help explain thehigh returns thatsome venture capitalists
demand on their equity investments in fledgling businesses.
3.Adjustthebetatoreflecttotalriskratherthanmarketrisk.
This adjustment is a relatively simple one, since the
R-squared oftheregressionmeasurestheproportionofthe
risk that is market risk. Dividing the market beta by the
squarerootoftheR-squared(thusobtainingthecorrelation
coefficient) yields a total beta. For a private firm with a
bottom-up market beta of 0.82 and an average bottom-up
R-squaredofabout 16 percent,thetotalbetacanbecomputed
as follows:
Usingthis totalbeta wouldyielda muchhigherand more
realistic estimate of the cost of equity.
Thus, private businesses will generally have much higher
costsof equitythantheirpublicly traded counterpartswith
diversified investors. While many of them ultimately
capitulatebysellingtopubliclytradedcompetitorsorgoing
public,somefirmschoosetoremainprivateandthrive.Todo
so,theyhavetodiversifyontheirown(asmanyfamily-run
businessesin AsiaandLatin Americahavedone)oraccept
the lower value as a price paid for maintaining total control.
ILLUSTRATION2.3: Bottom-UpBeta and Total Beta for
Kristin Kandy