The Price of Diversifiable Risk in Venture Capital and Private Equity

This paper explores the venture capital (VC) market and extends the standard principal-agent problem between the investor and venture capitalist to show how it alters the interaction between the venture capitalist and the entrepreneur. The nature of the three way interaction results in a correlation between total risk and investor net of fee returns. Thus, we show how and why diversifiable risk should be priced in VC deals even though investors are fully diversified. We then take our theory to a unique data set and show that there is a strong correlation between realized risk and investor returns, as predicted by the theory.