Why Do Entrepreneurs Ignore the Poor Risk-Return Trade-offs of Private Equity Investing?
Research by Tobias J. Moskowitz
Many entrepreneurs invest substantial amounts of money
in their own privately held companies. Recent research suggests
that such investment strategies result in a much less attractive
risk-return trade-off than investing in publicly traded stocks.
Ask a random sampling of observers to describe entrepreneurs,
and their responses might very well include words such as
"innovative," "enterprising," and "adventuresome."
Few people would describe entrepreneurs as "poorly diversified
investors." However, this description may be more accurate
than one would expect.
In the recent study "The Returns to Entrepreneurial
Investment: A Private Equity Premium Puzzle?," Tobias
J. Moskowitz, an associate professor at the University of
Chicago Graduate School of Business, and Annette Vissing-Jørgensen
of Northwestern University's Kellogg School of Management,
find that most U.S. household investment in private equity
is centered in privately held firms in which the households
are actively involved in managing the firm. Yet despite the
high risk posed by this poor diversification in start-up companies,
the returns to private equity are astonishingly low.
Moskowitz notes that the sheer volume of investment in privately
held companies makes it a worthwhile topic to study. With
approximately five million small businesses in the United
States, the sum of private equity investments constitutes
a slightly larger fraction of the total economy than the entire
public equity market.
"When you say entrepreneur, most people picture the
kind of firms that seek venture capital," says Moskowitz.
"But those firms represent less than one percent of the
overall private equity market. Our use of the term entrepreneur
encompasses everything that's not publicly traded, from gas
stations and mom-and-pop stores to the bigger firms trying
to go public. Despite their size in the economy, we know very
little about the risk-return trade-offs of these entrepreneurs."
To examine the reasons why many entrepreneurs hold poorly
diversified portfolios, the authors compared investors in
privately held firms with public equity investors who are
likely to be poorly diversified-namely, investors in publicly
held corporations in which they or a family member work.
For public equity markets, the authors find holdings of stock
in investors' own publicly held companies to comprise only
10 percent of their total portfolios, compared with private
equity investors' allocation of 45 percent of their portfolios
to their own privately held companies. Furthermore, investment
in privately held firms tends to be concentrated in the hands
of company managers, making the lack of diversification more
"The tendency for people to invest in their own company
stock is the most troubling aspect of the lack of diversification
in public markets," Moskowitz observes. "But even
that behavior pales in comparison to many private equity investors'
The Nonexistent Premium
To account for the disproportionate amount of assets that
entrepreneurs invest in their own privately held firms, the
authors searched for a "private equity premium."
The private equity premium refers to a gain in returns above
that of public markets, which might explain why investors
would risk having such a poorly diversified portfolio.
"On average, you would expect investors to be compensated
for risking so much on their own companies, but this turns
out not to be the case," says Moskowitz.
Using data from the 1989, 1992, 1995 and 1998 editions of
the Survey of Consumer Finances (SCF), Moskowitz and Vissing-Jørgensen
examined returns on private and public equity investing over
the period 1989 to 1998. The authors found returns on both
private and public equity to be remarkably similar.
The authors addressed an array of potential biases that might
have been inherent in their comparison. The most significant
potential bias is the fact that many entrepreneurs do not
pay themselves a salary. To account for this issue, the authors
subtracted the estimated annual wages of those entrepreneurs
not reporting salaries from earnings, and found investment
returns on private companies to be considerably smaller than
those for publicly traded stocks.
Next, the authors tested the accuracy of their findings by
deliberately overestimating the returns of private firms.
They based the overestimation on the unrealistic assumption
that proprietorships, partnerships, and S corporations (which
don't pay corporate taxes) don't retain any earnings. Hence,
actual retained earnings would be counted twice as both dividend
and capital gain. Even using these conditions, the returns
on private equity investments still fell below those of the
public market in two out of three of the three-year sample
Private equity returns consistently equaled or fell below
those of the publicly traded stock market in additional bias
tests, even when including the possibility that tax evasion
or underreporting the value of private equity gains might
explain the inability of private equity returns to exceed
those of public equity.
Having shown the public and private markets yielded similar
returns from 1989 to 1998, the authors next turned to data
sources from 1952 to 1999. Using equity data from the Federal
Reserve Board's Flow of Funds Accounts (FFA), and income data
from the National Income and Product Accounts (NIPA), Moskowitz
and Vissing-Jørgensen found additional evidence highlighting
a similarity in the returns on investments for private and
public equity. Furthermore, when private equity returns were
contrasted with returns from the smallest 10 percent of publicly
traded firms, the authors found public stocks substantially
outperformed private firms.
"The fact that returns to private and public equity
investments were similar using two independent data sources,
SCF and FFA/NIPA, is comforting," says Moskowitz. "If
there had been significant error, you wouldn't find a relationship
between these data sets."
The Risk of Private Equity
Moskowitz and Vissing-Jørgensen argue that the risk-return
trade-off assumed by an entrepreneur investing heavily in
his or her own company is far worse than the trade-off in
the private equity index. In addition, this trade-off is much
less appealing than that of the index of publicly traded stocks.
One of the greatest risks associated with entrepreneurship
is the potential for business liquidation and the loss of
every dollar initially invested in a fledgling enterprise.
The survival rates of private firms are only 34 percent over
the initial decade of the organization's existence. Thus,
two-thirds of private firms fail or liquidate within the first
What percentage of an initial investment does an entrepreneur
stand to lose? Using data from 2000 provided by the U.S. Small
Business Administration, the authors conclude that the founder
of a new private company faces a 10 percent chance of losing
all of his or her investment. However, even among those entrepreneurs
whose businesses survive, almost one in three would have been
better off investing in an index of all publicly traded companies
than in their own privately held companies.
Why Become an Entrepreneur?
With the poor risk-return relationship clearly documented,
the question persists: Why do people become entrepreneurs,
risking so much of their own money?
First, entrepreneurs may have a greater tolerance for risk.
Though entrepreneurs make enormous investments in their own
firms, the remainder of their portfolios resembles those of
non-entrepreneurs, even among the wealthiest 5 percent of
the population. If entrepreneurs weren't so risk tolerant,
Moskowitz notes, they would be expected to fill the remainder
of their portfolios with highly conservative holdings to offset
the risk of investing in their own firms.
A second, though less likely, explanation may be financial
gains apart from investment returns. Although tax evasion
motives and salaries were taken into account in their calculations,
the authors acknowledge they may be missing other perquisites
such as company cars or lavish vacations.
"We examine how large these other monetary benefits
to entrepreneurship would have to be to deliver the higher
private equity return that theory predicts," says Moskowitz.
"We find that those other monetary benefits would have
to be implausibly large."
A third possible factor might be entrepreneurs' non-financial
lifestyle benefits, such as the flexibility and autonomy of
self-employment. This is likely to be a significant motivating
A fourth explanation may be what the authors refer to as
"a preference for skewness." Moskowitz explains
that those with a preference for skewness envision themselves
as the next Bill Gates, yet recognize the long odds of such
A fifth and final factor may be overoptimism. In contrast
to entrepreneurs with a preference for skewness, overoptimistic
entrepreneurs believe they have a higher probability of being
successful than in reality.
"For those entrepreneurs with a preference for skewness,
they understand the risks, but decide to go for it anyway,"
notes Moskowitz. "On the flip side, entrepreneurs who
are overoptimistic simply don't understand the risks. They
say, 'I know most new companies fail, but that won't happen
to me.' Overoptimism is a misperception of risk."
The authors suggest that distinguishing among the motives
for entrepreneurship may have important implications for policymakers.
For example, entrepreneurs who envision themselves to be a
latter-day Henry Ford or Bill Gates are seduced into entrepreneurship
by tiny but not insurmountable odds of amassing enormous sums
of money. For entrepreneurs who understand the risks but are
just making bets, policymakers should consider the effect
of progressive taxation of high-income individuals, which
may dampen incentives to launch new companies.
"If potential entrepreneurs don't understand the risks
at all, maybe we shouldn't encourage them to start new businesses,"
says Moskowitz. "Instead, we should educate them about
the nature of the risks."