Academic journal article Journal of Small Business Management

Investment Patterns of Informal Investors in the Alberta Private Equity Market

Academic journal article Journal of Small Business Management

Investment Patterns of Informal Investors in the Alberta Private Equity Market

Article excerpt

This study identifies three main types of informal investors in private equity markets: relationship investors, opportunity-based investors, and angel investors. We find evidence that the first two investor types are a major total source of capital and they prefer to invest smaller amounts close to home and in the context of existing relationships. With respect to angel investors, we find evidence of stratification in their desired investment amount which is consistent with a model where their investments evolve though a life cycle of investing. We also find evidence that changes to capital market regulations that allow for lower investment amounts by this type of investor increase the amount of capital available for early-stage firms.

Introduction

The high degree of uncertainty in private equity investment situations imposes significant capital market imperfections that are not comprehended by standard securities legislation. Traditional regulatory regimes protect the rights of arm's length investors as they purchase securities of firms that operate in relatively established markets with proven technologies. In contrast, private equity investments are characterized by uncertainty along three dimensions: technological, market, and agency. In large public equity markets, investors are provided with a variety of mechanisms that protect against agency problems, and these mechanisms also help address investor concerns about technology and market risk. Unfortunately, many of these mechanisms are not available to help investors reliably mitigate investment uncertainty in private equity markets.

For example, in private equity markets, legal recourse is not sufficient to protect investors against agency risk because uncertainty over technological development or market evolution clouds the courts' ability to hold agents accountable. In addition, the costs of litigation may exceed the wealth level of a failed entrepreneur, making it less likely that a dissatisfied investor will initiate a lawsuit. As a result, small firm access to equity markets is rationed. There is, however, evidence (Berger and Udell 1998) that investment by wealthy individuals, angels, appears to bridge the gap between the demand and supply of equity capital in this context.

Our work contributes to a growing body of literature on private equity investment by identifying the heterogeneous participants in this market. We focus our study on informal investors and begin by identifying the risk factors that will affect their investment strategies. A key risk dimension is the informational asymmetry that is at the core of agency problems. We model the behavior of investors in this investment situation and identify strategies that could be used by informal investors to mitigate their risks.

Our study documents changes to securities regulations that allow exemptions from prospectus requirements. We show that these changes lowered the cost of raising capital by early-stage firms because they allow informal investors to better mitigate agency risk. Based on securities law in the Canadian province of Alberta, we are able to identify exemptions that will be used by three different types of informal investors that we term relationship investors, opportunity-based investors, and angel investors. A recent overhaul of the Alberta Securities Commission (ASC) regulations for exempt investment has provided us with a unique opportunity to examine the behavior of these informal private equity investors. Based on our earlier model, we develop a set of propositions for informal equity investors.

We then test the model using empirical observations of private (exempt) market equity investments. (1) The data contains enough detail to allow us to examine private equity offerings at the level of the offering firm, and at the level of the individual investor. Thus, we are able to test a number of propositions with respect to the behavior of informal investors in this market. …

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