The Returns to Entrepreneurial Investment

The Returns to Entrepreneurial Investment:
A Private Equity Premium Puzzle?

Tobias J. Moskowitz; Annette Vissing-Jorgensen
The American Economic Review
, Vol. 92, No. 4. (Sep., 2002), pp. 745-778.

We document the return to investing in U.S. nonpublicly traded equity. Entrepreneurial investment is extremely concentrated, yet despite its poor diversification, we find that the returns to private equity are no higher than the returns to public equity. Given the large public equity premium, it is puzzling why households willingly invest substantial amounts in a single privately held firm with a seemingly far worse risk-return trade-off. We briefly discuss how large nonpecuniary benefits, a preference for skewness, or overestimates of the probability of survival could potentially explain investment in private equity despite these findings.

I seem to have a few problems with usability of underlying data…The authors note:

Hamilton (2000)… documents that individuals in the 1984 Survey of Income Program Participation (SIPP) choose self-employment despite facing a median (but not mean) stream of future earnings significantly less than that available as a paid employee. In addition, the cross-sectional standard deviation of self-employed earnings is substantially larger than that of wages from paid employment.

Why am I uncomfortable with this?

  1. At least some self-employed individuals (most notably, older immigrants who own small retail and service establishments) are downright unemployable; try finding a job if you are a 50-year-old with a limited command of spoken English…
  2. Self-employed individuals have the ability to pay at least some personal expenses out of pre-tax money and have it deducted from taxable income. So, given equal pre-tax income, a self-employed individual probably enjoys higher standard of living compared to a paid employee.

In addition, if entrepreneurial income is skewed and has substantial implied volatility, should we value self-employment as an option, rather than a stream of cash flows?

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