What Drives the Returns on Venture Capital Funds?

Despite the significance of venture capital (VC) in entrepreneurial financing and the increasing interest in VC by institutional investors, the literature has not examined what forces drive the returns on VC funds as an alternative investment class and how. This article studies this important topic using U.S. quarterly data between 1987 and 2004. Starting with seven financial variables that might be important determinants of the VC fund return based on theory and practice in the venture capital cycle, I use a structural vector autoregressive (VAR) model to examine whether these factors are important for the return on venture capital funds. Dynamic impulse response analysis illustrates that the excess return on venture capital funds has positive and significant response to shocks in the overall stock market excess return, IPO underpricing factor, and number of VC-backed IPOs, and negative and significant response to the book to market value factor and increase in delinquency rate on business loans. Variance decomposition further demonstrates that the overall stock market performance and IPO variables have the greatest contribution to explaining time-series variations in the VC fund excess return. Macroeconomic variables such as the growth in industrial production and change in unemployment rate do not appear to add explanatory power beyond the above financial determinants.