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

• Published date: 01 June 2015
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/ajfs.12097
• Author: Sang‐Soo Kim,Myung‐Jig Kim,Sang‐Heon Lee

Estimation of Risk and Return of Venture

Capital Investments in an Emerging Market:

An Iterative Generalized Method of

Moments Approach*

Myung-Jig Kim**

College of Economics and Finance, Hanyang University

Sang-Soo Kim

Korea Venture Investment Corporation

Sang-Heon Lee

College of Economics and Finance, Hanyang University

Received 6 September 2014; Accepted 15 January 2015

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) estima-

tion approach proposed by Driessen et al. (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 imple-

ment, 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 expe-

riences 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 mar-

ket 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.

*The authors are grateful to two anonymous AJFS referees, Booil Jeon, Kunho Kim, and par-

ticipants of the 11th HERI-ISBR Joint Symposium for their helpful comments. Any errors,

however, are entirely the responsibility of the authors.

**Corresponding author: Myung-Jig Kim, College of Economics and Finance, Hanyang

University, 222 Wangsimni-ro, Seongdong-gu, Seoul 133-791, Korea. Tel: +82-2-2220-1034,

Fax: +82-2-2293-1787, email: mjkim@hanyang.ac.kr.

Asia-Pacific Journal of Financial Studies (2015) 44, 475–495 doi:10.1111/ajfs.12097

©2015 Korean Securities Association 475

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.

Keywords Fama–French factors; Iterative GMM estimation; Risk and return; Venture invest-

ment

JEL Classification: G12, G24

1. Introduction

The investment of venture capital (VC) is currently attracting a lot of attention

from institutional investors worldwide as an alternative asset class. Investors seem

to believe that the risk–return profile of venture capital investments will help

improve their asset allocation by extending the efficient frontier to the northwest

region of the risk–return space. Despite the attractiveness of venture capital invest-

ments due to their relatively high expected returns and low asset correlation with

other asset classes, however, the industry has experienced tremendous ups and

downs over the last two decades. For instance, the amount invested in the United

States market reached an historic peak of US$105 billion in 2000, but plunged to

US$19.6 billion in 2003 when the IT bubble burst.

1

The market began to recover

steadily, marking US$32 billion in investments in 2007, but declined again to US

$20.3 billion in 2009 due to the outbreak of the global financial crisis. Because the

risk–return profile of VC is affected not only by such systematic risks, but also by

venture-specific characteristics, the risk–return analysis of VC investments is an

interesting topic for research in financial economics.

Similar to the VC market in the United States, emerging VC markets have also

experienced dramatic swings over the decades. In Korea, for instance, the amount of

funds raised by Korean VC firms in 2001 was less than half the peak level of 1.4 tril-

lion KRW recorded in 2000, a year before the IT bubble burst.

2

In order to promote

small business corporations and venture companies, the Korean government and gov-

ernment agencies have established a state-sponsored fund-of-funds, which is managed

by the Korea Venture Investment Corporation (KVIC). The size of the Korean fund-

of-funds was only 0.17 trillion KRW at the outset, but it grew to 1.6 trillion KRW by

the end of 2013. The Korean fund-of-funds had committed 2.4 trillion KRW to more

than 300 VC funds by the end of 2013. These VC funds raised a total of 9.2 trillion

KRW, with investments in more than 2200 companies. As of 2013, a total of 431 Kor-

ean VC funds are in operation, with three main LPs (namely the KVIC, pension funds

including the National Pension Service (NPS), and Korea Finance Corporation)

accounting for 18.8, 12.3 and 9.6% of the VC market, respectively.

1

Data are from PricewaterhouseCoopers/National Venture Capital Association MoneyTreeTM

Report.

2

The KRW-USD exchange rate is roughly 1000–1, which makes the size of the Korean VC

industry about one hundredth of the size of the United States market in 2000.

M.-J. Kim et al.

476 ©2015 Korean Securities Association