Article | Review of Financial Studies | August 2013

The Price of Diversifiable Risk in Venture Capital and Private Equity

by Michael Ewens, Charles Jones and Matthew Rhodes-Kropf

Abstract

This paper explores the private equity and venture capital (VC) markets and extends the standard principal-agent problem between the investors and venture capitalist to show how it alters the interaction between the venture capitalist and the entrepreneur. Since the investor-VC contract is set before the VC finds any investments, we show that it is the entrepreneur who must compensate the venture capitalist for any extra risk in the project even though it is the investor who requires the VC to hold the risk and even though the entrepreneur holds all of the market power in the model. Furthermore, although perfectly competitive investors expect zero alpha in equilibrium, the nature of the three way interaction results in a correlation between total risk and investor returns even net of fees. Thus, we show how and why diversifiable risk should be priced in VC deals even though investors are fully diversified. We then take our theory to a unique data set and show that while investors do earn zero alpha on average there is a strong correlation between realized risk and investor returns, exactly as predicted by the theory.

Keywords: Price; Risk and Uncertainty; Venture Capital; Private Equity; Contracts; Investment; Competition; Agency Theory; Investment Return; Forecasting and Prediction; Theory; Diversification;

Citation:

Ewens, Michael, Charles Jones, and Matthew Rhodes-Kropf. "The Price of Diversifiable Risk in Venture Capital and Private Equity." Review of Financial Studies 26, no. 8 (August 2013): 1854–1889.