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...firm in which the venture capitalist invests, and liquidity risk as the current and expected future external exit market conditions. We show that in times of expected illiquidity of exit markets (high liquidity risk), venture capitalists invest proportionately more in new high-tech and early-stage projects (high technology risk) in order to postpone exit requirements. When exit markets are liquid, venture capitalists rush to exit by investing more in later-stage projects. We further provide complementary evidence that shows that conditions of low liquidity risk give rise to less syndication. Our theory and supporting empirical results facilitate a unifying theme that links related research on illiquidity in private equity.
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Policymakers around the world often express concern about why there is not more investment in privately held early-stage companies. (1) Further, the extreme cyclicality of early-stage investment, and what the drivers are, remains a relatively unexplored issue in private equity and venture capital research. (2) This article introduces a new and somewhat counterintuitive theory to facilitate an understanding of these issues. The US data examined herein support the theory.
Venture capitalists ("VCs") invest in small private growth companies that typically do not have cash flows to pay interest on debt or dividends on equity. VCs invest in private companies over a period that generally ranges from two to seven years prior to exit. As such, VCs derive their returns through capital gains in exit transactions. IPO exits typically provide VCs with the greatest returns and reputational benefits (Gompers, 1996 and Gompers and Lerner, 1999, 2001). (3) Liquidity risk in the context of VC finance therefore refers to exit risk, particularly IPO exit risk. That is, liquidity risk refers to the risk of not being able to effectively exit and thus being forced either to remain much longer in the venture or to sell the shares at a high discount. (4) The risk of not being able to effectively exit an investment is an important reason why VCs require high returns on their investments (Lerner, 2000, 2002; Lerner and Schoar, 2004, 2005). It is therefore natural to expect that exit market liquidity affects VCs' incentives to invest in different types of entrepreneurial firms.
Liquidity risk is, of course, not the only type of risk that VCs face when deciding to invest in a particular project. The other types of risk may be grouped into a broad category of what we refer to in this article as technological risk, or the risk of investing in a project of uncertain quality (particular types of technological risk could include the quality of the product technology as well as the quality of entrepreneurs' technical and managerial abilities). This article considers whether changes in external conditions of liquidity risk give rise to adjustments in VCs' undertaking of projects with different degrees of technological risk. In particular, we investigate whether exit market liquidity affects the frequency of VC investment in nascent early-stage firms and high-tech firms with intangible assets. (5) We provide a theory and supporting empirical evidence that show the willingness of VCs to undertake projects of high technological risk is directly related to conditions of liquidity risk. We further provide complementary evidence that shows that external conditions of high liquidity risk give rise to more prevalent syndication, which in turn shows that while VCs assume more technological risk in periods of low liquidity, they take steps to mitigate this risk through syndication. We show that the theory and evidence in regards to liquidity risk introduced herein provides a unifying theme that links the results in a number of related papers on venture capital finance.
We introduce a theoretical model that shows that VCs will rationally trade-off liquidity risk against technological risk by investing more in early-stage projects when the liquidity of exit markets is low and thus the exit risk is high. The intuition underlying our model is as follows. By adjusting their portfolio of investments for long-term positions, VCs reduce their exposure to liquidity risk. This is important in explaining the choice of projects according to their stage of development (early stage versus expansion stage), and the decision whether to invest in completely new projects or to limit investments to ongoing projects. In contrast, when the liquidity of exit markets is high, VCs tend to invest proportionately more in later-stage projects in order to rush for exit and thus to hold short-term positions and technologically less risky projects. The theory therefore gives rise to a somewhat counterintuitive conjecture of a positive correspondence between conditions of external exit market liquidity risk and VCs' contemporaneous undertaking of a greater amount of technological risk.
It is important to point out that the ultimate source of the liquidity risk analyzed in this article is the difference in time preferences between VCs and management, since there is a greater incentive for VCs to cash out earlier than management. The time horizon of a VC is typically shorter because of his exit requirements. If VCs were long-term investors and would not wish to exit already after a few years, liquidity risk would not matter and incentives between VCs and management would probably be better aligned (provided managers are capable and wish to remain in place).
With respect to early-stage investments, there are therefore two opposite effects documented in this article. On the one hand, more liquidity increases the likelihood of investing in new ventures; but on the other hand, it reduces the likelihood that these new ventures are in the early stage. In other words, liquidity increases the absolute number of new investments, but reduces the proportion of ventures that get early-stage finance relative to the total number of investments. These results thus indicate that VCs adjust their expected demand for liquidity to the expected supply. If they expect low liquidity in the future, they reduce their future demand for liquidity by reducing the absolute number of new ventures and by postponing the demand for liquidity for a portion of the new investments by financing ventures in their early stages.
We empirically test our theory by examining how investment decisions evolve over time by looking at the period 1985-2004 in regards to the stage of entrepreneurial firm development, as well as the technological focus of investment. We use investment data from the VentureXpert database to test our research hypotheses. We document the existence of a negative relationship between the liquidity of exit markets and the likelihood of investing in new early-stage projects. The proxy used for liquidity is the annual IPO volume. Our estimations indicate that an increase in liquidity by 100 IPOs in a year reduces the likelihood of investing in new early-stage projects (as compared to new investments in other development stages) by approximately 1.5%-2.3% depending on the specification. These values are not excessively large, but are nevertheless economically significant as it is well documented that the IPO markets themselves experience very large swings (for recent work, see, e.g., Bradley, Jordan, and Ritter, 2003, Helwege and Liang, 2002, and Lowry, 2003).
At first thought, it may seem counterintuitive that there is a negative relation between the liquidity of IPO markets and early-stage investments. The oft-repeated casual empiricism (see, e.g., practitioner articles on www.ventureeconomics.com) is that there is more early-stage investment when stock markets are performing better (i.e., IPO markets are more liquid). In our analysis we provide independent controls for stock market conditions (with and without simultaneous consideration of IPO volume), and show a positive correspondence between the NASDAQ composite index and the likelihood of early-stage investments. This latter result is somewhat analogous to the money-chasing deals phenomenon analyzed by Gompers and Lerner (2000), but is an independent effect and different from the central liquidity issues considered in this article. (6)
To further our evidence on liquidity risk and early-stage investment, we show that conditions of exit market liquidity impact the decision to invest in new projects versus follow-on investment in continuing projects pursuant to staged financing (in the spirit of Gompers, 1995). An increase in IPO volume by 100 increases the probability of investment in a new project (as opposed to a follow-on project) by approximately 1.2%-4.1%, depending on the specification (similar to the evidence in Gompers and Lerner, 2000). Taken together with the first effect of IPO volume mentioned above, this means that there are two opposite effects when liquidity risk increases: First, there are proportionately more new early-stage projects, and second, since VCs invest in fewer new projects, there are more follow-on projects in the VCs' portfolio. The weight of follow-on investments in the overall portfolio will therefore be greater when liquidity risk is high since fewer new investments are made, while follow-on investments are often continued and are most likely already at the expansion stage or later stage of development.
We further provide complementary analyses of the relation between liquidity risk and syndication, in the spirit of Lerner (1994a, 1994b) and Brander, Amit, and Antweiler (2002). When liquidity risk is low, investment is less risky and thus we expect a less pronounced incentive to syndicate. Conversely, when liquidity risk is high, VCs prefer to mitigate risk by syndicating with more partners in order to better screen their projects and to provide complementary value-added assistance across undertaken projects. The data examined support this conjectured effect of liquidity on syndicate size. An increase in IPO volume by 100 gives rise to approximately 0.2 fewer syndicated partners.
The remainder of this article proceeds as follows. In Section I, we discuss the liquidity concept for private equity, and explain how our model and empirics relate to prior research on the topic. Section II provides a model that shows the effect of external exit market liquidity on the VC's assumption of technological risk. Three core testable hypotheses are summarized in Section II. In Section III, we present and describe the data. The empirical tests and results are provided in Section IV. Thereafter we discuss limitations and future research, and provide concluding remarks.
I. Liquidity Concept for Venture Capital and Private Equity
For such financial assets as publicly listed equity, there seems to be consensus about the concept of liquidity. Four different dimensions have been suggested to define the concept for traded assets (Harris, 2003; Kyle, 1985): width, immediacy, depth, and resiliency. Loosely speaking, liquidity refers to the ability to trade at low (explicit and implicit) transaction costs. Kyle (1985) further stresses the importance of continuous trading and frictionless markets to achieve perfect liquidity of assets.
As for real estate or art objects, private equity is infrequently traded and thus the standard concept of liquidity hardly applies. (7) Private equity investments are not continuously traded, since by definition they are private prior to the IPO. An important element that distinguishes private from public equity is that IPO markets are characterized by "hot" and "cold" issue phases and by clustering waves. In this article, liquidity is related to the possibility of exiting by either listing the company on a stock market or finding a strategic buyer. The notion of liquidity used here is closest to the dimension of immediacy, since here liquidity represents the likelihood of being able to divest (cost of immediacy). Das et al. (2003) show that this illiquidity may induce a substantial non-tradability discount.
Throughout this article, we use the number of IPOs per year on the NASDAQ, NYSE, and AMEX as proxy for the liquidity of exit markets. (8) Although this proxy considers only the IPO markets, it also gives a good idea of what happens on corporate M&A markets. There are strong links between stock markets and corporate M&A markets. In particular, stock market conditions are also crucial for acquisitions ("trade sales") for different reasons: 1) An IPO may represent an outside option for highly profitable ventures that have the potential to go public (in this case, it directly affects the price in an acquisition); 2) capital inflow into the VC market is strongly correlated with stock market conditions (this affects total investments and therefore also the absolute number of trade sales); 3) stock market conditions determine the cost of capital for acquisitions when the buyer is listed; and 4) stock markets also mirror general economic conditions. Therefore, we should expect M&A markets to closely follow the IPO cycle. Also, an IPO is very often (but not only) what VCs aim at when investing in a new venture (Gompers and Lerner, 1999, 2001). In fact, when we introduced controls for the liquidity of M&A markets, (9) we encountered a number of collinearity problems with our other liquidity measures. As such, consistent with Gompers and Lerner (1999, 2000, 2001), our focus is on the liquidity of IPO exit markets.
Our theory and supporting empirical evidence facilitate a unifying theme that links related research on illiquidity in private equity, including studies on VC fundraising, investing, and exiting. In regards to VC fundraising, Lerner and Schoar (2004) introduce an innovative model and provide new data that show that VCs choose greater technological risk (using the terminology in our article) in order to screen deep-pocket investors. The intuition underlying the Lerner and Schoar result is that institutional investors that face illiquidity constraints may not be able to provide additional capital in the VC's next round of fundraising, which would increase the cost of capital for the VC if the VC had to approach new outside investors. Our results are consistent, in that we may view the effectiveness of this screening tool as being subject to external exit market liquidity conditions. In periods of low exit market liquidity risk (in boom periods), the incentive for a VC to assume greater technological risk as a screening tool would be diminished, since institutional investors tend to be less subject to capital constraints in boom periods. Conversely, in periods of...
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