Academic journal article Financial Management

Liquidity, Technological Opportunities, and the Stage Distribution of Venture Capital Investments

Academic journal article Financial Management

Liquidity, Technological Opportunities, and the Stage Distribution of Venture Capital Investments

Article excerpt

This paper explores the determinants of the stage distribution of European venture capital investments from 1990 to 2011. Consistent with liquidity risk theory, we find that the likelihood of investing in earlier stages increases relative to all private equity investments during liquidity crisis years. While liquidity is the main driver of acquisition investments and, to some extent, of expansion financings, technological opportunities are overall the main driver of early and late stage venture capital investments. In contrast to the dotcom crash, the recent financial crisis negatively affected the relative likelihood of expansion investments, but not of early and late stage investments.

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Venture capital (VC) is an effective market-based solution for investment in high risk and opaque projects as it combines financial resources with specific screening, monitoring, and certification skills (Chan, 1983; Sahlman, 1990; Megginson and Weiss, 1991; Lerner, 1995; Hellman, 1998; Kaplan and Stromberg, 2001; Ueda, 2004; Caselli, Gatti, and Perrini, 2009) and with substantive knowledge of markets and technologies (Cohen and Levin, 1989; Kortum and Lerner, 2000; Cornelli and Yosha, 2003; Denis, 2004). (1) Capital flows in this market, however, have displayed sensitivity to past performance and cyclical patterns over time (Gompers and Lerner, 2000; Kaplan and Schoar, 2005). Furthermore, turmoil in international financial markets can affect the demand and supply of VC, alter the routes of capital flows across nations and financial intermediaries, and change allocation decisions between asset classes. Having shaken the foundations of the global financial system, the recent crisis has tested the resilience of VC markets and raised questions about their reliability as a funding mechanism. (2)

From a theoretical viewpoint, the crisis provides an excellent opportunity to revisit and further develop theories that explain the role of exits in VC contracting (Black and Gilson, 1998; Aghion, Bolton, and Tirole, 2004) and predict the stage distribution of private equity investments (Gompers, 1995; Cumming, Fleming, and Schwienbacher, 2005, 2009). Liquidity risk theory posits that investors face a trade off between liquidity risk and technological risk, and are more likely to invest in earlier stages in times of liquidity crises. Large time series variations in the market for new equity issues induced by the financial crisis allow us to disentangle the liquidity explanation for the stage distribution of investments from competing hypotheses derived from other macroeconomic factors. In particular, by incorporating insights from the economics of innovation, we uncover the role of technological opportunities in driving investment stage choices. From an empirical viewpoint, the crisis calls for an in-depth analysis of the long-term development patterns of the sector to deepen our understanding of its challenges and future prospects (Kedrosky, 2009; Mason, 2009; Lerner, 2011).

In this paper, we are interested in structural changes in the stage distribution of investments. We investigate the relative importance of exit channel liquidity in private equity investments at different stages of a firm's development. Our analysis focuses on the time variation in investors' choices of early versus late stage investments in relation to the broader macroeconomic framework and identifies the drivers of investment stage distribution. We posit that investors' choices will be sensitive to liquidity risk and the availability of technological opportunities. We expect to find different effects depending on market conditions and across investment stages. We test the explanatory power of liquidity and technological opportunities as drivers of the stage distribution of private equity investments. In our empirical analyses, we use information on 35,240 European private equity investments in the period 1990-2011, extracted from Thomson Reuters' private equity database, which we augment with macroeconomic indicators from Eurostat and other sources. …

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