Launching a startup? Know the difference between Venture Capitalist, Private Equity Firm and Vulture Capitalist…

Getting straight to the point: Although venture funds and vulture fund as such fall under private equity funds, there is a certain distinction among them depending on the stage at which they invest.

Keep in mind: No matter when the investment is made, end-goal of every such fund is to exit the company in profitable state (at least for them).

I intend to present the difference with the help of pictorial representation of each with an objective to keep text to minimum and let pictures do the talk:
Note: - Just assume that the suited up gentleman in the pictures to follow represent an ideal exit condition for these firms.

(Exit strategies and other nitty-gritties of private equity funds not covered in this article - will dedicate another article for that)

• Venture Funds: Venture funds generally invest during the early stage of the company i.e. when the company is in its nappy pads. Plan is to make investment in multiple such start-ups with a valid assumption that in the long run only few of them would survive.
  But the few that survive surely bring a huge return on the investment made.

• Private Equity firms: Private equity firms generally target “mature” companies.
  They do not have to perform a task of bringing up a nascent company. Objective is to influx expertise and improve efficiency in handling of the company as a whole, thus enhancing the growth rate.

Not going into the details, but there are different ways in which private equity firms invest. (Article coming soon)

• Vulture Capitalist: Ahh… well they are vultures… literally!
  These funds believe in investing distressed companies i.e. companies which are on the brink of bankruptcy or are at a dead-end. Because of such conditions, they get to buy companies at very low costs. 
  Primary objective here is to cut cost as much as possible. Measures taken include cutting jobs, firing people, shutting down loss-making business and what not. 
  But yes, end goal here as well is to make the company up and running and say good bye once profit has been made.

Trust me – you never want to be in a condition where you get to deal with a vulture capitalist.

References: 

• http://www.investopedia.com/ask/answers/020415/what-difference-between-private-equity-and-venture-capital.asp
• https://en.wikipedia.org/wiki/Vulture_capitalist
• https://commons.wikimedia.org/wiki/File:Baby_anthony_liekens_01-human.svg.
• http://www.freestockphotos.biz/stockphoto/15110
• https://pixabay.com/en/photos/drunk/
• https://pixabay.com/en/man-male-person-standing-black-316893/

Risk - A pictorial description

Build Up

When first asked to define Risk, I was like, that's so easy. Risk is...a… mmm... it is... mmmm... well risk is risk. How the heck can I define risk? Risk is risk just as cat is cat, pain is pain, time is time. Isn't is that obvious? You bet...
Well, risk is not just a word, as far as this finance domain is considered. Imagine its importance when I say that numerous highly talented people dedicate their lives to provide value to this word.

Definition

Ahhh, after creating such a hype, I can finally write down a layman definition of this four letter word:
"Risk is what you take in order to achieve the return"
Higher the return desired, more is the risk one must take.
Nerdy Note: Higher the risk doesn't always mean higher the return. You only get paid for systematic risk in the real world, not for unsystematic risk that you can shoo away by diversifying.

Types of Risk

Risk is divided mainly into following categories:

1. Credit Risk

1. Market Risk

1. Operational Risk

1. Regulatory Risk

1. Other Risks (Liquidity Risk, Sovereign Risk, Political Risk etc.)

I’ll try to explain different types of risk with the help of a silly example of an ice-cream loving boy and an ice-cream seller.
Consider an ideal world:

• A kid wants an ice-cream.

• Ice cream costs X INR (Indian Rupee).

• He gives X INR to the ice-cream seller.

• Ice-cream seller gives a delicious ice-cream to him.

• He enjoys his ice-cream happily… End of Story

Now let’s take each categories of risk separately...

Credit Risk

Definition:“Credit risk is most simply defined as the potential that a bank borrower or counter-party will fail to meet its obligations in accordance with agreed terms”
as per bcbs54.
Basically the risk that one counter-party has if another counter-party does not fulfill its side of the agreement for the given deal (intentionally or due to adverse circumstances).

In a world exposed to credit risk:

• A kid wants an ice-cream.

• Ice cream costs X INR (Indian Rupee).

• He gives X INR to the ice-cream seller.

• Ice-cream seller refuses to give ice-cream (Counterparty failed to meet its obligation)

• The kid not only loses money but also doesn’t get any ice-cream.

Market Risk

Definition:Market risk is the risk possessed due to change in the market conditions.

Any change in market conditions (Interest rate change, government policies, economic conditions etc.) affects the value of an asset/portfolio either in positive way or negative way. Sensitivity of one asset/portfolio to market conditions may differ from that of another, but no asset is completely isolated from market conditions.

In a world exposed to market risk:

• A kid wants an ice-cream.
• Ice cream costs X INR (Indian Rupee).
• However due to sudden increase in demand, ice cream seller increases the cost to 2X INR (Change in market conditions affecting the price of ice-cream)
• But since the kid couldn’t anticipate this sudden increase in price and has only X INR, he has to live without an ice-cream.

Operational Risk

Definition:

As per Basel II: Operational risk is defined as the risk of loss resulting from inadequate or failed processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

This is basically the risk arising due to flaws in operational and functional activities of a firm.

In a world exposed to operational risk:

• A kid wants an ice-cream.
• Ice cream costs X INR (Indian Rupee).
• He gives X INR to the ice-cream seller.
• Ice-cream seller gives a delicious ice-cream to the kid.
• By mistake, ice-cream falls from his hands before he could consume it (Failed to operate properly)

Regulatory Risk

Definition:

Regulatory risk is the risk that may arise due to change in regulations or law that may adversely affect the concerned industry.

It is the risk that regulatory policies may mandate the changes in how business should be carried.

In a world exposed to regulatory risk:

• A kid wants an ice-cream.
• Ice cream costs X INR (Indian Rupee).
• Kid is about to purchase it but his dad (The Regulator), who is concerned about his health, stops him from doing so.

PS: I have tried to keep text as minimum as possible. This is just a high level description of different types of risk and I know that examples are bit lame, but I do believe they do a good job explaining the concepts in a simplified way possible.

References:

• www.bis.org/publ/bcbs54.htm
• http://www.investopedia.com/terms/m/marketrisk.asp
• economictimes.indiatimes.com/definition/regulatory-risk
• www.garp.org/media/673303/operational%20risk%20slides.pdf
• CFA Curriculum
• Basel Documents
• Investopedia

Capital Asset Pricing Model

Definition:

One of the most simple and highly revered model in finance, Capital Asset Pricing Model (CAPM) is used to estimate the required rate of return on a risky asset.

Mathematical Representation:

It is given by a simple linear equation as:

E(R_a) = RFR + β [E(R_m) – RFR]

where,

E(R_a) = expected rate of return on a risky asset.

RFR = risk free rate

β = beta

E(R_m) = Expected market return

Post-mortem of the equation:

Equation states that expected rate of return on given risky asset E(R_a) is equal to the sum of risk-free rate (RFR) and beta(β) adjusted  market risk premium ([E(R_m) – RFR]).

Before dissecting the different components of CAPM, let’s first plot this on graph.

CAPM equation is that of a straight line (y = mx + c),

Where y = E(R_a),  c= RFR, x = β and m =  [E(R_m) – RFR]

                 

 Green line represents the CAPM equation. This line is known as Security Market Line (SML).           

Also note that when β = 1, then E(R_a) = E(R_m) and the portfolio is known as market portfolio.

Assumptions of CAPM:

• CAPM is based on REM (Rational Economic Man) concept of traditional finance. It assumes that all investors are rational and risk-averse, holding a diversified portfolio with an aim to maximize economic utilities.
• All investors have a portfolio which is a combination of market portfolio and the risk-free asset, adjusted to their risk-averse appetite.
• Unlimited lending and borrowing can be done at the risk free rate.
• Transaction, administrative and other overhead costs are zero.
• Most importantly, model assumes that expected return on a risky asset can be determined as a function of its systematic risk only.

Components of CAPM explained:  

• First component of CAPM is RFR i.e. risk free rate. It is, as the name suggest, the return that you can earn risk free. Though no asset is risk free but U.S. Treasury bills and bonds are generally used as a proxy for the risk free rate. RFR to be used depends on the duration of risky asset under consideration, using long term bonds for longer risky assets and so forth.
• Second component is E(R_m) i.e. expected market return: It determines the expected return of the market as a whole and can be based on past returns or expected future returns. There are various ways to determine expected market return.
• E(R_m) – RFR is also known as market risk premium i.e. how much did market as a whole return above the risk free rate.
• β i.e. Beta : This is the most crucial of components and measures the systematic risk of holding a risky asset.Basically risk can be divided into two components: Unsystematic risk and systematic risk. Unsystematic risk also known as idiosyncratic risk refers to risk associated with individual assets.Ideally, we can reduce our unsystematic risk by holding a diversified portfolio. However, systematic risk refers to the risk that is common to all securities i.e. market risk. This cannot be reduced by holding a diversified portfolio and hence investor must be paid for exposing himself/herself to this risk. β measures this systematic risk and thus is considered while calculating the expected return on the risky asset.
  
  If β > 1, it implies that asset is riskier than the market as a whole and thus E(R_a) > E(R_m)If β < 1, it implies that asset is less risky than the market as a whole and thus E(R_a) < E(R_m)
  
  β is defined by the formula:
                                                 
  where
  
  
  Cov(i,mkt) = covariance between the asset’s return and return on the market 
  σ_mkt^2 = standard deviation of market
  

  
  

  
  

  Thus β is the standardized measure of systematic risk.

Application of CAPM:

As explained, CAPM is basically used to calculate the expected return on any risky asset.

This is really helpful when evaluating if an asset is fairly priced, overvalued or undervalued.

Fairly Valued:

If E(R_a) = R , then the asset is fairly valued

Overvalued:

If E(R_a) > R, then the asses is said to be overvalued.

Undervalued:

If E(R_a) < R, then the asset is said to be undervalued.

Implications of categorizing an asset as fairly valued, undervalued or overvalued:

If an asset is overvalued, then sell (or short sell) it as it is expected to decrease in value.

If an asset is undervalued, then buy it as it is expected to increase in value.

If an asset is fairly valued, then buy, sell or ignore. Doesn’t really matter.

Problems with CAPM:

• One of the main issues with CAPM, as is with any traditional model, is the assumptions that investors are REM (Rational and Economic Men). Rarely are the investors rational and rarely does CAPM map perfectly in the real world.
• It assumes that risk of an asset is solely dependent on beta (market risk). All other factors are ignored.
• Unsystematic risk is assumed to be compensated by holding a well-diversified portfolio. Hardly this is the case.
• Assumes there is no taxes, transaction or any other overhead cost. Nothing comes for free.
• Assumes that RFR exists. Remember we use treasury bills as proxy for RFR. Nothing is risk-free in this world.

References:

https://en.wikipedia.org/wiki/Capital_asset_pricing_model

http://www.investinganswers.com/financial-dictionary/stock-valuation/capital-asset-pricing-model-capm-1125

http://www.investopedia.com/terms/c/capm.asp

CFA curriculum: Level I, Level II, Level III (Various books)