An exploration of tools of analysis commonly used by private equity in making investment decision

2.3.2 Recent tools of investment assessment: real options

Three points need to be thought through under this subdivision. First of all, the concept of real options will be expounded; in the second place the defining features that make an investment proposal eligible to real options, and in the third place, what we shall name the «competitive advantage», which such techniques can procure to private equity firms in investment assessment of newly created firms.

Expression created by Myers (1977) and, as stated supra, the notion of real options began to be of any centre of interest of academics in the 80s. Since that period, there have been a number of conferences and writings on this topic to such an extent that real options have evolved from a less valuable topic «to one that now receives active, mainstream academic and industry attention» (Borison , 2005, p. 17). Be that as it may, real options method is suitable to any situation where there is a certain amount of flexibility. In such cases, the venture capitalist is in the same situation as the financial manager who can increase or decrease his position in a security given predetermined conditions. A venture capital manager can also be compared to a financial manager who holds an option. Flexibility of an investment has a value, the value of the option associated with it. For example, in the field of industrial investments, real options are equivalent of «the right not the obligation, to change an investment project, particularly when new information on its prospective returns becomes available» (Vernimmen et al., 2009, p. 374). This definite property of a flexible investment is referred to as a real option. Conversely, in the circumstances where it is hard to recognize the adaptability of an investment, Vernimmen et al., (2009) describe that as «hidden options» (Vernimmen et al., 2009, p.374).

An investment proposal needs to meet three factors in order to be qualified to real options. First, there must be some uncertainty surrounding the project. Secondly, there should be additional information arriving over the course of time. Thirdly, there must be the possibility to make significant changes to the project on the basis of this information.
A number of various types of real options can be presented in investment projects: the option to launch a new project; the option to expand, reduce or abandon the project; or the possibility to defer the project or delay the progress of work. According to the first type, Vernimmen et al., (2009) put forward that it is similar to a «call option on a new business. Its exercise price is the start up investment, [a significant element] in the valuation of many companies. In these cases, they are not valued on their own value, but according to their ability to generate new investment opportunities, even though the nature and returns are still uncertain.» (Vernimmen et al., 2009, p. 374).

Finally, the benefits of real options have been highlighted by Krychowski and Quélin (2010) in the following way: «The main contribution of RO [Real Option] is to recognize that investment projects can evolve over time, and that this flexibility has value. Myers (1984) considered that RO is a powerful approach to reconcile strategic and financial analysis» (Krychowski and Quélin, 2010, p. 65).

As it has earlier been mentioned in this work, it could add value to the current literature on methods assessing investment decision by means of a survey of venture capital firms to find out what techniques they use in practice concerning investment. Of course, a pilot study has already been carried out in the fields of venture capitalist investment appraisal in Australia ( Wright and Proimos, 2005). But it was, to some extent, narrow since it was focussed on a specific source of risk named information asymmetry, «which is caused by lack of information on the part of the VCs, and which can lead to the added risks of adverse selection and moral hazard» ( Wright and Proimos, 2005, p. 272). Anyway, what are the bare bones of this literature review?