CHAPTER 26

Relationship between Risk and Returns in Venture Capital and Private Equity Investments

INTRODUCTION

Analysts are often confronted with the issue of choosing appropriate rates of return with which to discount cash flows estimated for venture capital and private equity investments. While these terms sometimes are used interchangeably and sometimes private equity includes venture capital, we will differentiate between the two terms: Venture capital investments are meant to refer to investments in new companies, generally with a limited history of revenues; private equity investments are investments in established companies (often including leveraged buyouts).

Both types of investments have limited liquidity. Their costs of capital embody risk premiums appropriate for business and financial risks and risk premiums for the risk of limited marketability.

For example, a venture capital investment is typically made by making an investment in a closely held business; if the company is successful, liquidity for the investors may be realized either by an initial public offering (IPO) or by selling the business. The private equity investment can be in a closely held company, can be a minority ...

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