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TheCostofCapitalforEarly
StageBiotechnologyVentures
IainCockburnandJoshLerner
BostonUniversityandHarvardUniversity
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ExecutiveSummary
EvidenceshowsthattheCostofCapitalfor
venturebackedearlystagecompaniesinlifesciencesishigh:
Manyestimatessuggest20%orhigher
Thisreflectsinvestors expectationofareturnsufficienttocompensatethemfortakingonextraordinaryrisk
Permanentlyloweringrealizedreturnswillleadtolowerinvestmentinacriticalcomponentofthelifesciencesindustry
2
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PurposeofStudy
Understandingcostofcapitaliscriticalin
economicmodelingoftheimpactofregulatoryandpolicychangesoninvestment
andindustryeconomics:
Forallpubliclytradedcompanies,allsectors,
averageisaboutaround10%
Projectseekstounderstandwhetherthisisappropriateforprivatebiopharma companies
3
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TheCostofCapital CostofCapitalisacriticalbenchmarkforassessing
commercialviabilityofaproject Measuresopportunitycostofresourcesemployed
Oftenusedasahurdlerateofreturn todecidewhethertoinvestinacompany
Alsousedasadiscountrate toevaluatefuturecashflows
Outsideinvestorswillputmoneyintoventurefunds
onlyiftheyexpectreturns(IRR)>CostofCapital Veryimportanttogetthisrightinevaluatingthe
economicsoflongterm,riskyprojects
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TheCostofCapital(2)
Combines(1)timevalueofmoney,(2)riskof
notgettingyourmoneyback Forlarge,diversifiedcompanieswithpredictable
cashflows,typicalCostofCapitalisabout10%
Forsmallercompaniesfacingsignificant(andnondiversifiable)businessandtechnologyrisk,CostofCapitalismuchhigher:hereinvestorsdemandadditionalcompensationfortakingonhigherrisk(e.g.,biotechstartups)
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Simpleeconomicsofbiotechventures
Biotechhasseveralchallengingfeaturesforventure
investors (1)Verylongtimetomarket(typically10yearsormore) (2)Veryhighlevelsofrisk(fewerthan1%ofdrug
candidateswillmakeittomarket)
(3)Largeamountsofcapitalcontinuallyneededtomovemosttechnologiesforward
(4) Thefewsuccessfulcompaniesusuallyhaveabigdevelopmentpartnerand/oranacquirer
Comparedtomanyotherassets,ventureinvestorsneedtotakeonmorerisk,holdilliquidinvestments,andwaitlongerforareturn andthereforerequireahigherrateofreturn
=ahighCostofCapital
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Thebiopharmaceuticalecosystem
Drugdevelopmenttakesplacewithinacomplexweb
ofinterdependentorganizations universities/NIH,R&Dboutiques, established
biopharmaceuticalcompanies,healthcareproviders
Venturebackedcompaniesplayacriticalroleinfillingthefrontendofthedrugdevelopmentpipeline(andincreatingtoolsandplatformstomake
drugdevelopmentfaster/better/cheaper) Morethan50%ofmoleculesthatgointohumansoriginate
andareacquiredfromentrepreneurialcompanies
Seee.g.CockburnHealthAffairs (2004)
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Thebiopharmaceuticalecosystem
New Drugs
New biotech
companies
Established
pharma and
bio firms
Physicians
and providers
Universities, NIH,
foundations etc.
Acquisitions, partnering,
and licensing from
biotech accounts for
67% of new drugsNature Rev. Drug Discovery,2008
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Successfulproductsneedtogeneratereturns
toencourageinvestmentininnovation
Mostbiotechstartupsrelyonpartnershipswithlargercompaniesforlateclinicaldevelopment,regulatoryaffairs,
manufacturingandmarketing Ifthesepartnersexpectpotentialnewproductstohavelower
salesorshorterexclusivityperiods,theywillplacelowervaluesontheproductstheylicenseoracquire
Inturn,thismeanslowerexpectedreturnstoinvestorsinthesmallcompanies,leadingtohigherinvestmenthurdle
Impactofthiswillripplethroughtheecosystem fewerprojectsbeingfundedmeansaweakerindustrypipeline,and
fewernewdrugs Venturebackedfirmsareakeystonespecies intheecosystem
Thissectorisalreadyunderseverestress currentperceptionsaremakingithardtoraisemoney
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NewVentureFundraisingHasDeclinedSource:ThomsonReutersVentureXpert database
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
New
CapitalRaised
byVentureFu
nds
$B 19.2 28.7 31.9 35.6 28.3 17.2
2004 2005 2006 2007 2008 Q109x4
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VentureInvestmentisDown;
BiotechInvestmentMuchMoreSoSource:ThomsonReuters/NVCAMoneyTree Report.DataSource:ThomsonReuters
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
VentureCa
pitalInvestmentinCompanie
s($B)
AllVC 22.2 23.0 26.5 30.7 28.2 12.0Biotech 4.2 3.9 4.6 5.3 4.5 1.1
2004 2005 2006 2007 2008 Q109x4
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WhatistheCostofCapitalfor
biotechnologyventures?
EvidenceonCostofCapitalcomesfromtwo
principalsources Actualreturnsrealizedonventureinvestmentsin
biotech
Weassumethatcompetitivesupplyofinvestmentwill
driverealizedaveragereturnsclosetotheCostof
Capital
Unlessinvestorsgetgoodreturns,theywontputmoremoneyinventurefunds!
Expected returnssuggestedbyfinancetheory
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Whatistherateofreturnto
investmentsinventurecapital?
Verydifficulttomeasure
Highlyvariableovertime Manyfailures+afewbigwins
Privatelyheldcompanies,proprietarydata
Fundsversusindividualinvestments
PooledaverageIRR,allventurecapital: January1989December2008:17.0%.
Largecapreturnsoversameintervalwere8.4%.
Source:ThomsonReutersVentureXpert;IbbotsonAssociates
Exceptionalreturnsreflectexceptionalrisk! Longrunaverageconcealsplentyofbadyears
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10yearrollingreturnsto
investorsinVCfundsintheU.S.
0%
5%
10%
15%
20%
25%
30%
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Source: Authors' analysis of Thomson VentureXpert dataNetIRR
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Cumulativeventurereturns
overvarioustimeperiods
20%
15%
10%
5%
0%
5%
10%
15%
20%
20Years 10
Years 5
Years 3
Years 1
Year
15Source:ThomsonVentureXpert.AllreturnsfortheperiodendingDecember31,2008.
NetreturntoinvestorsinVCfunds.
Verylowreturnsin
recentyears likelyto
discourageinvestorsif
continuetobelow
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Decliningreturnsinrecentperiods Dramaticdropinreturnssinceburstingofbubble in2000:
IPOexitshavedriedup Manyobservershaveexpressedconcernsthat
ventureecosystemisunderstress:
Institutionsandindividualsunlikelytoinvestatsamerateunlesscanbeassuredofsatisfactoryreturns
Fallenpublicmarketvaluationsmeanlowervaluationsofprivatecompanies
Investorconcernsaboutfutureoutcomes
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Whataboutbiotech? CambridgeAssociatesInc.isanindustrystandarddatasource,
andmaintainsunusuallycomprehensivedata,tracking80%+ofindividualventureinvestmentssincethelate1970s
Canidentifybiopharma ventureswithsomespecificityinthesedata,notjusthealthcare ingeneral
Rateofreturn(IRR)on1606biopharma companiesnowacquired,gonepublic,orfailedwas25.7%grossfrom1986
2008;correspondsto20.7% netreturntoinvestors Aboveaveragereturnscomparedtoallventurecapitalreflectabove
averageriskofbiotech Assumes500basispointgrosstonetdifferential
Usefulguidetohistoricalrealizedreturns,butdoesntaccountforoverhang ofunrealizedinvestments: OverallIRR,includinganother1223unrealizedinvestmentscurrently
heldinportfolios,is~15.7%nettoinvestors
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Cashmultiplesrealizedfrombiotechinvestments
Source:CambridgeAssociates.Includesallexitedbiotechdealsasof12/31/08.1606totaldeals.
44%ofdealswereafullorpartialloss
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HistoricalreturndataCambridgeAssociates
1606biotechcompanies19862008:
20.7%averagegrossIRR onrealized biopharmainvestments,afterfeesandothercosts(5%)
Buthugerisks:
44%ofinvestmentswereafullorpartialloss 2/3ofprofitableinvestmentstook5yearsormoretoberealized
Another1223investmentsinthisdatasethaveyettopayout:evenripe investmentsareverydifficulttorealizeincurrentmarketconditions
SoVCsevaluatinganinvestmentwouldneedtoanticipate40%todeliver20%IRRoverall
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Howdoesthisrelateto
CostofCapital?
Realizedratesofreturnindicatehowmuchventurebackedcompaniesneedtopay foroutsidecapital
TheoryofcorporatefinancetellsushowtomeasureCostofCapitalmorerigorouslyin
termsoftherateofreturninvestorsexpectedatthetimeoftheinvestment,usingtheCAPM model
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Costofcapitalandthecapitalasset
pricingmodel(CAPM) ProvideswaytocomputeCostofCapital, basedon
ratesofreturnondebtandequity)
IntheCAPM,returnonequityisgivenby:
RateofReturn=riskfreerate+ xriskpremium
Riskfreerate=Tnotes(e.g.4%)
Riskpremium=paymenttoequityinvestorstotakeongeneralundiversifiable risk(5% 7%)
isacompanyspecificmeasureofrisk Fortheaveragematurecompany, =1 Forriskiercompanies, >1
Forveryriskycompanies, >2
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IllustrativeCostsofCapitalRiskfree
rate
Equityrisk
premium
WACC/
Costof
Capital
Riskfree(e.g.,Treasury
bonds)
4% + 0.0 = 4%
Mature,diversifiedfirm 4% + 1.0 x 7% = 11%
Midcapbiotechcompany 4% + 1.5 x 7% = 14.5%
Smallcap,earlystage
biotechcompany
4% + 2.0 x 7% = 18%
Ventureinvestmentinbiotech
4% + 2.5 x 7% = 21.5%
Note:Assumesnodebt
Publishedstudiesshow forpubliclytradedsmallcapbiotechs isaround1.52.0(Barra Betas,
IbbotsonBetaBook,Golec &Vernon.2007,DiMasi &Grabowski,2007). Forallventure isaround2(DriessenLinPhalippou,2007;Woodward,2005),likelyhigherforbiotechinvestments
Notemuchhigherthan
recentreturns!
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CostofCapitalRiseswithRisk
0.0
5.0
10.0
15.0
20.0
25.0
Cost
ofCapital(%)
CoC 4.0 11.0 14.5 18.0 21.5
RiskFree Mature
Firm
(Fortune500)Mid
cap
biotech Small
cap
biotechPrivate
biotech
startup
Note:Illustrativedata.Assumesnodebt.
Publishedstudiesandstandardreferencesourcesshow forpubliclytradedsmallcapbiotechs isaround1.52.0(Barra
Betas,IbbotsonBetaBook,Golec &Vernon, 2007,DiMasi &Grabowski,2007). Forallventure isaround2(DriessenLinPhalippou,2007;Woodward,2005),likelyhigherforbiotechinvestments
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Evidenceonriskandreturns
forbiotechnology WACCforpubliclytradedbiotechstocks
Golec &Vernon(2007): 16.25%
DiMasi &Grabowski(2007):1317%
Estimatesof forsmallcapbiotechstocks Forasampleof90lifesciencescompanieswithmarketcapbelow
$250MM, srangeashighas3.0 [Bloomberg]
AICPAguidanceforvaluingearlystagecompanies:19.2%CostofCapital
GolecVernonmodelsuggests2/3rdsofhigherCostofCapitalforbiotech(versuspharmaceuticalfirms)isduetosmallsizefactor: Impliesthatcostsofcapitalwillbeevenhigherforsmallestbiotechfirms
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Whyis andthereforeCostofCapital
sohighforbiotechcompanies? Immaturityandresultingfragility
Size Microcap riskpremiumis9%
Limitedliquidity
OTCtraded,smallvolumes Considerableexposuretoeconomicfluctuations,
whichcanleadto:
Inabilitytoaccesscapitalmarkets
Cutbackoncorporatealliancespending
Reducedwillingnesstoholdyoung,riskystocks
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OtherevidenceonCostofCapital Almostnoabilityofthesecompaniestoborrow
mediumorlongtermevenatcreditcard interestrates riskissohighthatlendersrequiresubstantialupsidethroughwarrantsetc.tocompensatethemforhighprobabilityofdefault
VeryhighhurdleratesusedbyventureinvestorstobeabletomeettheirCostofCapital:
Oftenashighas50%oreven75%forearlystagecompanies.
ReflectsbothhighCostofCapitalandcorrectionforfactthatentrepreneurs projectionsareoftenoptimistic.
Plummer(1987);Lerner,Leamon,andHardymon (2007).
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Finalthoughts Canidentifyreturnstoinvestinginearlystageinvestments
(andthusCostofCapital)from:
Actualreturns Expectedreturns
BothmethodologiessuggestCostofCapitalisquitehigh
Recentreturns(IRR)haventkeptup
Reflectsharsheconomicsofbiopharma investorsrequiresufficientreturnstoovercomeilliquidity,longtimehorizons,andtechnologyrisk
Regulatory/policychangesthatreducereturnsinbiopharma
willdriveventureinvestmentintoothersectorsorassetclasses
Lessventureinvestmentwillmeanfewernewdrugcandidatesatatimewhentheindustryisstrugglingtomaintainproductivity
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TechnicalAppendix
MeasuringtheCostofCapital
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1.Measuringventurereturns
Venturereturnsarehighlyvariable:
Insomeperiods,hugelypositive:e.g.,19962000.
Insome,verylow:e.g.,198389,200103.
Toget averagereturnsthatinvestorsanticipate,mustlookoveralongtime
periodandaverageoutgoodandbadperiods.
Keyquestionisadditionalrateofreturn(spread)overotherassets
classes Noteasytocalculatethisforventurecapital:needtoidentify specific
investments,thenfollowthemoverlongperiodsuntil(if)apayoffis
realized
Truncationbias ifpotentiallargepayoffsarestillinplay Needtotrack2nd,3rd,4th subsequentroundsofinvestmentinthesame
company,adjustfordilutionofshareholdingsetc.
Datahighlyproprietary:usuallyonlyreportedinaggregate
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Totalventurecapitalreturns
ThomsonVentureXpert compilesreturnsovermanyfundsoverlongtime
periods:
Looksatactualreturnsrealizedaswellasinterimvaluations.
PooledaverageIRR,allventurecapital:
1970s December2008:15.3%.
January1989December2008:17.0%.
January1999December2008:15.4%.
ProblemisthatsourceslikeVentureXpert compilereturnsonafundbyfundbasis.
Mostfundsinvestinamixtureofinformationtechnologyandlifesciences.
Thus,whilewecanmeasurereturnstoventureinvestorsinaggregate,wecannotsaybasedonthesedatawhatreturnsareforbiotechspecifically
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CambridgeAssociatesdata
C.A.maintainsunusuallycomprehensivedata,trackingindividualinvestmentssincethelate1970s
Canidentifybio/pharma ventureswithsomespecificity,notjusthealthcare ingeneral
Forinvestmentsin1606biotechcompanies19862008:
25.7%averagegrossIRRforfullyrealizedinvestments,upto500basispointslesstotheinvestors
Forall2829companies,including1223unrealizedinvestments,IRRtodatehasbeen20.7%gross/15.7%net
Notehugerisks: 44%ofinvestmentswereafullorpartialloss
2/3ofprofitableinvestmentstook5yearsormoretoberealized
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2.Lookingatexpectedreturns
Theright approachtoestimatingtheCostofCapitalistolookatwhattheexpectationsofinvestorswereatthetimeoftheinvestment.
Financetheorygivesusindicationsofwhatthisexpectationwouldbe. Evaluationofpublicmarketshasadvancedconsiderablyrecently, based
ontherecognitionthatinvestorsmusttakeportfolioviewofinvestments.
InsightoftheCAPMmodel.
Riskisameasureofthecorrelationofoneassetsreturnwiththeoverallmarket.
Newinnovationsinmultifactormodels.
Correlationwiththemarketisnottheonlysourceofrisk.
Multifactormodelsincreasinglyusedtomeasurereturnsofanassetclassandreturnsofindividualinvestors.
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Riskadjustingreturns:CAPMmodel
Allmodelsofreturnsshowthatrisk isdeterminedbythecorrelationofonereturnwiththereturnonasetoffactors
CapitalAssetPricingModel(CAPM) Riskismeasuredbythedegreeofcorrelationwiththemarket.
Investorswealthisdependentuponwherethemarketis.
Woulddemandlowerreturnsonaninvestmentthattendstobeahedgeonmarket.
Greatercomovementwiththemarketimplieshigherrequiredreturns.
Regressionanalysisusedtoestimateparameters Betaiscommonlyusedmeasureofrisk.
Betaofthemarketis1.
Higherbetameanshigherrisk.
Interceptintheregression(alpha)measuresriskadjustedreturns. Whatsleftoverafteradjustingforcomovement withthemarket.
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Riskadjustingreturns:AlternativetotheCAPM
Alternative3factormodel(FamaFrench).
Marketrisk.
Sizerisk. Smallcompaniesareriskierthanbigcompanies.
Booktomarketfactor.
Highbooktomarketcompanies(valuestocks)areriskierthangrowthcompanies(distress).
Bothmodelsusedtopricevariousstockandbondportfoliosquitesuccessfully.
WillfocushereonCAPM,thoughbothapproachesgivesimilarresults.
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Returnsandriskpremia forsmallfirms
Riskpremiumismuchlargerforsmallcapstocks:pointstomuch higherriskformicro ventures
Ibbotsonanalysisofallstocksgivessizepremium forsmallestcategory(mktcap5%(JohnCampbell,Estimatingtheequitypremium, Harvardworkingpaper,2008.)
Impliesexpectedreturnof2021%.
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Difficultieswithapplyingframeworkto
analyzingventurecapitalreturns
Allexpectedreturnmodelsaredrivenoffofreturncorrelations.
Privateequityreturncorrelationwithotherassetclasseshavelittle
meaning. Privateequityportfoliosoftenkeptatbook.
Hesitancytowritedownandup:
Certainlyhistorically,andeveninpostFAS157world.
Leadstolargedownwardbiasinestimatedcorrelations.
Cannotusemostcommonmodelstoriskadjustreturns.
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Acriticalproblem:staleprices
Whateffectdoestheaccountingconventionofkeepinginvestmentsatbookvaluedotopotentialcalculations?
Significantdownwardbiasincalculatedcorrelationswithotherassetreturns:Investmentsseemlessriskythantheyactuallyare.
Needperiodicportfoliovaluesthataretrue values.
Thesolution:markingtomarket:
Differentpapersusesdifferentapproaches.
Revalueattimesofwritedownsorwriteups.
Lookatchangesinoperatingperformance.
Lookatchangingpriceearningsratioinpublicmarket. Usetheinformationonmovementinsimilarprivateequityprices toadjust.
Getperiodicseriesofreturns,whichthencomparetopublicmarketdata.
Illustration:
Correlation
with the S&P
500
Correlation
with the S&P
500
Correlation
with the S&P
500
GE 0.743 IBM 0.582 S&P 500 1.000
GE with One Stale
Month 0.372
IBM with One
Stale Month 0.307
S&P 500 with One
Stale Month 0.490
GE with Two Stale
Months 0.334
IBM with Two
Stale Months 0.249
S&P 500 with Two
Stale Months 0.407
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Noteonexpectedreturnsforventurecapital
Thetrueexpectedreturnsinventurecapitalarelikelytobehigherthan
thecalculatedonesdueto:
Theneedtocompensateinvestorsforilliquidity(these
calculations assumenoliquiditypremium).
Thegreaterriskofbiotechinvestments(asseenabove,actualreturns
arehigherforbiotech).
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ReferencesCockburn,I.(2004)TheChangingStructureofthePharmaceuticalIndustry Health
Affairs, 23(1),pp.1022.DiMasi,J.andGrabowski,H.(2007)TheCostofBiopharmaceuticalR&D:IsBiotech
Different? ManagerialandDecisionEconomics, 28,pp.469479.Driessen,J.,Phalippou,L.andLin,T.(2007)ANewMethodtoEstimateRiskand
ReturnofNonTradedAssetsfromCashFlows:TheCaseofPrivateEquityFunds,Unpublishedworkingpaper,availableatSSRN:http://ssrn.com/abstract=965917.
Golec,J.andVernon,J.(2007)FinancialRiskInTheBiotechnologyIndustry NBERWorkingPaperNo.13604.Lerner,J.,Leamon,A.andHardymon F.(2007)VentureCapitalandPrivateEquity:ACasebook.NewYork,JohnWiley&Sons.
Plummer,J.(1987),QEDReportonVentureCapitalFinancialAnalysis,PaloAlto,CA,QEDResearch.
Woodward,S.(2005),MeasuringRiskandPerformanceforPrivateEquity,Unpublishedworkingpaper,availableathttp://www.sandhillecon.com/pdf/MeasuringRiskPerformance.pdf.