Volatility and Venture Capital

Abstract

The performance of venture capital (VC) investments load positively on shocks to aggregate return volatility. I document this novel source of risk at the asset-class, fund, and portfolio-company levels. The positive relation between VC performance and volatility is driven by the option-like structure of VC investments, especially by VCs' contractual option to reinvest. At the asset-class level, shocks to aggregate volatility explain a substantial fraction of VC returns. At the fund level, consistent with the reinvestment channel, this exposure is concentrated in years two through four of fund life and in early-stage VC funds, which have more embedded reinvestment options. For VC-backed portfolio companies, volatility shocks correlate with faster and more frequent reinvestment. The level of volatility at the time of investment has no relation with future performance, consistent with competitive markets. Overall, my results imply that the option-like features of VC investments are first-order determinants of risk in VC. Abstract:The performance of venture capital (VC) investments load positively on shocks to aggregate return volatility. I document this novel source of risk at the asset-class, fund, and portfolio-company levels. The positive relation between VC performance and volatility is driven by the option-like structure of VC investments, especially by VCs' contractual option to reinvest. At the asset-class level, shocks to aggregate volatility explain a substantial fraction of VC returns. At the fund level, consistent with the reinvestment channel, this exposure is concentrated in years two through four of fund life and in early-stage VC funds, which have more embedded reinvestment options. For VC-backed portfolio companies, volatility shocks correlate with faster and more frequent reinvestment. The level of volatility at the time of investment has no relation with future performance, consistent with competitive markets. Overall, my results imply that the option-like features of VC investments are first-order determinants of risk in VC.JEL codes: G11, G24

Venture Capitalists and COVID-19

“…Second, volatility and disruption may increase VCs' returns as a result of the option-like nature of VCs' contractual payouts (Peters (2018)), consistent with the mild long-term impact on returns that VCs predict. Third, the increased use of VC-friendly terms that VCs expected (but that did not materialize) is consistent with more uncertainty or asymmetric information (Kaplan and Strömberg (2004)).…”

“…Past research by Korteweg and Sorensen (2010), Ewens, Jones, and Rhodes-Kropf (2013), and others has shown venture capital to have relatively high systematic risk, which might make it perform especially poorly under such swings. Conversely, Peters (2018) argued that the optionality of venture capital allows it to thrive in disruptive and volatile conditions, which might cause venture capital investments to outperform in the disruptive COVID-19 environment.…”

Venture Capitalists and COVID-19

“…Second, VCs' portfolios may gain in value in disruptive and volatile environments. If portfolio companies are real options on innovative technologies and business models, an increase in volatility may increase the value of those options and thus the value of a VC's portfolio (Fluck, Garrison, and Myers, 2006;Peters, 2018). Regardless of the channel, VCs' relatively strong performance during the pandemic is consistent with much lower systematic risk than the VC industry exhibited in the dotcom crash and the global financial crisis earlier this century.…”

The Effects of Public and Private Equity Markets on Firm Behavior

“…The illiquid nature of private equity markets also implies that, in contrast to shareholders in public firms, investors in privately held corporations are typically forced to hold large and undiversified equity stakes (Hall & Woodward 2010;Heaton & Lucas 2004). Such idiosyncratic risk exposure is likely to be priced and increase the cost of capital of privately held firms (Peters 2018). Relatedly, Bodnaruk et al (2008) show that private firms owned by less diversified controlling shareholders are more likely to go public and that these undiversified shareholders tend to sell more shares at the IPO.…”