax Compliance Žrms inwhich the household has its largest MeasurementProgram (TCMP). Given the sub- activelymanaged equity share. The aggregate stantialuncertainty about the actual amount of market-to-bookratio for proprietorshipsand incomeunderreporting to the IRS inany given partnershipsis 1.74 and for SandC cor- year,we employa constant75-percent adjust- porationsis 1.24, indicating that households menteach year. Our resultingreturns for P&P aredistinguishing between market and book overthe 1952 to 1999period are very similar to values.Furthermore, the dispersion of house- whatwould be obtained using the same income holdmarket-to-book ratios is substantial. The underreportingadjustment as NIPA. Second,we lowerquartile of reportedmarket-to-book ratios subtractthe capital consumption adjustment in- for proprietorshipsand partnerships is 0.95, cludedin NIPA proŽts from earningsto get a whilethe median and upper quartile is 1.25and measureof the actual proŽ t owsto proprietors. 4.58,respectively. The lower quartile, median, Tothe extent that tax laws allow for different andupper quartile for SandC corporationsis 1, depreciationthan the true economic depreciation, 1.47,and 6.41, respectively (leaving out house- thedifference will show up in the capital gain holdswith zero book equity values). This indi- componentof returns. Third, as a measureof catesthat the majority of households are not actualretained earnings in the Ž rm, we usecapital simplyreporting book values. expendituresplus net acquisition of Ž nancialas- Finally,the private and public equity returns setsminus net increase in liabilities (excluding seemto move together over the three subperi- “proprietors’net investment” ). Thismeasures the ods.Moreover, in thenext subsection, we show amountowners must have invested to cover Ž rm thatthe two return series are highly correlated investment,whether from proŽts or additional overthe longer time period from 1952to 1999. paid-infunds. The ratio of retained earnings to proŽts averages 23 percent for the1952 to 1999 E. AnotherData Source— the FFA/ NIPA sampleand 25 percent for 1989to 1998. For privateS andC corporations,we estimate For furtherrobustness, Table 4 alsocomputes dividendincome as total dividends paid by all thereturn to private equity using data from the corporations(from NIPA) minusdividends paid FFA/NIPA. Thenational accounts do not rely on bypubliccorporations (from CRSP). 18 In addi- surveyinformation and are therefore free ofpo- tion,we add20 percent of the NIPA income tentialhousehold reporting biases and provide an independentcheck on our return estimates. TheFFA marketequity estimates for propri- 17 TheNIPA data donot rely on IRSdata priorto 1959, etorsand partnerships and S andC corporations see Parker(1984). aredescribed in Section III, subsectionA. For 18 Sinceneither the NIPA northe CRSP dividend series theincome component of returns, we adjust adjustsfor intercorporate holdings, our measure ofprivateS andC dividendswill also double-count dividends due to NIPA P&Pincomein three ways. First, we intercorporateholdings. However, since ourmeasure of changethe adjustment for misreportingof prof- equityalso double-counts intercorporate holdings, our re- itson income tax returns to be 75 percent in turnestimates shouldnot be biased. 764 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 underreportingadjustment made to totalcorpo- longeranalysis is that we canonly examine rateproŽ ts. 19 AppendixC detailsthe exact ta- proprietorsand partnerships (as discussedear- blesand line items we usefrom theFFA/ NIPA. lier).Again, we donot account for Žrm entry Usingthese equity and dividend series, Panel andexit in this calculation, but comparing lines AofTable4 reportsan averageannual return to 5and10 in Table 4, the SCF numberssuggest privateequity of 4.1, 16.7, and 22.4 percent thatthese effects largely cancel out for propri- from 1990to 1992, 1993 to 1995, and 1996 to etorsand partnerships. The SCF numbersomit 1998,respectively, using an estatemultiplier of theeffects of new equity to existing Ž rms and 200for SandC corporations.When employing equityrecovered by discontinuedŽ rms. We ar- anestate multiplier of 300, the returns drop to guedthat these effects are small and likely 2.1,14.7, and 19.4, respectively. These returns cancelout for allprivate equity. This is likely subtractout the average labor adjustment from thecase for proprietorsand partnerships as theSCF (6.5percent per year for P&P and1.2 well.20 percentfor S&C), andshould be compared to Table6 PanelA reportsthe arithmetic and line4 inPanel A for theSCF. The FFA/ NIPA geometricaverage annual returns and standard returnsare lower in the Ž rst subperiod,but deviationto private equity for P&Poverthe slightlyhigher in the latter two periods. Com- 1952to 1999 time period. Panel B reportsthe paredto the public returns, the private FFA/ averagepublic equity return and standard devi- NIPA returnsare lower in two of the three ationover the same period. The private and subperiods.We donot adjust for Žrm entryor publicequity returns are similar. Moreover, exitin the FFA/ NIPA (sincean entry adjust- whencomparing the private returns to the mentis not feasible), but the SCF numbers smallestdecile of CRSP stocks,the public eq- suggestthat the total effect of this is small uityreturns signiŽ cantly outperform private eq- (comparelines 4 and9 inTable 4). uityover the longer period. Separatingout P&P returnsfrom S&C,it is Sincethe P&P equitycontain stangibleas- againthe P&P returnsthat are the lowest. How- setsat market value, but does not capture the ever,even the S&C returnsusing an estate valueof intangibles,it isusefulto compareits multiplierof 200 (our highest return estimates) returnto book equity returns in the public donotconsistently outperform the public index. market.Using Compust atdataon publicbook Anadvantageof the FFA/ NIPA datais thatit values[which is only availabl efrom 1963on isavailable since 1952, allowing a comparison andis deŽ ned as in Eugene F. Famaand ofprivate and public equity returns over a KennethR. French(1993) to bebookvalue of longertime period. Since public equity experi- stockholder’s equityplus balance- sheetde- encedlarge growth over the 1990’ s, it isuseful ferred taxesand investme nttax credit minus toexamine private and public equity returns thebook value of preferred stock], we com- overa longerperiod. The drawback from the parepublic value-we ightedbook equity re- turnsto P&Preturnsfrom theFFA from 1963 to1999. A comparisonwith public book eq- 19 Based onSCF market valueof private S andC cor- uityreturns also abstracts from publicmarket porations,these corporationsaccount for between 24and51 percentof all corporateequity. Since part of the hidden realizations,which Fama and French (2001) incomeis likelyretained in theŽ rm (andthus shows up as arguehas in ated estimate softhepublic eq- capital gains),we addonly 20 percentof theNIPA corpo- uitypremium over the last half-cent ury.The rate incomeunderreporting adjustment to private S andC bookequity returns on publicequity are about proŽts. The NIPA incomeunderreporting adjustment for corporationsis around15 percent during the 1989 to 1998 period.For large Ccorporations(assets greater than$10 millionwith no distinction between publicand private C 20 Inthe 1993 NSSBF, new equityto existing P&P Ž rms corporations),the IRS TCMPdoes not report recommended is 10billion annually. We estimated thatsales/ liquidations changesin income, only the changes in taxes. The results amountto 35 billion(likely an upper bound). If halfof this basedon audit yields imply recommended dollartax in- isattributed to proprietor and partnerships, the net effect is creases of21.4 percent using 1985 data. With progressive 17.5 2 10 5 7.5billion per year. This is about 0.4 percent taxes theunderlying income changes will be smaller, con- ofP&P equityin the 1992 FFA, implying only a small sistentwith the NIPA adjustment. downwardbias in ourreturn estimates. VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 765

TABLE 6—THE RETURNS TO PRIVATE EQUITY (1953–1999)

Annualizedreturns Arithmetic Geometric Standard Returns average average deviation A. PrivateEquity Returns (from the FFA/ NIPA): Proprietorsand partnerships, equity returns 13.1 12.8 6.9 1953–1999 Proprietorsand partnerships, equity returns 13.2 12.8 7.7 1963–1999

B. PublicEquity Returns (from CRSP): Value-weightedindex, market equityreturns 14.0 12.7 17.0 1953–1999 Value-weightedindex, book equity returns 15.6 15.6 3.7 1963–1999 Value-weightedsmallest decile,market 24.2 18.2 41.1 equityreturns 1953– 1999 Correlationbetween P&PandCRSP (book) equity returns 1963– 1999: 0.70

Notes: PanelA reportsthe returns to private equity in proprietorships and partnerships. Return estimates pertainto data fromthe FFA/ NIPA overthe period 1952 to 1999. Returns are calculated assuminglabor income adjustments of 6.5 percent. Proprietors’ income is calcu- latedas stated inAppendix C. PanelB reportsreturns to publicly traded equity over the same time periodfrom CRSP. All returns are nominal.

2to3percentper year higher than the returns volatilityto thepublic equity book return vola- toequity in private P&Ps. tility.Finally, to gauge the riskiness of market Insum, these numbers based on the FFA/ equityreturns, note that the annual standard NIPA arereassuring, conŽ rming our previous deviationof the smallest decile of public Ž rm conclusionthat the returns to privateand public returnsis 41.1 percent. A portfolioof even equityare similar. smallerprivate Ž rms islikely to be as volatile. Moreimportantly, since entrepreneurs typically F. TheRisk of Private Equity ownequity in a singleprivate Ž rm, the risk facedby the average entrepreneur may be Is theprivate market riskier in aggregate than higherstill. thepublic market? This is hardto evaluatewith Inthe next section, we analyzeŽ rm-level theavailable data. The P&P equityin theFFAis entrepreneurialrisk and returns. We arguethat a“mix”of book and market equity since it therisk-return trade-off faced by the typical capturestangible assets at market value but does entrepreneuris much worse thanthat of the notcapture intangibles. As reportedin Table privateequity index, and, therefore, also likely 6,the standard deviation of the P&P equity tobe muchworse thanthat of thepublic equity returnseries is about twice that of the public index. equitybook return series and a bitless than half thatof the public market-value return series. IV.The Distributionof Returns Figure1 plotsthe FFA/ NIPA returnseries of AcrossPrivate Firms privateproprietors and partnerships and the bookequity returns series for publicŽ rms. The Sincemost entrepreneurs own equity in a seriesexhibit a strongcorrelation of 0.70 over singleprivate Ž rm for whichthey have an active the1963 to 1999period, suggesting that it may managementinterest, we areinterested in char- bemore relevant to compare the P&P return acterizingthe distribution of returns across 766 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

FIGURE 1. THE RETURNS TO PRIVATE AND PUBLIC EQUITY (1963–1999) Notes: Theannual returns to the index of FFA/ NIPA privateproprietor and partnership equity and book equity returns to the indexof publiccorporations from the CRSP– Compustat universe are plottedover the period 1963– 1999.

individualentrepreneurs. In this section, we Žrst investorcares about the return to investing in a discussthe conditions under which the index singleŽ rm, ratherthan an index of private eq- returnwill be a goodestimate of the average uity.Unfortunately, available data do notallow individualreturn. We arguethat the average usto directly compute the average geometric geometric(buy-and-hold) return in the cross- returnacross Ž rms. We onlyhave estimates of sectionof Ž rms islikely substantially lower Žrm survivalrates and Ž rm-levelreturns condi- thanthe geometric average return of the pri- tionalon survival, but do not have Ž rm-level vateequity index. To document the dramatic informationabout the return to Ž rms whowere amountsof idiosyncratic private Ž rm risk,we discontinued(bankrupt, sold, etc.). To our thenexamine the returns to an individual entre- knowledge,no comprehensive data of this sort preneurby considering Ž rm survivalrates and exists.In this subsection we argue,however, thedistribution of individual entrepreneur re- thatthe index return we calculatemost likely turnsconditional on Ž rm survival. overstatesthe average of the returns across in- dividualentrepreneurs. A. WhenAre Aggregate Returns a Good Datafrom theSCF indicatethat the typical Measureof the Returns to the Average investmenthorizon of an entrepreneur is long. SinglePrivate Firm? Theaverage surviving entrepreneur has owned hisŽ rm for aboutten years at the time of the Thedocumented poor diversiŽ cation of pri- survey,implying a typicalhorizon of atleastten vateequity holdings suggests that the typical years.Illiquidity of privateequity is one factor VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 767 contributingto long holding periods. Long 1.21 Thedenominator in the calculation of holdingperiods suggest that entrepreneurs are 1 1 rgeometric,index isthe total purchase price for primarilyconcerned with the buy-and-hold re- the N Ž rms at date t.Thenumerator is thetotal turnof theirinvestment. For example,if returns valueof these N Ž rms at date t 1 1,including consistedonly of capital gains, and horizons the K obtainedfrom sellingthe oldest Ž rm toa were exogenous,entrepreneurs would care publiccompany. aboutthe geometric return over their holding Underthis scenario of gradual Ž rm growth, period.Moreover, the theoretical models of thegeometric index return and the average geo- Heatonand Lucas (2001), Brennan and Torous metricreturn across Ž rms areidentical (and (1999),and Benartzi (2000) (motivated in the In- bothare constant over time): troduction)all focus on buy-and-hold returns of individuals.Consequently, we focuson whether 1 1 raverage,geometric 5 K1/N thegeometric return on the index is an upward- biasedestimate of the average geometric return 1 1 rgeometric,index acrossindividuals. To the extent that returns have astochasticdividend component, the entrepreneur K1/N 1 K2/N 1 ... 1 K willcare not only about the properties of the 5 5 K1/N. 1/N 2/N ... ~N 2 1!/N geometricreturn but also about other features of 1 1 K 1 K 1 1 K thereturn path. In this case, determining whether theprivate equity index returns and poor diversi- If growthis not gradual (and still with no Žcationdocumented earlier constitutes a puzzle idiosyncraticrisk) the geometric index return requiresfurther theoretical work. We leavethis for willnot be identical to the average geometric futurestudy and focus here on whether the aver- returnacross Ž rms. Inthe case of earlygrowth, agegeometric return across Ž rms islower than the theindex return will understate the average geometricvalue-weighted return. We arguethat geometricreturn across Ž rms, whilethe oppo- thisis likely to be the case, strengthening the sitewill be true under late growth. For example, conclusionthat the returns to private equity are ifŽ rm valuegrows to K afteronly one period surprisinglylow. andthen stays constant (early growth), the re- Thekey feature of the return distribution turns are: whichleads to the geometric index return being anupward-biased estimate of the average geo- 1 1 raverage,geometric 5 K1/N metricreturn across Ž rms isthe presence of idiosyncraticŽ rm risk.To illustrate this, con- NK siderŽ rst thecase with no idiosyncratic risk. 1 1 rgeometric,index 5 , K1/N. Supposethe typical Ž rm livesfor N periods, 1 1 ~N 2 1!K wherethe initial investment is $1,and the Ž rm growsexponentially to be worth $ K at date N. Onthe other hand, if Ž rm valuestays constant at Thesetting is one with “ overlappingŽ rm gen- $1until date N 2 1,andthen jumps to $ K at erations,”in which one Ž rm isborn each year date N (lategrowth), the returns are: andone Ž rm issold in each period at age N. Thus, N isthe holding period of thefounder. To 1 1 raverage,geometric 5 K1/N simplifythe calculations, assume that private Žrms aresold to public Ž rms after N periods. ~N 2 1! 1 K Thegeometric return obtained by each founder 1 1 rgeometric,index 5 . K1/N. is simply K1/N,whichis therefore also the av- N eragegeometric return across entrepreneurs. Thegeometric index return, 1 1 rgeometric,index, isthe return to buying all N privateŽ rms in existenceat date t (thenewborn Ž rm, the 21 Withthe adjustment to date t 1 1valuefor the 1-year-oldŽ rm, ...,upto the N 2 1-year- newbornŽ rm at date t 1 1(as inthe index calculations oldŽ rm) andholding these Ž rms untildate t 1 above)this Ž rm willnot affect ourcalculations. 768 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

Withoutidiosyncratic risk, the bias in the largerwith gradual or lategrowth. Although we indexreturn depends on the growth proŽ le of donot have adequate Ž rm-levelinformation to Žrms. However,when adding idiosyncratic risk, directlydetermine whether early, gradual, or thegeometric index return is likelyto belower lategrowth occurs, the fact that risk seems to thanthe average geometric return across Ž rms, declinewith age suggests that early growth and evenin cases with substantial early growth. earlyrisk are probably most consistent with the Consideraugmenting the above setting as fol- data. lows.Suppose Ž rms facea constantbankruptcy Whilethe calculat ionsare admitted lysim- probabilityover time and that equity investors ple,they illustrat ethatour geometri cindex inbankrupt Ž rms losehalf of their investment. returnis likely to be a substantiallyupward- Theprobability of bankruptcy, p,iscalibrated biasedestimate of the typical geometri cre- toa 35-percentsurvival rate of Žrms withinthe turnto asingleŽ rm. Hence,the true return to Žrst tenyears of life. Furthermore, in each apoorlydiversiŽ ed individualentrepren euris period,surviving Ž rms facea two-pointdistri- likelymuch lower than our previous calcula- butionof returns.The two points of this distri- tionssuggest. We nowturn to documen ting butionare chosen to generatepre-chosen values theamount of idiosync raticrisk of a single for themean and standard deviation of aŽrm’s privateŽ rm. return.To capture early growth, assume the meanreturn conditional on survival declines B. PrivateFirm SurvivalRates withŽ rm ageaccording to the formula mt 5 1 1 [0.4/1 1 (t 2 1)b], where b 5 0.3 to Certainly,a largepart of the risk associated generatea strongdecline in mean returns over withstarting a newbusiness is the risk of fail- Žrm life(e.g., from 40percentper year at age 1 ure,as opposedto ariskydistribution of returns to18 percent per year at age5). If volatility st conditionalon survival. In order to gauge this, isconstant at 30 percentper year [likely a fairly we appealto outside evidence on Ž rm survival lownumber for thetypical private Ž rm given rates.Timothy Dunne et al. (1988) construct thatthe annual standard deviation of a typical Žrm survivalrates based on the 1967, 1972, singlepublic Ž rm’s equityreturn is 50 to 60 1977,and 1982 Censusof Manufacturers, and percentaccording to Campbell et al. (2001)], Žndthaton average61.5 percent of Žrms exitin and N 5 20,thenthe geometric index return is theŽ veyearsfollowing the Ž rst censusin which 10.9percent per year while the average geomet- theywere observed.On average, 79.6 percent of ricreturn across Ž rms is4.7 percent per year. As Žrms exitwithin ten years. Popkin and Kirchhoff analternative scenario, if volatilityis allowedto (1991)analyze survival rates by ageof business declinewith Ž rm agesuch that the Sharpe ratio from 1976to 1986, using the UnitedStates (mt/st)isconstant over a Žrm’s life(equal to EstablishmentLongitu dinalMicroda ta Ž le 0.3),then the geometric index return is 10.9 (USELM) whichis based on Dun and Bradstreet’ s percentper year while the average geometric marketingŽ le.They estimate that the two-year returnacross Ž rms isas low as 211.7percent survivalrate of Ž rms whowere lessthan two per year.22 yearsold in 1976 is 76.9 percent, and the ten- Thesecalculations illustrate how even a low yearsurvival rate is 34.4 percent. Survival rates levelof idiosyncratic risk will bias the index increasewith initial Ž rm age.Firms whowere returnupward, even with early Ž rm growth.The between10 and 19 years old had a two-year differencebetween the index return and the survivalrate of 73.9 percent and a ten-year averageindividual Ž rm returnwould be even survivalrate of 46.9 percent. Itis difŽ cult to evaluate how much owners losewhen their business is discontinued. Data 22 Several empirical facts suggestthe presence of“ early providedby the U.S. SmallBusiness Adminis- risk.”Firstly, bankruptcy rates declinewith Ž rm age [Joel tration(2000) document that the average annual Popkinand Bruce A.Kirchoff(1991)]. Secondly, the cross- sectionalstandard deviation of average geometric returns numberof Ž rm bankruptciesover the 1990 to across survivingŽ rms is decliningwith holding period in 1997period was 59,393(source: The Adminis- the SCF. trativeOfŽ ce of the U.S. Courts).The number VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 769 ofbankruptcies is somewhat lower than the privatecompanies in which the household has averagenumber of business failures of 78,711 itslargest actively managed equity position. overthis period (source: Dun and Bradstreet Thefollowing information is available from the Corporation).A businessfailure is deŽned as an SCF:the year in which the Ž rm was founded/ enterprisethat ceases operation with a lossto acquired,Ž rm proŽts in the year before the oneor more creditors. The average number of surveyinterview, the market value of theown- failuresconstitute 15.3 percent of the average ershipshare in theinterview year (estimated by totalnumber of employer Ž rm terminations, therespondent), and the basis value for tax whichwas 515,273over the same time period. purposesof the current ownership share. We Owners infailed companies probably lose all of usethe latter as an estimate of theinitial value theirinitial equity investment (since they dis- oftheentrepreneur’ s equityinvestment. continuewith debt outstanding). Entrepreneurs We estimatethe geometric average annual can,in fact, lose more than their equity invest- capitalgain over the period since the Ž rm was mentsince Ž rm debtis often backed by personal founded/acquired.Assuming the current proŽ t collateral(typically home equity). Assuming toequity ratio is representative of thosein pre- theylose all of their equity in failed Ž rms, viousyears, we alsoconstruct an estimateof the combiningthe survival rates with the share of incomestream to the household from theinvest- discontinuedŽ rms whofail, the founder of a ment.These returns represent the price appre- newprivate company faces a (1 2 0.344) 3 ciationand income received from theinitial 0.153 3 100 5 10.0percent risk of losingall of investmentdate to the time of the survey. We his/herinvestment within the Ž rst tenyears. arenot able to constructestimates of thereturn For theremainder of discontinued Ž rms itis obtainedthrough the full period of ownership, difŽcult to evaluate how much of the initial ofcourse, since households may keep their equityinvestment by owners has been lost, if ownershipshare in the company for many any.Some Ž rms maybe discontinuedwith a full yearsafter the survey. We arealso not able to orpartial equity investment loss due to poor constructreturn estimates for householdinvest- futureprospects. Others are successful, and may mentsthat did not survive. Hence, we empha- besold to new owners or “ cashedout.” The sizethat the distribution of returnswe calculate numberof Ž rm sales/takeoversis quite low. is conditionalon survival, anddoes not repre- Basedon the 1993 NSSBF about70,000 Ž rms sentthe unconditional distribution of returns. were acquiredwithin the last two years (two We plotin Figure 2 thedistribution of returns yearsto account for possiblelag in introduction from privateequity investment. The graphs per- tothe Dun and Bradstreet database on which the tainto the distribution of household returns from NSSBF sampleis based). This implies that ap- the1989 SCF. Other survey years were similar. 23 proximately350,000 (or about70 percent of) TheŽ rst graphplots the histogram of average terminatedŽ rms liquidated.It is likely that en- annualcapital gains accrued across households trepreneurslose at leastsome, if notall, of their overthe period since the Ž rm was founded/ investmentupon liquidation. Clearly, failure/ acquired.For eachhousehold, we computethe liquidationposes a greatrisk. geometricaverage annual capital gain as

C. Entrepreneur-LevelReturns (4) Conditionalon Survival Value at the 1/~Years since founded/acquired ! timeof the survey Therest of this section focuses on thecondi- 2 1. tionaldistribution of entrepreneurial returns to Value of 1 original investment 2 documentthat substantial idiosyncratic risk ex- istseven conditional on survival.Using data on individualhousehold investment in private eq- 23 We focuson householdswith initial investments of at uityfrom theSCF, we calculatethe distribution least $1,000(1983 dollars using the CPI for all urban acrosshouseholds of returns since they found- consumers).This implies dropping about 5 percentof the ed/acquireda privateŽ rm. We examinethose entrepreneurhouseholds. All graphs employ SCF weights. 770 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

FIGURE 2. THE CONDITIONAL DISTRIBUTIONOF RETURNS TO PRIVATE EQUITY ACROSS HOUSEHOLDS Notes: Householddata fromthe 1989 SCF are usedto plot the returns to private equity investment in surviving Ž rms. The topleft plotshows the histogram of geometric average annualcapital gainsaccrued across households.The top right plot showsthe histogram of earningsrates (earningsin the year priorto the survey divided by market valueof equity)accrued across households.The bottom left plotshows the histogram across householdsof thegeometric average returnon investment ifhouseholds had instead invested their wealth inthe CRSP value-weighted index of all publiclytraded equity over the same horizonas theirprivate equity investment. The bottom right plot shows the histogram across householdsof thetotal average return(capital gainplus earnings, where 30percent of earningsare assumed tobe retainedin the Ž rm) onprivateequity in excess oftheCRSP index return over each household’s holdingperiod.

Thedistribution of capitalgains, conditional on theholding periods over which these annualized survival,is wide. 24 Usingthe 1989 survey, the capitalgains have been obtained, 43 percent of medianof the capital gain distribution is 6.9 householdshad invested in private equity for percentper year, while the Ž rst quartileis 0and Žveyearsor lessat thetime of the survey, 47.3 thethird quartile is 18.6 percent per year. As for percenthad invested for betweenŽ veand 25 years,and 9.6 percent had invested for more than25 years (averaged across all four survey 24 We plothouseholds who lost all oftheir initial capital years). butstill say theyare inbusiness at 2100percent in this Žgure.These householdsare notincluded in the subsequent Thesecondgraph plots the histogram of earn- graphssince itis notpossible to deŽ ne proŽ t/ equityfor ingsrates, deŽ ned as earnings in the year before companieswith zero equity. thesurvey divided by the total market value of VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 771 theŽ rm. Thereis substantial variation in earn- D. Conditionalversus Unconditional Mean ingsrates, although most households report zero andVariance orpositive earnings rates. The third graph in eachpanel plots the histogram of thegeometric Finally,our conclusions that entrepreneurial averagereturns households would have ob- returnsappear unattractive are based on an es- tainedhad they invested their wealth in the timateof the unconditional distribution of pri- CRSPindexof all publicly traded equity over vateequity returns. That is, for arandomly thesame horizon as theirprivate equity invest- chosenentrepreneur, investment in private eq- ment.For example,for aninvestor who held uityseems like a baddeal. However, entrepre- privateequity in hiscompany for 30yearsat the neursmay have superior information about their timeof the 1989 survey, we computethe geo- Žrm’s prospects.In this case, the conditional metricaverage annual return to investingin the varianceof returnsto each entrepreneur may be CRSPindex over those same 30 years (i.e., from muchlower than suggested by the poor diver- 1959to 1989). As shownin the graph, the distri- siŽcation and high Ž rm-levelrisk. Thus, for butionof returns on a diversiŽed public equity someindividuals, entering entrepreneurship indexover the same investment horizon is tight, maybe averygood deal. However, if entrepre- witha minimumreturn of 5.6 percent per year and neurshipis attractive for someentrepreneurs, amaximumreturn of 19.9 percent per year. thenit must be even less attractive for other TheŽ nalgraph combines the capital gain and entrepreneursthan what our index return esti- incomecomponents for theprivate Ž rms tocon- matessuggest. Hence, if the low returns appear structa totalreturn, where we assumeearnings puzzlingon average, they must be even more ratesare constant over time and equal those in puzzlingfor asegmentof the entrepreneur theinterview year, and that (for simplicity)30 population. percentof proŽts areretained in the Ž rm across allŽ rm types. 25 We thensubtract from thistotal V.WhyDo People Become Entrepreneurs? returnthe return the household could have ob- tainedby investing in theCRSP index over the Inthis section, we briey discusspossible sameperiod. This essentially combines the Ž rst explanationsfor whyprivate equity investors threeplots into one. willinglyinvest in concentrated private equity Eventhough this distribution is conditional on portfoliosdespite the seemingly poor risk– survival,around 30 percent of households would returntrade-off. havebeen better off investingin the CRSP index ratherthan their own company. Moreover, there is A. OptimalContracting and the Ability substantialvariation in the excess returns to pri- toDiversify vateover public equity investment, even condi- tionalon survival. The excess return distribution is Concentratedprivate equity investments highlyskewed. While the median excess return couldbe motivatedby issuesof moralhazard or is18.2 percent per year, the average excess return asymmetricinformation. Institutional and gov- is139.6 percent per year due to a fairlysmall ernmentalmonitoring is also far lessprevalent fractionof households with very large annualized inthe private market, making assignment of excessreturns. These high mean/ medianexcess controlrights of the Ž rm evenmore critical. returnsare to a largeextent due to households with However,this cannot explain why individuals smallinitial investments. When households are enterinto entrepreneurship initially, given the weightedby the size of their initial investment, the poorrisk– return trade-off. medianexcess return is 22.0percent per year whilethe mean excess return is 24.4 percent. B. WhyAre Entrepreneurs Willing to Participatein the First Place?

25 Sincewe wishto have uniform assumptions across Žrm types,and since ourprevious calculations employed WeconsiderŽvepossible explanat ionsfor 40-percentretention for C corporationsand 20 percent for entryinto entrepren eurship,despite the poor all otherŽ rm types,a 30-percentretention rate isused. risk–return trade-off of existing entrepreneurs: 772 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 highentrepreneur risk tolerance, large additional for themedian entrepreneur (using data from pecuniarybeneŽ ts, non-pecuniary beneŽ ts, a pref- the1998 SCF, focusing on entrepreneurswith at erencefor skewness,and overoptimism and mis- least$5,000 of private equity holdings and perceivedrisk. weightinghouseholds by the size of theirhold- ings).This seems high given that salaries and 1. RiskTolerance. —If entrepreneurshave unreportedincome from taxevasion are already verylow risk aversion, then disutility from poor accountedfor. diversiŽcation may be small and the returns to Inaddition, we shouldconsider the fact that privateequity need not be higher than those of investorscompare asset returns after personal publicequity. Gentry and Hubbard (2001a) taxes.Previously, we usedsurvey data or NIPA comparethe composit ionof entrepre neur datawith an adjustment for incomeunderre- portfoliosto those of non-entrepreneurs using portingon taxreturns to producemore accurate the1989 SCF. They Ž ndthat (apart from the pre-personaltax returns, comparable to the re- sizeableinvestment in the private equity of their turnsfrom CRSP.It remains to consider ownŽ rm), therest of entrepreneurs’ portfolios whetherpersonal taxes differ between private arequite similar to non-entrepreneurs, even for andpublic equity-holders. Certainly, since en- thosein the top 5 percentof the wealth distri- trepreneurssave taxes on incomethey hide from bution.Since entrepreneurs do not invest the theIRS, their effective tax rate is lower than the remainderof their wealth any more conserva- statutoryrate. This effect is likelyto be small. 27 tivelythan non-entrepreneurs, they may be Furthermore,a substantialfraction of public morerisk tolerant. However, it is possible that equityis held in tax-advantaged accounts, re- privateequity-holders might be expected to ducingthe effective tax rates paid on public holdlarger shares of their remaining wealth in equity. publicequity. This is suggestedby theresults of Onthecost side, at least25 billiondollars in Heatonand Lucas (2001) and is dueto the fact proŽts in each of the SCF yearspertain to thatprivate equity income provides not only householdswho report a zeromarket value and “backgroundrisk” but also positive income azerotax basis for theirequity share. It may be owon average. 26 morereasonable to exclude these households from ouranalysis, which would lower our re- 2. OtherPecuniary BeneŽ ts and Costs. — turnestimates by about0.5 percent per year. A Salariesderived from privatecompanies are largefraction of these proŽ ts are in partner- alreadyaccounted for inourreturn calculations. ships.The zero equity value may simply re ect Toassess the beneŽ ts derived from possible thefact that equity shares are not tradable in perquisitetaking, we computehow large these theseŽ rms, butrather are payments for labor beneŽts would have to be to provide a 10per- inputto employees who make partner. centper year return premium in private equity overpublic equity. This amounts to 143percent 3. NonpecuniaryBeneŽ ts. —Inaddition, non- oftotalannual household income (or $460,000) pecuniarybeneŽ ts derived from entrepreneur- shipmay explain the concentrated equity holdings.Over 21percent of survey respon- 26 Furthermore,even the wealthiest managers appear far dentsin the1992 EconomicCensus Character- fromrisk neutral. A recent article inthe WallStreet Journal isticsof BusinessOwners statedbeing their own (“YourMoney Matters. Hedging a SingleStock Has Ups, bossas themain reason for startingthe Ž rm, as Downs,”by RuthSimon, 2 February2000) cites therising popularityof hedgingstrategies offeredby investmentŽ rms toreduce exposureto own-company stock performance for topexecutives (as manyas acouplethousand such strate- 27 Forexample, if the statutory personal tax rate is 30 giesare executedeach year).This suggests that executives percent,and 30 percent of income is shelteredfrom tax docare aboutthe volatility of their own company stock authorities,the effective taxrate is 21percent. This in- holdings,and take steps toreduce theirexposure to theŽ rm. creases theincome component of after-tax returnsof private One ofthe more notableparticipants in these strategies is companiesrelative topublic companies, assuming the latter TedTurner, despite his more than$9 billion wealth (at the doesnot hide income, by 9 percent(e.g., from 10 percent time ofthearticle). peryear to10.9 percent). VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 773 opposedto having a primaryor secondary We showedpreviously that the average re- sourceof income as the main reason. Other turn,conditional on survival, from privateeq- studieshave also identiŽ ed the  exibilityand uityis about24 percent greater than the public autonomyof self-employment as a majornon- marketreturn. Hence, if entrepreneurs simply pecuniarybeneŽ t [see DavidG. Blanchower believetheir probability of survival is sufŽ - andAndrew J.Oswald(1992)]. Indeed, Hamil- cientlyhigh, then the distribution of future re- ton(2000) interprets his results for themedian turnswould look very attractive. Survey entrepreneuras evidence of largenonpecuniary evidenceof entrepreneursis consistentwith this beneŽ ts. notion.Arnold C. Cooperet al.(1988) Ž ndthat Usingthe calculat ionfrom above,a 10- 68percent of entrepreneursthink that the odds percent(of privateequity investment) nonpecu- oftheir business succeeding is better than the niarybeneŽ t wouldhave to amount to 143 oddsfor anotherbusiness like theirs; only 5 percentof total annual income or $460,000. percentthink their odds are worse. In addition, Whilea substantialamount, this may not be athirdof entrepreneurs believe their probability unreasonable.Certainly, many Ž nancialecono- ofsuccess(e.g., surviving) is 1, and72 percent mistswillingly give up substantial amounts by ofentrepreneurs think their probability of suc- choosingto remain in academia, where the ac- cessis at least 0.80. J. EdwardRusso and Paul ademiclifestyle may be considered a nonpecu- J.H.Schoemaker(1992) Ž ndthatmanagers are niarybeneŽ t. dramaticallyoverconŽ dent. 28 Mostlikely, it is somecombination of allŽ ve 4. Preferencefor Skewness. —Ratherthan explanationsthat contributes to entrepreneurial tryto augment the Ž rst momentof the return activity.Quantifying the impact each has on the distributionof privateequity through additional propensityto become an entrepreneur, as well pecuniaryor nonpecuniary beneŽ ts, a motiva- ason subsequentreturns, is an interesting issue tionfor entrepreneurshipmay lie in highermo- leftfor futureresearch. mentsof the distribution. For instance,Fig- ure2 showsthat the distribution of entrepre- VI.Concluding Remarks(Is There a Puzzle?) neurialreturns is highly skewed with a fatright tail.If entrepreneurshave a preferencefor We Žndthat the majority of household in- skewness,then they may be willingto accept vestmentin private companies is concentrated alowermean return despite the high variance. ina single,risky, privately held Ž rm inwhich Apreferencefor skewnesscould explain the thehousehold has an active management inter- resultin Gentry and Hubbard (2001b) that est.Despite the risks these investors face in progressivemarginal tax rates discoura ges takingon large amounts of idiosyncratic risk, entryinto entrepren eurship. thereturns to private equity are surprisingly AlanKraus andRobert Litzenberger (1976) low.We conductthe Ž rst comprehensivestudy andCampbell R. Harveyand Akhtar Siddique ofthe unconditional returns to all nonpublicly (2000)argue that investors have a strongskew- tradedequity. Controlling for thelabor compo- nesspreference. However, skewness in returns nentof returns, adjusting for entryand exit of canalso be obtained more easily through the Žrm equityover time (as bestpossible), and optionsmarket or various trading strategies in addressingissues related to potentiallydistorted publicmarkets. Hence, the skewness of private estimatesof market values and Ž rm proŽts (e.g., equityreturns may not be the only attribute dueto tax evasion motives) we Žndthat the attractinginvestors. averagereturn to privateequity is similarto that ofpublic equity. Given the large equity pre- 5. Overoptimismand Misperceived Risk. — miumdemanded by investorsin public markets, Finally,entrepreneurs may behave in a manner thatis not perfectly rational. For instance,they maybe overlyoptimistic about the Ž rm’s mean 28 AntonioBernardo and Ivo Welch (1998) argue why prospectsor they may irrationally believe that individualsremain overconŽdent in an entrepreneurial havingcontrol of the Ž rm lowersrisk. setting. 774 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002 itseems surprising that entrepreneurs are will- entrepreneursenter business with overoptimis- ingto invest so heavily in a singleprivate Ž rm ticexpectations, government educational efforts whichoffers afar worse risk-returntrade-off. (as opposedto government-subsidize dsmall We recognizethat a precisemeasure of the businessloans) may be warranted. meanreturn to private equity is extremely dif- Žcultto obtain. Expected returns are notoriously APPENDIX A: ESTIMATING THE VALUE OF EQUITY difŽcult to estimateand our estimates are based IN PRIVATE S AND C CORPORATIONS BASED ON onrelatively short sample periods (nine years ESTATE TAX RETURNS for theSCF and47 years for theFFA/ NIPA). ThisdifŽ culty is exacerbated when using fairly Toobtainan estimateof thevalue of equityin imprecisedata on estimates of private Ž rm privateS andC corporationswhich is indepen- valuesand proŽ ts. Nevertheless, the estimated dentof the SCF equitynumbers, we followa realizedreturns to private equity are quite methodused by the IRS toestimate wealth highlycorrelated with public equity returns, in- basedon estate tax returns. The approach is dicatingit islesslikely that the realized returns describedin Section III-A. ThisAppendix pro- representan abnormal draw for oneof the two videsevidence that owners of private equity marketsonly or simply measurement error in havelower mortality than others at thesame age ourdata. Moreover, we arguedearlier that it is andwith similar wealth. Thus, a multiplier unlikelythat the private equity mean return higherthan that used by theIRS shouldbe used exceedsthe public equity mean return by 10 for thiscategory of wealth. percentper year (as theorysuggests it should). Sincemost private equity is owned by house- Our Žndingsfor theprivate equity market holdswith active management interests, it is presenta challengeto theories seeking to ex- unlikelythat holders of privateequity have the plainthe size of the equity premium in public samemortality rates as others at the same age marketswithin a homogeneousagent framework. andwith similar wealth (as isassumed in the Whetheror notour results constitu teapuz- IRS multiplier).Entrepreneurs are likely to sell zleremains an open question .Onthe empir- off theirprivate businesses when their health icalside, more informati onaboutthe amount deteriorates,making active management difŽ - ofequity recovered in liquidat edŽ rms would cult.Consequently, a smallerpercentage of enablea moreprecise estimate of theuncon- privateequity (than of other wealth compo- ditionalreturns to private equity and the nents)shows up onestatetax returns for agiven cross-sectionaldistribu tionof thosereturns. It year. wouldalso be interesti ngto obtain a longer Twomeasures of respondent health are avail- returnseries for SandC corporationsto de- ablein theSCF tosupportthis. Question X6030 termineif the fact that S andC corporations asks,“ Wouldyou say your health is excellent, outperform proprietorsandpartnersh ipsis ro- good,fair, or poor?” and question X7381 asks bustto other sample periods outside of the “Abouthow old do you think you will live to 1990’s. On the theory side, models that cap- be?”Responses to the Ž rst questionare avail- turethe correlati onof human and Ž nancial ablefor the1989, 1992, 1995, and 1998 surveys capitalreturns and allow for consumptionby andfor thesecond for 1995and 1998. Merging theentrepren eurbefore the terminal date are thedata across years, and restricting attention to needed. householdswith assets greater than $600,000, Finally,distinguishing among other motives we Žndthat the percent of household heads for entrepreneurship(i.e., private beneŽ ts of reportingto be in poor health (for couplesthe control,preferences for skewness,and misper- respondentis the male) is 2.3 percent for non- ceptionsof theprobability of failure)may have businessowners and 0.8 percent for ownersof importantpolicy implications. For example,if equityin private S andC corporations,using entrepreneursare enticed by smallprobabilities SCFweightsand further weighting by amount ofvery large returns, high tax rates for high- ofprivate equity owned. This ratio (2.3/ 0.8) incomeindividuals could have strong adverse equals2.9. In addition, the percent of house- growtheffects. On the other hand, if many holdsexpecting to liveŽ ve(ten)years or lessis VOL.92 NO. 4 MOSKOWITZAND VISSING-JØRGENSEN: ENTREPRENEURIAL INVESTMENT 775

3.9(10.8) percent for nonbusinessowners and combinationof thevariables, producing 15 sets 1.5(5.2) percent for ownersof privateS andC ofregressioncoefŽ cients. This is donefor each corporationequity, corresponding to a ratioof yearand category separately. These regression 2.6(2.1). Using the same weights as above,the coefŽcients are then used to predictthe value of ownersof private S andC corporationequity thosedeals with missing price information, but areabout three years younger than nonbusiness havingat least one of the other variables. For owners.Taking this into account would lower example,if a dealis missing its value but has thedifferential in mortality a bit. informationon book value, we estimateits Insum, if mortalityis approximatelylinear in valueby multiplying its book value times the thesemeasures of health, this suggests using a coefŽcient estimated from theunivariate regres- multiplierfor SandC privateequity which is sionof dealmarket value on book value for all betweentwo and three times higher than that dealswith prices. If adealhas more than one usedfor otherwealth components. This is our dataitem, then we employthe corresponding motivationfor employingmultipliers of 200 multivariateregression coefŽ cients from deals and300 to estimate the total value of S andC withprices. In other words, we usethe regres- equitybased on estate tax returns. sioncoefŽ cients from theappropriate combina- tionof data items for whichthe deal has APPENDIX B: ESTIMATING THE VALUE OF MISSING recordedinformation. This provides an estimate MERGERS AND ACQUISITIONS IN THE ofthe value of missing deals while taking into SDC DATABASE accountthe characteristics of such deals (i.e., thatthey are typically smaller). Finally, for For eachdeal in theSDC databasewith miss- thosedeals with missing value and no addi- ingprice information, we searchfor dataon the tionalinformation on the other four data items, transactionto indicate its size. We foundfour we simplyassign the average of the estimated dataitems with broader coverage than deal valuesof missingdeals to these transactions. If value.These are: book value; property, plant anything,this is likely to overstateour numbers andequipment; total assets; and number of em- slightly.These estimated values are computed ployeesof the target. We thentake the deals for eachsubcategory of mergerand acquisition withprice data and run a cross-sectionalregres- activityin the same manner and added to the sionof alldeal values on a constantand each of valueof dealswith price information to produce thesevariables individually, as well as every atotalor “ scaled”value for eachsubcategory.

APPENDIX C: DETAILS ON NUMBERS FROM THE FFA AND NIPA

A. Series Used inOurCalculations Based on the FFA andNIPA

Wecalculate thebaseline annual returns to proprietorships and partnerships (P&P) as,

P&P~Equity!t 1 1 1 P&P~Profits!t 1 1 2 CCAt 1 1 2 REt 1 1 1 DTax adj.t 1 1

P&P~Equity!t where

1. P&P(Equity) 5 (FFA,Table btab100d, FL153080015) 2 (Value of1 to4 familyrental properties not owned by corporationsfrom the Bureauof EconomicAnalysis, Žxedassets, detailedresidential table). 2. P&P(ProŽts) 5 NIPA,Table 1.14, line 9. 3. CCA 5 Capitalconsumption adjustment 5 NIPA,Table 1.14, line 12 plus line 16. 4. RE 5 Retainedearnings 5 (FFA,Table utab103d, FU116300005 1 FU113180005) 1 (FFA,Table utab104d, FU136000105 1 FU133180005). 776 THEAMERICAN ECONOMIC REVIEW SEPTEMBER2002

5. DTax adj. 5 Changein tax adjustment 5 (0.75 2 NIPA P&Ptax adjustment percent used) 3 (NIPA nonfarmP&P proŽts as reportedto the IRS), where NIPA P&Ptaxadjustment percent used 5 (NIPA Table8.23, line 2/ NIPA Table8.23, line 1)andNIPA nonfarmP&P proŽts are as reportedto the IRS inNIPA Table8.23, line 1.

Wecalculate thebaseline annual returns to private S&C corporations as

private all public all S&C ~Equity!t 1 1 1 S&C ~Div.!t 1 1 2 S&C ~Div.!t 1 1 1 0.2~S&C ~Tax adj.!t 1 1 ! private S&C ~Equity!t where:

1. S&Cprivate(Equity) isestimated basedon estate taxreturns as describedin Appendix A. 2. S&Call(Div.) 5 NIPA dividendspaid in cash orassets accordingto the IRS (NIPA, Table 8.25, line 29), plus Posttabulationamendments andrevisions (NIPA, Table 8.25, line 30). 3. S&Cpublic(Div.) 5 dividendspaid by companies listed on the NYSE, AMEX, or NASDAQ calculated as theincome returnon theCRSP value-weighted index times thetotal market valueof NYSE,AMEX, and NASDAQ equity. 4. S&Call(Tax adj.) 5 NIPA adjustmentfor misreporting on incometax returns, NIPA Table8.25, line 2. See thetext for thechoice of thefactor 0.2.

Notethat the FFA/ NIPA frequentlyupdate their data. Our numbers are basedon thelatest availablereleases as ofJanuary 1, 2002. Furtheradjustments for the labor component of proŽ ts are describedin thetext.

B. IncomeUnderreporting on Tax Forms

Thissubsection describes theŽ ndingsof the IRS TaxCompliance Measurement Program(TCMP), which motivates the incomeunderreporting adjustment in NIPA. Everythird year between 1973and 1988 a sample ofabout55,000 tax Ž lers was subjectedto extensiveaudits. The TCMP programhas since beendiscontinued. TCMP audits differed from regular IRS audits in that only experienced IRS examiners were used,and in that examiners reviewed each item onthereturn line by line.The TCMP studiesinclude information about all componentsof income, including income from proprietorships and partnerships. These studieswere supplementedby separate studiesof small corporationincome tax returns for 1977 and 1980. For large corporations,regular audit yields were extrapolatedby theIRS based on aregressionusing averages ofdata for1984, 1985, and 1986 to compute what audit yields wouldhave been had all large corporationsbeen audited. The results of thestudies up to1982 are summarized inIRS (1988). Accordingto the TCMP results, income underreporting on taxreturns is veryprevalent, especially amongsmall Žrms. For thecategory “ OtherSole Proprietorship” which refers tononfarm sole proprietors with the exception of informalsuppliers (baby-sitters,street vendors,etc.) theratio of detected nonreportedincome to taxpayer reported income (accounting for both understatedincome and overstated expenses) is 0.219for 1973, 0.229 for 1976, 0.299 for 1979, and 0.419 for 1982. For partnershipsthe ratios are 0.139for 1973, 0.248 for 1976, and 0.277 for 1979 (the 1982 ratio is less reliable since reported partnershipproŽ ts are close tozero inthat year). The reason NIPA uses larger taxadjustments for proprietors and partnerships isthat the TCMP conjectures that for every dollar detected inthe TCMP audit an extra 2.34dollars go undetected for proprietors(3.28 for partnerships). From what we were able todetermine these “multipliers”are basedon very little information,and one wonders whether the IRS has anincentive to in ate these numbers.Nonetheless, to be conservative we use anincome underreporting adjustment which re ects theuse ofsuchmultipliers.

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