Venture Capital
Informational Hold-up and Performance Persistence in Venture Capital
Why don’t successful venture capitalists eliminate excess demand for their follow-on funds by aggressively raising their performance fees? We propose a theory of learning that leads to informational hold-up in the VC market. Investors in a fund learn whether the VC has skill or was lucky, whereas potential outside investors only observe returns. This gives the VC’s current investors hold-up power when the VC raises his next fund: Without their backing, he cannot persuade anyone else to fund him, since outside investors would interpret the lack of backing as a sign that his skill is low. This hold-up power diminishes the VC’s ability to increase fees inline with performance. The model provides a rationale for the persistence in after-fee returns documented by Kaplan and Schoar (2005). Empirical evidence from a large sample of U.S. VC funds is consistent with the model. We estimate that up to 68.7% of VC firms lack skill.
Papers
ABSTRACT (Click Here To Open )
Why don't successful venture capitalists eliminate excess demand for their follow-on funds by aggressively raising their performance fees? We propose a theory of learning that leads to informational hold-up in the VC market. Investors in a fund l earn whether the VC has skill or was lucky, whereas potential outside investors only observe returns. This gives the VC's current investors hold-up power when the VC raises his next fund: Without their backing, he cannot persuade anyone else to fund him, since outside investors would interpret the lack of backing as a sign that his skill is low. This hold-up power diminishes the VC's ability to increase fees in line with performance. The model provides a rationale for the persistence in after-fee returns documented by Kaplan and Schoar (2005). Empirical evidence from a large sample of U.S. VC funds is consistent with the model. We estimate that up to 68.7% of VC firms lack skill.
Why don't successful venture capitalists eliminate excess demand for their follow-on funds by aggressively raising their performance fees? We propose a theory of learning that leads to informational hold-up in the VC market. Investors in a fund l earn whether the VC has skill or was lucky, whereas potential outside investors only observe returns. This gives the VC's current investors hold-up power when the VC raises his next fund: Without their backing, he cannot persuade anyone else to fund him, since outside investors would interpret the lack of backing as a sign that his skill is low. This hold-up power diminishes the VC's ability to increase fees in line with performance. The model provides a rationale for the persistence in after-fee returns documented by Kaplan and Schoar (2005). Empirical evidence from a large sample of U.S. VC funds is consistent with the model. We estimate that up to 68.7% of VC firms lack skill.
ABSTRACT (Click here to open)
We examine whether strong networks among incumbent venture capital firms help restrict entry into local VC markets in the U.S., thus improving VCs' bargaining power over entrepreneurs. We show that VC markets with more extensive networking among the incumbent players experience less entry. The effect is sizeable economically and appears robust to plausible endogeneity concerns. Entry is accommodated if the entrant has established relationships with a target-market incumbent in its own home market. In turn, incumbents react strategically to an increased threat of entry, in the sense that they freeze out any incumbent that builds a relationship with a potential entrant. Finally, companies seeking venture capital raise money on worse terms in more densely networked markets while increased entry is associated with higher valuations.
We examine whether strong networks among incumbent venture capital firms help restrict entry into local VC markets in the U.S., thus improving VCs' bargaining power over entrepreneurs. We show that VC markets with more extensive networking among the incumbent players experience less entry. The effect is sizeable economically and appears robust to plausible endogeneity concerns. Entry is accommodated if the entrant has established relationships with a target-market incumbent in its own home market. In turn, incumbents react strategically to an increased threat of entry, in the sense that they freeze out any incumbent that builds a relationship with a potential entrant. Finally, companies seeking venture capital raise money on worse terms in more densely networked markets while increased entry is associated with higher valuations.
ABSTRACT (Click Here To Open)
Shareholder agreements govern the relations among shareholders in privately held firms, such as joint ventures and venture capital-backed companies. We provide an economic explanation for key clauses in such agreements—namely, put and call options, tag-along and drag-along rights, demand and piggy-back rights, and catch-up clauses. In a dynamic moral hazard setting, we show that these clauses can ensure that the contract parties make efficient ex ante invest-ments in the firm. They do so by constraining renegotiation. In the absence of the clauses,ex ante investment would be distorted by unconstrained renegotiation aimed at (i) precluding value-destroying ex post transfers, (ii) inducing value-increasing ex post investments, or (iii) precluding hold-out on value-increasing sales to a trade buyer or the IPO market. (JEL: G34)
Shareholder agreements govern the relations among shareholders in privately held firms, such as joint ventures and venture capital-backed companies. We provide an economic explanation for key clauses in such agreements—namely, put and call options, tag-along and drag-along rights, demand and piggy-back rights, and catch-up clauses. In a dynamic moral hazard setting, we show that these clauses can ensure that the contract parties make efficient ex ante invest-ments in the firm. They do so by constraining renegotiation. In the absence of the clauses,ex ante investment would be distorted by unconstrained renegotiation aimed at (i) precluding value-destroying ex post transfers, (ii) inducing value-increasing ex post investments, or (iii) precluding hold-out on value-increasing sales to a trade buyer or the IPO market. (JEL: G34)
ABSTRACT (Click Here To Open)
Many financial markets are characterized by strong relationships and networks, rather than arm's-length, spot-market transactions. We examine the performance consequences of this organizational choice in the context of relationships established when VCs syndicate portfolio company investments. VC firms that enjoy more influential network positions have significantly better fund performance, as measured by the proportion of investments that are successfully exited through an IPO or sale to another company. Similarly, the portfolio companies of better-networked VC firms are significantly more likely to survive to subsequent financing and to eventual exit. Finally, we provide initial evidence on the evolution of VC networks.
Many financial markets are characterized by strong relationships and networks, rather than arm's-length, spot-market transactions. We examine the performance consequences of this organizational choice in the context of relationships established when VCs syndicate portfolio company investments. VC firms that enjoy more influential network positions have significantly better fund performance, as measured by the proportion of investments that are successfully exited through an IPO or sale to another company. Similarly, the portfolio companies of better-networked VC firms are significantly more likely to survive to subsequent financing and to eventual exit. Finally, we provide initial evidence on the evolution of VC networks.
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