Risk Model for Venture Capital Funds

Abstract

Venture capital funds operate in an opaque and illiquid market, where standard risk models are not directly applicable. We here propose a framework for a risk model for venture capital funds and fund-of-funds. In a previous paper, we proposed a consistent framework for performance and liquidity forecasting within the validity of the interim internal rate of return concept. However, its outcomes are not associated to a probability and expected values are without the notion of risk. In the present paper, we explain that knowledge of the level and timing of future cashflow scenarios allow calculating any measure needed to capture the risk profile of a fund. For example, it leads to a probability distribution of internal rate of return and profit/loss that allows computing a probability of default on an internal rate of return target or a value-at-risk. We believe that the most appropriate way to generate these future cashflows is on a fund level and ideally data-driven i.e. based on historical cashflows of comparable funds. We motivate our approach by discussing the different modelling avenues. In this context, we explicitly point out that a venture capital fund is conceptually different to an investment fund with quoted stocks due to the direct influence exercised by the venture capital fund management team on the companies. We also discuss the problems of the implementation of a risk model and the availability of data. We give a concrete example on how to use our framework, even with a dataset of unliquidated funds.

Keywords: venture capital, private equity, risk model, modelling, risk management, pricing, fund, fund-of-fund