Understanding the Risks in Investment Returns
A Practical Guide by Cary Potter, Managing Partner of Deal Valuation, LLC
It’s About Risk
Investment returns are directly correlated with risk. Every investment carries inherent risk, and in an efficient market with normalized supply and demand, expected returns reflect those risks. The greater the uncertainty of an outcome, the greater the return an investor requires.
The Value Equation
Risk is one of the three pillars of value alongside cash flow and growth. Understanding how risk drives required returns is foundational to understanding how equity is allocated across a multi-class capital structure.
Investment Vehicles Covered (from lowest to highest risk)
The book examines historical return data across seven investment vehicles, ordered from least to most risk:
- Government Bonds
- Municipal Bonds
- Corporate Bonds
- Corporate Stock (Preferred and Common)
- REITs (Asset-Backed Funds)
- Mutual Funds (Corporate Equity Funds)
- Options and Futures
Government Bonds
Issued by the U.S. Treasury to finance federal operations and projects, government bonds are considered the closest thing to a risk-free investment. Because the risk of default is historically low, returns on these bonds have been correspondingly low over the past decade. They serve as the baseline anchor for all other return comparisons.
Municipal Bonds
Issued by states, cities, and counties to fund day-to-day obligations and capital projects such as roads, bridges, and hospitals. Returns are driven by the continued growth and stability of local and state governments. Municipal bonds carry slightly more risk than government bonds but remain in the lower end of the risk spectrum.
Corporate Bonds
Corporate bonds are debt instruments where an investor loans money to a corporation expecting repayment plus interest at maturity. Investment-grade corporate bonds are relatively safe and low-yielding. Non-investment-grade (high yield) bonds carry more risk but offer higher returns. Unlike stock, corporate bonds are often backed by asset collateral, giving them a more secure position in the capital structure.
REITs
Real Estate Investment Trusts own or finance income-producing real estate across a range of property sectors. REITs are required to pay out 95% of their profits to qualify, making them an income-generating vehicle. They trade on major stock exchanges and offer portfolio diversification with returns driven by rental income and property appreciation.
Mutual Funds
Mutual funds pool investments across a portfolio of corporate equities, offering diversified exposure to corporate stock returns. Returns reflect the collective performance of the underlying companies held in the fund.
Corporate Stock
Corporate stock gives investors an ownership stake in a company, with returns coming from dividends and price appreciation. Stock is more volatile than bonds because it is more sensitive to economic changes. Preferred stock holds priority over common stock in the event of liquidation, a concept that connects directly to the waterfall structures covered in the DFPM.
Options and Futures
Options and futures represent rights to buy or sell assets at a future price. They carry the highest risk and potential return of all the vehicles covered in the book. In the context of the DFPM, options represent the final tranche of the waterfall, the most subordinate and highest-risk position in the capital stack, requiring the highest discount rate at 23.5%.
Tranche Discount Rates
Pepperdine Private Capital Markets Data
Tranche Capital Class Discount Rate Basis Book Reference Tranche 1 Senior / Asset Lending 12.0% 50% $10M ABL Median + 50% $10M Mezz Median Government & Corporate Bond baseline Tranche 2 Preferred Liquidation Preference 13.0% 1% premium, Debt vs. PE quartile difference Corporate Bond to Corporate Stock range Tranche 3 Common Participates 16.0% 3% premium, VC, and Angel quartile differences Corporate Stock range Tranche 4 Preferred Converts 19.0% Additional 3% premium, subordinate convertible position Mutual Fund / Equity Fund range Tranche 5 Options Exercise 23.5% Expansion phase equity returns, highest risk tranche Options and Futures range
Source: Pepperdine University Private Capital Markets Report. Return ranges based on market data presented in My First Book on Returns — Understanding the Risks in Investment Returns, Deal Valuation, LLC.
How This Connects to the DFPM
The return data across these seven investment vehicles provides the market-based foundation for selecting discount rates in the Discounted Future Proceeds Method. Each tranche in a waterfall corresponds to a position on the risk-return spectrum, from senior secured debt anchored near government and corporate bond rates, through to common equity and options at the high end. By grounding tranche discount rates in observable market data, the DFPM produces equity allocations that reflect real investor return expectations.
★★★★★
Cary Potter is the Managing Partner of Deal Valuation, LLC, based in Irvine, California. With 30 years of valuation experience across KPMG, Oracle Capital, and American Appraisal, Cary specializes in multi-class equity structures, 409A valuations, and the application of market return data to complex waterfall analysis for PE- and VC-backed companies. He holds the Accredited Senior Appraiser (ASA) designation from the American Society of Appraisers and is Certified in Entity and Intangible Valuations (CEIV) through the AICPA.