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Venture Capital Funds Investing in Minority-Owned Businesses: Evaluating Performance and Strategy
Abstract
The strong performance of minority-oriented private equity funds in the 1990s drew increased attention and additional funding to this important source of capital for minority-owned businesses. New data from a recent survey of minority-oriented funds allows for an analysis of their investment strategies during the economic downturn at the start of the 21st century and in their investment returns across the boom-bust cycle. Key findings from the study are presented below.* The decline in returns from minority-oriented private equity funds at the turn of the century mirrors the falling investment returns throughout the venture capital industry and the stock market at that time. Comparisons suggest that minority-oriented funds outperformed both the NASDAQ and the S&P 500 stock indices for most of the time period considered.* The sharp drop in the surveyed funds' returns in 2000 is especially significant because their investment volume was at an all-time high during that year. This increase in volume was fueled by substantial growth in funding from public pension funds, a funding source that was previously only available to a handful of minority-oriented private equity funds.* Minority-oriented funds, particularly the newer generation of funds that emerged during this period, diversified their investments, focusing increasingly on investments in high-tech lines of business and in nonminority-owned businesses. Regression analysis indicates, however, that there were higher returns for funds that invested in minority-owned companies and old-economy industries.* The minority-oriented venture capital industry already is recovering from its turn-of-the-century downturn. The internal rate of return on investments that were initiated after 2001 and were realized by yearend 2006 was an impressive 29.1 percent.
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Research has identified the means by which venture capitalists (VCs) in the United States add value to their portfolio firms beyond money. The venture capital industry has expanded into other nations, and this study explores the relations of venture capitalists with their portfolio firms in the three largest European venture capital markets –- the United Kingdom, France and the Netherlands. Roles for VCs are categorized as strategic (e.g., providing business advice), interpersonal (e.g., mentoring the CEO), and networking (providing links to other resources). Utilizing agency and organization theory perspectives, this study analyzes governance and decision making issues from the viewpoints of the VCs. Perceived risks and uncertainty are hypothesized to increase the level of interaction between CEO and VC, and to increase the value added by such interaction. Interviews and surveys of venture capitalists and the CEOs of their portfolio firms were conducted in the US in 1987-1988. In 1982, a similar questionnaire was administered to VCs in the three European countries. Both similarities and differences were found among the four countries. In the US and the UK, for example, VCs interact more frequently with their portfolio firms, to monitor and assist them, than do those in France and the Netherlands. However, in all four countries VCs rate the greatest value added as strategic, and the least as networking. The situations in which VCs are likely to provide assistance are also examined. Further research is needed on the interaction between formal governance and more informal oversight.
This study analyzes the performance of investments made by venture-capital (VC) funds that specialize in financing minority business enterprises (MBEs). Existing studies document that MBEs have less access to financing—equity as well as debt—than similarly situated firms owned by nonminority whites. The apparent existence of a discriminatory financing environment creates an underserved market and, hence, attractive opportunities are available to firms capable of identifying and serving MBE financing needs. Analyzing cash-flow data on VC investments, we find that the minority-oriented funds earned yields on their realized equity investments that were slightly higher than the returns reported by mainstream VC funds. Considering differences in methodologies used to generate rate-of-return data for the MBE—as opposed to the nonminority-oriented funds—we conclude that the minority VC funds are earning yields on their realized investments that are at least equivalent to those of the broader VC industry.
This study of the venture capital firms that concentrate on making equity investments in minority business enterprises is based on a survey conducted in 2001 of 24 respondents from 50 venture capital funds operated by members of the National Association of Investment Companies. The issues considered include: to what extent minority owned businesses have access to venture capital, what types of businesses get such support, the origins of the venture capital funds, and the profitability of these venture capital firms.The study revealed the following points: mature, minority-oriented venture capital funds are highly profitable; such funds did not over-concentrate in dotcoms and other high-technology ventures; and the major sources of funding for minority-oriented venture capital funds are public pension funds, commercial banks, and insurance companies.With continued successful investing, this financial industry niche may sustain its rapid growth. These funds are less risky and may exhibit less volatility than has plagued the industry. The high returns generated by these successful companies will dispel the mistaken assumption they are low-return social investors.
Much important work has informed us of rates of return earned by venture capitalists, the importance of venture capitalists to the “going public” process, and the criteria venture capitalists use to evaluate deals. This paper seeks to add to the literature by testing hypotheses, based upon both the finance and strategic management literature, regarding certain venture capitalist investment practices.Venture capitalists seek to control or manage risk (Driscoll 1974; MacMillan, Siegel, and SubbaNarasimha 1985). Financing structure and investment strategy provide several means for venture capitalists to do this. Tools available to the venture capitalist include portfolio diversification to spread risk across different industries, firms, or hot/cold IPO markets to minimize unsystematic or investment-specific risk. Information sharing, networking, and specialization can also be used to control unsystematic risk.Several hypotheses are developed from these conflicting perspectives. Data used to test the hypotheses are derived from responses to a survey of venture capitalists. Three hundred surveys were mailed to venture capitalists; 98, or 32.7%,returned usable responses.Portfolio diversification is a well-known means to control risk exposure by reducing unsystematic or specific risks. However, Bygrave (1987, 1988), as well as financial intermediation theorists, argues that maintaining a high degree of specialization is useful for controlling risk as well as for gaining access to networks, information, and deal flow from other venture investors. The analyses of this paper build upon Bygrave's work. We construct more rigorous tests to resolve the conflict between the diversification and information-sharing hypotheses. Our hypothesis tests were usually resolved in favor of the information-sharing view. For example, venture capitalists in the sample that were heavily involved in seed round financing were diversified across fewer numbers of firms and industries.Further evidence in favor of information sharing is seen in investment patterns across different financing stages. Diversification would imply maintaining a portfolio of investments across the different investment stages. The information sharing/specialization view would argue that it is best to stay focused on a single stage or several “connected” stages. The empirical evidence from the sample once again favors the specialization perspective.This research provides information of use to venture capitalists, as they seek information on how best to control risk; to entrepreneurs, as they learn of the factors venture capitalists consider in determining their investment strategy; and to academicians, as such studies provide insight to general industry practice and thus help to form the basis of classroom discussion and future research endeavors.
We examine the impact of personal wealth on small business loan turndowns across demographic groups. Information on home ownership, home equity, and personal net worth, in combination with a rich set of explanatory variables, furthers our understanding of the credit market experiences of small businesses across demographic groups. We find substantial unexplained differences in denial rates between African-American-, Hispanic-, Asian-, and white-owned firms. We find that greater personal wealth is associated with a lower probability of loan denial. However, even after controlling for personal wealth, large differences in denial rates across demographic groups remain.
We use data from the 1993 and 1998 National Surveys of Small Business Finances to examine the existence of racial discrimination in the small-business credit market. We conduct an econometric analysis of loan outcomes by race and find that black-owned small businesses are about twice as likely to be denied credit even after controlling for differences in creditworthiness and other factors. A series of specification checks indicates that this gap is unlikely to be explained by omitted variable bias. These results indicate that the racial disparity in credit availability is likely caused by discrimination. Copyright (c) 2003 President and Fellows of Harvard College and the Massachusetts Institute of Technology.
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five plus percent per annum relative to the aggregate public equity market. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.
This paper investigates the performance of private equity partnerships using a data set of individual fund returns collected by Venture Economics. Over the sample period, average fund returns net of fees approximately equal the S&P 500 although there is a large degree of heterogeneity among fund returns. Returns persist strongly across funds raised by individual private equity partnerships. The returns also improve with partnership experience. Better performing funds are more likely to raise follow-on funds and raise larger funds than funds that perform poorly. This relationship is concave so that top performing funds do not grow proportionally as much as the average fund in the market. At the industry level, we show that market entry in the private equity industry is cyclical. Funds (and partnerships) started in boom times are less likely to raise follow-on funds, suggesting that these funds subsequently perform worse. Aggregate industry returns are lower following a boom, but most of this effect is driven by the poor performance of new entrants, while the returns of established funds are much less affected by these industry cycles. Several of these results differ markedly from those for mutual funds.
This study analyzes the performance of mature investments made by venture-capital (VC) funds that specialize in financing minority business enterprises. We explore the hypothesis that VCs focusing on investing in minority businesses earn attractive returns because this market niche is underserved. Minority VC funds collectively earned yields on their realized investments that were estimated to be broadly equivalent to those of the mainstream VC industry. However, these yields vary greatly from fund to fund. VC fund traits that predict high yields on individual investments are identified by estimating multivariate regressions explaining net investment returns. Copyright (c)2008 The Ohio State University.
The authors derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed-fraction contract, where he always receives a fixed fraction of the project's payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds. Copyright 1994 by American Finance Association.
The authors present new ways of looking at economic organizations andsystems. Individuals' judgments entail errors (they sometimes reject good projects and accept bad projects). The architecture of an economicsystem, specifying how the decision making units are organized togetherwithin a system, who gathers what information, and who communicates what with whom, affects its performance both because it influences thenature of errors that individuals make within the system, and becauseit has a critical effect on the aggregation of individuals' errors. Theperformance of two polar architectures, decentralized (polyarchical) versus centralized (hierarchical) decision-making authorities are analyzed and compared. Copyright 1986 by American Economic Association.
- Timothy Bates
- William Bradford
Bates, Timothy, and William Bradford. 2002. Venture Capital Investment in Minority Business (Report to the Ewing
Marion Kauffman Foundation, July).