The Price of Diversifiable Risk in Venture Capital and Private Equity

Abstract

This paper demonstrates how the principal-agent problem between venture capitalists and their investors (limited partners) causes limited partner returns to depend on diversifiable risk. Our theory shows why the need for investors to motivate VCs alters the negotiations between VCs and entrepreneurs and changes how new firms are priced. The three-way interaction rationalizes the use of high discount rates by VCs and predicts a correlation between total risk and net of fee investor returns. We take our theory to a unique data set and find empirical support for the effect of the principal-agent problem on equilibrium private equity asset prices.

Keywords: Venture Capital, Idiosyncratic Risk, Principal-agent problem, Private Equity

JEL Classification: G24, D82, G31