Risk of Entrepreneurial Investments - Term Paper Example

Risk and return of entrepreneurial investments_______________ Introduction__________________________________________ Without taking risk, no return is possible on entrepreneurial investments. Taking risk is the first and foremost prerequisite to enjoy the fruit of return. Mostly, risk and return are associated and are linked with entrepreneurial investments. Private equity firms invest equity funds in order to receive and increase returns. In the recent years, we have witnessed extraordinary entrepreneurial investments have been done in the private equity funds. In this regard, venture capital partnerships have played a significant role and have made this industry grow (Kaplan and Schoar, 2003). In order to validate their claim, Kaplan and Schoar (2003) analysed the history of venture capital partnerships which had increased in the year of 1990 from less than $10 billion to over $180 billion till the year of 2000. Entrepreneurial investments require taking many risks and return measurement methods. But, before going to take risk, capital is required to be available for the purpose of investments. Many methods are available that can be used for the purpose of arranging capital. Venture capital can be a good source of finance. In which mostly, wealthy individuals provide their capital to investment companies, small business, and limited partnerships. This type of capital is collected to invest in a new business or ventures. A considerable amount of capital is required to invest with the intent of receiving high returns. Furthermore, angel investors also provide capital for those who wants to establish their small business or those who want to become investment entrepreneurs. This type of capital is mostly provided and given for a one-time injection. This one time injection provides a root to grow the tree of a business or investment. Also, Initial Public Offerings (IPOs) can also be used for the purpose of raising capital. This raised capital can be used for the purpose of doing further investment in different and variety of assets. But, using this method of collecting capital requires a company to issue a publically tradable shares and securities. After arranging and investing capital, return can be measured and understood with the use and application of the Internal Rate of Return (IRR). The internal rate of return provides a figure of the annual yield on an investment (Gottschalg & Phalippou, 2007). This yield measurement tool is considerably helpful to determining the level of yield that can be expected from a set of investments. A particular numerical method of the internal rate of return is used to obtain the figure of yield. Also, Net Present Value (NPV) is a widely used as a tool of evaluation. This tool of evaluation can be used to determine and highlight an investment project from a set of different investment projects that have positive cash flows. Thus, the positive net cash flows authenticate and validate to go with the project for the purpose of investment. In the subsequent parts of this piece of work, first, private equity funds, angel investors, venture capitalists, IPOs are further elaborated. Then, IRR and NPV are explained. But before conclusion, some focus is given to US or EU returns of entrepreneurial finance are explained. Private Equity Funds____________________________________ Private equity is not quoted like public equity in the capital markets. Fund managers first try to arrange some funds. And subsequently, these funds are invested into public and private companies. Various sources are available that can be used for the purpose of raising funds. For example, angle investors, venture capitalists and so on. Mostly, it is these sources that play a vital and pivotal role in raising funds. Additionally, some academic gurus call them institutional investors as well. Various reasons can require a need to raise funds or capital. Sometimes, a company may require to facilitate and to fulfil the purchase needs of new assets to add to the efficiency of a business; to fulfil a short term need by providing some funds in the use of working capital; or funds may be invested by purchasing the securities of other companies. It totally depends on the financial intentions of fund managers to determine and allocate an appropriate level of funds to a particular set of investments. Risk and returns from private equity differ from the risk and returns from the publically traded equity, and there are numerous causes for that (CoChrane, 2001). First, private equity investments are relatively more illiquid than the public equity. This causes investors to demand higher returns to offset the illiquid element of the private equity investments. Additionally, a comparatively larger share of investments is done in the private equities; as a result, the investors prefer to require more returns to compensate them for putting their all eggs in single basket of investment; or their investment is not diversified to minimize or allocate risk to a variety of investments. Various attempts are made to determine the private equity returns. Cochrane (2001) analyses the related risks and returns of venture capital investment with the help and use of Venture One database. This data highlights that the dollar investment and the number of shares, which are sold at each turn of venture capital investment. To calculate the level of return, it is only possible when some type of exit events like IPO or business liquidation takes place (Cochrane, 2001). Unfortunately, under such types of situation a threat of biased sample selection appears. And only better functioning companies may be selected and determined. Additionally, most of the companies prefer to remain with their identity of a private company. Undoubtedly, for these private companies no return can be determined and can be calculated. Venture Capital________________________________________ Venture capital plays a pivotal role in the companies in which they invest (Dennis, 2004) and this hypothesis that venture capitalists provide mentoring, strategic guidance, names venture capitalists as are the active investors (Jensen, 1993). Additionally, theories relating to financial intermediation put focus on the monitoring role of intermediaries (Diamond, 1984; Stiglitz, 1985) To start a new business, venture capitalist can be a good source of finance. In order to clearly explain the entire concept of Venture Capital, Metrick and Yasuda (2011) has provided the entire process under which the flow of capital moves and passes different stages. The most important factor is that the funds of venture capital are obtained and managed by the fund managers. This means the venture capitalists provide their money to fund managers. In the next step, the fund managers plan to invest capital in some of the most lucrative portfolio companies. The fund managers, first, analyse companies. By using evaluative methods like Earnings Per Share (EPS), dividend policy and so on, the fund managers become in a position to understand and predict the most lucrative returns. In the subsequent stage, the exit stage occurs; either Initial Public Offerings (IPOs) or the sale of portfolio companies requires a need to exit the provided capital. In the final stage, the exited capital enters into the stage of limited partners. The end of final stage brings the beginning of first stage of the process (Metrick & Yasuda, 2011). Angel Investor_________________________________________ Angel investor brings capital and technical expertise for the purpose of doing business. Angel investor differs from venture capitalist (Metrick Yasuda, 2011). For instance, venture capitalist only brings capital into a business. On the other hand, the angel investor not only brings capital but also provides technical expertise as well. With the help of technical expertise, angel investor becomes in a better position to invest and secure better returns than the venture capitalist. In contrast, the returns of venture capitalist significantly depend on the technical skills and technical expertise of fund managers who invest capital provided and given by venture capitalist. Angel investors are better equipped and are in stronger position in comparison with the venture capitalist in a sense that angel investors take investment decisions on their own. Initial Public Offering(IPO)______________________________ Initial public offering is a process in which a company issues its shares and equity in public and offers investors and other shareholders to purchase the offered equity or shares. Numerous benefits and some disadvantages are part of this entire process of initial public offering. For instance, by going public, a company will have an access to raise more funds for the purpose of doing investment. Furthermore, if a company starts trading its equity publicly or in stock or share markets, this indicates that company has become financially equipped and strong enough; and in order to pursue its corporate objectives, the company intends to raise more funds. But, there are some disadvantages for going public. For instance, the company is required to follow many public related regulations. And it has to ensure the maximum possible transparency and accountability of its financial and non-financial records. As the debacle of Enron; and certain mighty giants companies in the recent financial history has occurred, any breach of compliance or regulatory requirements may cost the existence of the company. Internal Rate of Return (IRR)_____________________________ Internal rate of return is a rate of interest that equates the initial amount of investment with the present value of the future cash inflows (Siegel & Shim, 2000). Internal rate of returns works under a decision rule, i.e. accept the project if the internal rate of return outshines or exceeds the cost of capital; otherwise, do not accept the project of investment and reject it. In its computation part, the internal rate of return takes into account the initial amount of investment, total estimated life of a project, annual cash flows and the percentage of minimum required rate of return, which is also called as a cost of capital. And these elements are further computed with the help and use of present value. And the question like whether investment project should be undertaken or not is totally rests on the subsequent answers, if the internal rate of return exceeds the amount of cost of capital, without any delay, the project must be undertaken. Otherwise, if the cost of capital is more than the internal rate of return, in this case, it is not wise to go with the investment project; it must be rejected. This cost of capital can be used to highlight the most relevant and lucrative private equity investments. The absence of publically available information also hinders to understand the true role of internal rate of return in the use and application of private equity investment projects. Net Present Value______________________________________ Net present value is the difference between the initial investment and the present value of all cash inflows. All related cash inflows and there present value is determined; and the amount of initial amount is given. Here, the present value of future cash flows is obtained with the use of cost of capital as the discount rate, and the future cash flows are discounted (Schewser, 2010). This discount rate is applied on the components of cash flows in order to bring their future values into the current values. Also, the net present value determines that whether a particular investment project can be acceptable or not. For that purpose, a decision tool is that if the net present value of an investment project is positive; it would be appropriate to go with the project. But, NPV can have pretty limited role since most of the private equity investment is not publically available. Entrepreneurial returns: US and Europe equity markets_________ Comparing returns in the US economy with the economy of Europe would not be meaningful. The US economy has different financial regulatory framework in comparison with the European regulatory framework. For instance, if a comparison is done on internal rate of returns in US and European markets, it would require multiple adjustments for the contemporaneous stock market returns (Rin and et al., 2006). Additionally, there is huge performance gap between US and European investors. European venture capitalists are less experienced than their US counterparts (Schwienbacher 2004; Bascha and Walz 2001; Kaplan, Martel and Stromberg, 2003). This would directly influence the returns in their respective markets. Conclusion____________________________________________ Risk and return are inter-linked: Without taking the one other cannot be attained and achieved. Angel investors and venture capitalists provide the best sources for the purpose of equity investments. The methods like IRR and NPV can be used to measure the returns. These equity returns differ in America to European returns. Multiple factors play their role that makes a comparison between them invalid and irrelevant. Additionally, mostly the information of private equity investment is not publically available. As a result, it becomes difficult to measure and compare the private equity performance in America and in European equity markets. References 1. Metrick A, Yasuda, A 201 ‘venture Capital and the Finance of Innovation,’ 2nd edn, John Wiley & Sons, Inc., United States of America. 2. Kaplan, S, Schoar, A 2003, ‘Private equity performance: returns, persistence, and capital flows,’ Working Paper, University of Chicago. 3. Gottachalg, O, Phalippou, L2007, ‘The Truth About Private Equity Performance,’ Harvard Business Review. 4. Cochrane, J 2001, ’The risk and return of venture capital,’ Working Paper, University of Chicago. 5. Siegel, J 2000,’Dictionary of accounting terms’ 3rd ed., Hauppauge NY Barrons Educational Series.   6. Jensen, M1993, ‘The modern industrial revolution, exit, and the failure of internal control systems,’ Journal of Finance 48, 831 – 880. 7. Diamond, D1984, Financial intermediation and delegated monitoring, Review of Economic Studies LI, 393 – 414. 8. Stiglitz, J 1985, ‘Credit markets and the control of capital,’ Journal of Money, Credit, and Banking 17, 133 – 152 9. Denis, DJ 2004,’Entrepreneurial finance: an overview of the issues and evidence,’ Journal of Corporate Finance vol. pp. 301-326. 10. Schewser, 2010, ‘Ethical and professional standards, and quantitative methods’, Kaplan: USA. 11. Bascha, A., and U. Walz. 2001. Financing Practices in the German Venture Capital Industry – An Empirical Assessment. Mimeo. Frankfurt: CFS. 12. Kaplan, S., and P. Strömberg. 2002. ‘Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts’. Review of Economic Studies 70(2): 281-315 13. Schwienbacher, A. 2004. An Empirical Analysis of Venture Capital Exits in Europe and in the United States. Mimeo. Amsterdam: University of Amsterdam. 14. Rin, MD, Hedge, U, Liobet, G, Walz, U2006,’The Law and Finance of Venture Capital Financing in Europe: Findings from the Ricafe Research Project,’ European Business Organisation Law Review 7:525-547 Read More