Estimation of Risk and Return of Venture Capital Investments in an Emerging Market: An Iterative Generalized Method of Moments Approach

Abstract

This paper examines the risks and returns of venture capital investments using the Fama-French (Journal of Financial Economics, 1993; 33: 3) factor model and cash flow data. In doing so, this paper extends the single-stage generalized method of moments (GMM) estimation approach proposed by Driessen etal. (Journal of Financial and Quantitative Analysis, 2012; 47: 511) to iterative GMM estimation by explicitly introducing the heteroskedasticity consistent covariance estimator. The iterative GMM method is simpler and faster to implement, it allows for a formal test for over-identifying restrictions, and it seems to perform well in the small sample herein. Using the venture capital cash flow data of all liquidated funds incepted from 1999 to 2006 compiled by the Korea Venture Capital Association (KVCA), this paper finds that both market and high-minus-low (HML) factors are important. Unlike experiences in the United States market, however, the contribution of market factors is small and positive, whereas the contribution of HML factors is large and negative in the emerging market in Korea. This means that Korean venture capital strategies take a short position in value stocks and a long position in growth stocks. Because growth stocks lag while value stocks perform well during the sample period herein, the cost of capital turns out to be nearly zero. This is compensated for by a large positive abnormal return, yielding the expected return of 11.05% per year on venture capital investments in the Korean market.