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The Returns to Entrepreneurial Investment: a Private Equity Premium Puzzle?

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The Returns to Entrepreneurial Investment: a Private Equity Premium Puzzle? 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 diversi cation, we ndthatthe 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 rm witha seeminglyfar worse risk-returntrade-off. We brie y discusshow large nonpecuniary bene ts, a prefer- encefor skewness, or overestimates of theprobability of survivalcould potentially explaininvestment in private equity despite these ndings. (JEL G11,G12, M13) Assetpricing and investment theory rely crit- tionof equityreturns across nonpublicly traded icallyon our understanding of investors’ port- rms. 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. Speci 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 rst setof estimatesof the returns and risks for the entiremarket of nonpublic equity. *Moskowitz:Graduate Schoolof Business, University We ndinvestment 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, AndrewMetrick, SendhilMullainathan, Ann Semer, Per Stromberg,and sem- ofdiversi 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 nancingof private rms, venturecapital accountsfor a Choice,and the WFA meetings for 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]. nancialsupport. Vissing-Jø rgensen thanks the National Inaddition, venture capital pertainsto averyspeci c typeof Science Foundationfor 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 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-aversioncoef 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 ndthat the theprivate 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. Brennan and Walter riskierthan investing in the public equity index. N.Torous(1999) estimate a certaintyequiva- First,survival rates of private rms areonly lentwealth loss of investingin asingle(public) around34 percentover the rst tenyears of the rm ofabout 64 percent over a ten-yearhorizon rm’s life.Second, even conditional on sur- for aninvestorwith a relativerisk-aversion co- vival,the distribution of equity returns across efcient 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 efcient of 3. Shlomo Benartzi (2000) ndsthat sameprivate rm inwhich he works, making areturnpremium of 20percentis neededfor an hisequity return highly correlated with his hu- individual(with relative risk-aversion coef - mancapital return. Fourth, while it isdifcult 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 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 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 rm, Ofcourse,obtaining a precisemeasure of the rm birthsand deaths, initial public offerings meanreturn to private equity is extremely dif- andacquisitions, and potential income underre- cult.The notoriously dif cult exercise of esti- portingdue to tax evasion. Overall, the diversi- matingthe mean on a highlyvolatile return edportfolio of public equity seems to offer a seriesover a relativelyshort time period is well far moreattractive risk-return trade-off than that known.This dif 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 diversication 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 and the 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 rm valuesand pro 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 non nancial income as sampleperiod (including the longer period from exogenous,our ndingsemphasiz ethata 1952to 1999). 3 Theimplication
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