How top venture capital firms keep winning

(MoneyWatch) When it comes to stocks, bonds and hedge funds, there's no evidence that past winners keep on winning beyond the randomly expected. However, the asset class of private equity-venture capital does indeed show persistence of outperformance. While the overall evidence of the performance of private equity isn't encouraging (in general, the findings show that it has underperformed similarly risky but public small value stocks, without even considering adjusting for the lack of liquidity), a 2005 study showed that older funds with more of a track record tended to have better performance. Thus, the authors recommended that investors should choose a firm with a long track record of superior performance.

This begs the question of how these firms continue to outperform. While skill in selecting investments is certainly one plausible explanation for the persistence of outperformance, there's another -- successful firms are able to charge a premium for their capital, giving them an advantage in generating higher returns. David Hsu, author of the study "What Do Entrepreneurs Pay for Venture Capital Affiliation?" found VCs with strong reputations make offers at a 10-14 percent discount, yet are three times as likely to have their offers accepted.

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Hsu explains that if a company borrows from a bank and the terms are similar, it doesn't matter what bank it gets the money from. However, firms seeking venture capital investments are likely seeking not just cash, but also the venture firm's reputation and network. A VC firm can also add value by providing guidance on strategic planning, attracting top-caliber employees and lining up the best IPO underwriters. Thus a start-up may not always choose the best "pre-money" offer when it raises private equity.

Hsu found that "a lot of money is left on the table" by startup companies:

• Less than half of the firms surveyed accepted their best financial offer.
• When firms took less money, the differences between the accepted offer and highest offer ranged from a low of 3.6 percent to a high of 217 percent, with an average of 33.2 percent.

Hsu claims that reputation has a lot to do with it: "Outsiders may say, 'I don't know the entrepreneur, but I know the venture capital firm through its prior deals' and make inferences about the quality of the company they are looking at." In other words, "When the quality of a start-up cannot be directly observed, external actors rely on the quality of the start-up's affiliates as a signal of the start-up's own quality."

The bottom line is that entrepreneurs raising equity capital know that "[i]t is far more important whose money you get than how much you get or how much you pay for it." This knowledge allows successful VCs to charge a higher cost for their capital. And that in turn helps explain the persistence in outperformance.

If you are considering investing in venture capital-private equity, "The Quest for Alpha" has a chapter on the asset class that presents the historical evidence and the risks involved. The chapter contains the following warning from David Swensen, chief investment officer of the Yale Endowment Fund: "Understanding the difficulty of identifying superior hedge fund, venture capital and leveraged buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating, active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection poses grave risks to portfolio assets."

Those who choose to ignore Swensen's warning still need to understand that it's important to diversify the risks. This is best achieved by investing indirectly through a private equity fund rather than through direct investments in individual companies. Because most such funds typically limit their investments to a relatively small number, it is also prudent to diversify by investing in more than one fund. And, finally, you should remember that the top-notch funds are likely closed to individual investors. They get all the capital they need from the Yales of the world.

Image courtesy of Flickr user 401(K) 2013.