The risk-return attributes of publicly traded venture capital: Implications for investors and public policy

Abstract

Despite having provided original seed money to extremely successful start-ups such as Federal Express, Cray Research, and Apple Computer, the Small Business Administration (SBA) with encouragement from the U.S. Senate, has recently placed a moratorium on granting new small business investment company (SBIC) licenses. And, due to perceived fund mismanagement, at least some senators have suggested that the misguided SBIs could lead to “a mini S&L bailout.” Consequently, the SBA has threatened the existence of the SBIC government-assisted program. Two public policy issues arise. First, should the government sponsor SBICs given their past risk-return characteristics? Second, if SBA support does re-emerge, should changes be made to the organizational structure of SBICs? With respect to the first issue, our study examines the risk/return attributes of two categories of venture capital funds: publicly traded business development corporations (BDCs) and SBICs. Popular folklore, as well as a recent study in this journal, suggest that a well-diversified fund of venture capital containing both SBICs and BDCs outperforms the general market. While previous research assumes that SBICs are similar to BDCs, we find striking dissimilarities between these groups. During 1980–1986, SBICs demonstrate significantly greater total and unsystematic risk, but significantly less systematic risk than BDCs. In addition, SBICs experience much higher returns, on a risk adjusted basis, than either the market proxy or BDCs. Financial theory suggests a number of reasons for the differential performance among the two groups. Moreover, given the strong investment successes of publicly traded SBICs during the early to middle 1980s, and the ability of the public to monitor SBIC investment in lieu of the SBA, we conclude that continued SBA financing of SBICs benefits the investment community. However, the investment performance of SBICs in the late 1980s contrasts with the successes achieved earlier in the decade. Since 1986 many publicly traded SBICs have performed poorly, liquidated, or changed their organizational status. We conclude that many of these problems originate with the Investment Company Act of 1940. This Act limits operating flexibility of SBICs, discourages public trading and related monitoring by public investors, and reduces the equity capital cushion. Accordingly, we propose guidelines, including audit and equity capital considerations, that may mitigate difficulties stemming from the organizational structure of SBICs. Public policy issues related to SBA sponsorship of SBICs are relevant to individual and institutional investors—particularly as they relate to dividends, liquidity, investment allocation, and portfolio risk of venture capital related funds. For example, our study indicates that publicly traded SBICs, on average, appear to have greater corporate financial leverage and a large percentage of their portfolio invested in fixed income securities, compared with private SBICs (which invest more heavily in equity funds). To the extent that the SBA relaxes dividend payout restrictions on SBIC operating income, we might expect lower financial leverage and a greater portfolio allocation to equity instruments. This change would tend to reduce the financial risk related to SBIC ownership and encourage the provision of equity capital to emerging enterprises.