risk

Risk and return are the two sides of the same coin

I would argue that there is no return without risk. There are lot of investments which are considered low or no risk, such as property or passive investment funds for example. But this couldn’t be further from the truth.

Any investment can lose money due to market changes, especially stock market and private company investments. Most investment brochures include a line saying past performance is not indicative of future returns. It exists there for a reason albeit in the small print.

The risk free rate of return

There is a term in finance called the risk free rate of return. It is meant to describe a hypothetical investment with zero risk. Sadly such a thing doesn’t exist. The closet one available are government bonds. They are meant to underperform compared to stocks, however, the risk is low.

I have to point out that the current return of the 30year UK Gilt (bond) is 0.7% in terms of the interest paid against inflation of 1.1% in 2020, yielding a total of -0.4%.

Furthermore, bonds are not entirely risk free. It is possible for a country to default on it’s debt as Greece did. I doubt that this will happen in the UK or the USA, however, 30 years is an awful long time to predict anything.

Other theoretically risk free investments such as a savings accounts either fail to preserve the time value of money or barely maintain it. This is due to the low interest rate world we live in.

What is risk

Risk is the probability of losing money on a given investment, regardless of the asset type. It can refer to anything – property, stocks or a painting. Even a work of art can be stolen, damaged or destroyed leading to a 100% loss of capital if uninsured.

On a company level risk refers to the probability that a firm ends up without enough cash to meet its obligations to suppliers and debtors.

Currently a lot of companies in the hospitality and transportation industries are faced with great uncertainty. Therefore, their share price is more volatile resulting in large swings.

Besides risk volatility presents opportunity for outsized returns too. The share prices of such companies are rock bottom at the moment, thus investors may gain quite a bit should they emerge successful once the pandemic ends.

A good historical example is Apple which faced a real risk of bankruptcy in 1997 but managed to reach a trillion dollar valuation in 2018. This could have ended up very differently and investors could have lost their money.

How does risk affect return

There are a lot of methods to determine risk, financial or non-financial.

However, the most intuitive way to think about it is that the higher the risk is the higher the expected return. The simplest way to explain this is in terms of opportunity cost.

If I could get 20% interest on a savings account I’ll never buy stock unless I get at least 40%.

Private business

I had an opportunity to participate in a business. However, I calculated that the anticipated return was lower than the average stock market return of a buy and hold portfolio for the past 10 years.

Moreover, as a private company it required active management on a daily basis. So I was faced with the choice to either participate and wonder if I’d ever make any money or invest in the stock market and just watch paint dry while achieving a higher return at a lower risk.

Liquidity risk

The lower stock market risk comes from the fact that the investment is more liquid and listed companies are more stable. I can close all my positions and I will have access to the money within minutes, a day or two days at most.

Another advantage is the market efficiency as I can always get a fair price for a liquid stock. A private business on the other hand involves finding a buyer and a slow selling process which can take months.

The costs alone are prohibitive in the short term so I’d be stuck with it for at least a few years. This is one proxy for risk – liquidity.

Bankruptcy risk

Whenever I look into an investment I compare the risk and return of the alternatives. I would expect a higher return from a private company than the stock market due to the risk of bankruptcy.

Private companies fail more often than listed ones. 17,671 companies went bust in the UK last year.

Study parameters

I’ll discuss the expected risk and return of venture capital, private equity and property. Then I will compare the return of each with a stock market investment over the past 5 years.

The benchmark is a high risk equity investment concentrated in a S&P 500 total return index fund (currency unhedged). I know that the average yearly return for the past 5 years is 23.4%, coronavirus crash included.

Venture capital

Venture capital (VC) carries the highest risk. Start-ups usually need money to get off the ground, however, the funds raised from friends and family, the local bank and other sources can run dry fairly quickly.

This is when the founders seek VC funding which comes in various stages.

VC returns

A VC firm will require a higher return than the stock market. Otherwise why would they choose to invest in a start-up considering that 95% of them fail within the first 5 years.

Consequently, the expected VC return is 40-70% per year. VC funds usually receive equity which can be sold during a liquidity event such as a private sale or an initial public offering.

Overall, VC firms invest in multiple projects expecting to make a loss on most of them. However, the few successful ones produce outsized returns which can reach up to 10,000 times invested capital or maybe even more.

VC risk

VC investments have the lowest liquidity as start-ups often remain small, end up bankrupt, don’t attract buyers or fail to go public.

Moreover, they may require additional funding which can dilute the equity holdings of the VC firm. It is also difficult to use any financial metrics to forecast future performance.

Private equity

Private equity (PE) is involved in later stages of a firm’s development. If you are buying an established business you are a participant in a PE transaction.

These have a higher success rate of around 30%. However, 70% of the time the fund ends up with a bankrupt company or just breaks even.

Naturally, a PE house will seek an average portfolio return of 20-40% per year. Otherwise they could just invest in the stock market.

Every now and again a fund can achieve an outsized return, however, in most cases successful investments yield 4-8 times the invested capital.

Use of debt

This is where the use of debt comes in. An ideal situation would be if you are able to borrow 100% of the funds required for a buy-out against the company’s assets.

Granted, it would put a lot of pressure on the firm but if successful you’d be making money out of thin air. This is not a realistic scenario nowadays so the fund needs to put in some of their own capital, usually 10-20% or more. Nevertheless, debt improves the fund’s returns if the business is successful.

Notable cases

The biggest leveraged buy-out of all time was KKR’s purchase of RJR Nabisco.

Warren Buffett’s Berkshire Hathaway and 3G Capital attempted to write some new history with their $143bn bid for Unilever. However, the deal fell through. I was a bit disappointed as it would have been a very interesting case.

PE risk

PE investments are more liquid than venture capital. The firms are more established so they allow the use of financial forecasting. Regardless of this liquidity events are few and far between as the fund needs a few years to develop the company.

Even if successful there is no guarantee that the fund will find a buyer willing to purchase the company at the target price. Some private company shares have a secondary market, however, it is not as developed as the stock market.

Property

Property is a popular investment vehicle among individual investors. There are multiple courses, social media groups and other sources which promote the idea of the millionaire property tycoon.

The top 25 buy to let areas in the UK delivered an average gross yield of 8.5% unlike the worst performing ones which were around 2%. I will of course need to consider expenses as rent divided by price does not mean anything.

In a theoretical example (assuming that I will be unable to buy a house in the best area) a gross yield of 5% can quickly turn into a net 1.5% return on risk or 5.45% return on equity.

The hypothetical example does not take into account mortgage capital repayments which makes it comparable to the other options discussed. It is important to note that property investments can result in a loss in the same way as anything else.

Property is considered lower risk than VC, PE and stocks and you can clearly see that the market is pricing it in via the lower return.

It is expected to deliver a quarter of what you’d get from the stock market.

Results

The previous sections have set the scene in terms of expectations: VC should have the highest return, followed by PE, the stock market and property.

The actual results are somewhat different though. It is difficult to collect comprehensive performance data for private investments, hence I used the Thomson Reuters Venture Capital Index, Thomson Reuters Private Equity Buyout index and the FTSE 350 – Real Estate Investment Trusts REITs index.

The winner is VC with the astonishing return of 300% for 5 years. VC clearly succeeded in outperforming the stock market:

risk and return

The same cannot be said for PE as it underperformed during the whole period. Therefore, the S&P 500 gets the second place while PE gets the third:

risk and return

Property in the form of REITs just lost money:

risk and return

Conclusion

The results show that actual returns vary compared to the anticipated ones. A general assumption in finance is that a project will need to have a minimum return on equity of 20% per year otherwise the investor may choose to invest in stock.

This is substantiated by the performance of the S&P 500 over the past 5 years. VC also performed within the expected 40-70% range.

PE underperformed which can be explained by the slow economic growth over the past decade.

I’m not sure if I should be talking about the REITs but it is worth mentioning that the index contains commercial property which I’d expect would have performed worse than residential. I expect residential property prices to keep rising until a sufficient amount of them is being built or the interest rate increases.

The returns may vary, however, the risks remain the same. The important point is that macroeconomic conditions change from time to time which leads to changes in the risk profile and subsequent returns.

Investors need to be aware that some high risk investments may underperform or low risk ones may not even keep up with the ‘risk-free’ return of UK bonds.