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

• DOI: http://doi.org/10.1111/fima.12048
• Author: Andrea Mina,Henry Lahr
• Date: 01 June 2014
• Published date: 01 June 2014

Liquidity, Technological Opportunities,

and the Stage Distribution of Venture

Capital Investments

Henry Lahr and Andrea Mina∗

This paper explores the determinants of the stage distribution of European venture capital in-

vestments 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 relativelikelihood of expansion investments, but not of early and late stage

investments.

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 Str¨

omberg, 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).1Capital 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

We thank Marc Lipson (Editor) and an anonymous referee for helpful comments and valuablesuggestions. We are also

gratefulto our colleagues as well as the CBR associates and FINNOV researcherswho commented on previous versions of

the paper.All remaining errors are our own. We gratefully acknowledgefunding from the European Community’sSeventh

Framework Programme(FP7/2007-2013) under Socio-economic Sciences and Humanities grant agreement no. 217466,

and from the Department for Business Innovation and Skills (BIS), the Economic and Social ResearchCouncil (ESRC),

the National Endowment for Science, Technology and the Arts (NESTA) and the Technology Strategy Board, throughthe

UK Innovation Research Centre.

∗Henry Lahr is a Research Fellowat the Centre for Business Research and UK∼IRC, Judge Business School, University

of Cambridge in Cambridge, UK. AndreaMina is a University Lecturer in Economics of Innovation in the Judge Business

School, University of Cambridge in Cambridge, UK.

The copyright line in this article was changed on 11 December 2014 after online publication.

1We define private equity as independently managed, dedicated pools of capital focused on equity or equity-linked

investments in privatelyheld companies. We use the term private equity in a broad sense to include VC funds, as well as

buyout, turnaround, and mezzanine funds. VC funds are defined as those funds that invest in firms at the seed, early,or

later stage of the firm’s development.For a more detailed def inition,see the description of TableI.

2Fundraising by European private equity firms dropped to one-third of precrisis levels in 2009 according to Thomson

ONE data. VC fundraising as a subset of the private equity market declined more slowly, but remains depressed at half its

Financial Management •Summer 2014 •pages 291 - 325

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292 Financial Management rSummer 2014

From a theoretical viewpoint, the crisis provides an excellentoppor tunity to revisitand fur ther

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 hypothesesderived

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 investmentsin 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 driversof the stage distribution

of private equity investments. Inour 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. A focus on investments, as opposed to fundraising activities or fund returns, addresses

the link between financial intermediaries and the real economy.

Consistent with liquidity risk theory, our results demonstrate a greater likelihood of investing

in earlier stages relative to all private equity investments during crisis years. However, liquidity

risk theory cannot explain the decreasing likelihood of late stage investments in liquid markets,

which we find after controlling for deal characteristics and other environmental variables. While

liquidity seems to be the main driver of acquisition investments and, to some extent, of expan-

sion financings, technological opportunities are the most powerful explanation of earlier stage

investment choices. Firms’ expenditures for research and development explain about half of the

added log-likelihood in models for early and late stage investmentswhen compared to full models

including time dummies. Results indicating relatively weakerexplanatory power for liquidity risk

are supported by direct comparisons of the proportions of early and late stage investments in

periods before and after the financial crisis and the dotcom crash.

This analysis responds to the need for a better understanding of long-term regularities in the

stage allocation of VC. It also allows us to look at the specific effects of the financial crisis on VC-

backed entrepreneurial processes, whose earlier stages may be especially resource constrained,

and to verify which types of investments have been most affected and in what way. Overall, our

results document a decreasing number of investments after 2003, but a reverse trend for early

and late stage VC investments during the recent crisis. The crisis’ effect on seed investments

is, however, negative after controlling for deal characteristics and macroeconomic variables. We

argue that the positive residual effect of the crisis on late stage investments, which is at odds with

precrisis volume. Similarly, investments into European target firms plunged to levels last seen after the Internet bubble

burst around the year 2001.

Lahr & Mina rDeterminants of the Stage Distribution of Venture Capital Investments 293

the liquidity risk hypothesis, can be interpreted as an indication that investors are trying to keep

portfolio companies afloat while waiting for exit markets to recover.

In summary, our paper contributes to the literature on the drivingforces behind VC investments

by testing the liquidity risk hypothesisand integrating the effect of technological opportunities and

other key macroeconomic indicators. While Black and Gilson (1998) argue for the theoretical

importance of exit opportunities to solve governance problems in VC, Gompers et al. (2008)

empirically confirm the positive relationship between public market valuations and liquidity

signals and total VC investments, but do not distinguish investments by stage. This is done

by Cumming et al. (2005), who find relatively more early stage investments than late stage

investments in times of illiquid exit markets. A later paper by Cumming et al. (2009) reveals

a different pattern in investors’ behavior. Funds shift their stage focus from early stage to later

stages in a falling market. Our study examines and extends these results in the light of the

financial crisis as a liquidity crisis. While prior studies posit theoretical differences between

early stage and late stage VC, we find that these two stage classes behave similarly with respect

to exit channel liquidity, but rather differently from other private equity stages (i.e., expansion

and acquisition). By considering the full range of private equity stages, we answer the question

as to which stages are most affected by liquidity that was left open by Gompers et al. (2008).

We develop Gompers and Lerner’s (1999) suggestion that VC accumulates in regions with high

industrial and academic research and development (R&D) expenditures, and uncover strong and

positive effects of technological opportunities on VC investments. Finally, we integrate into our

analytical setting the sensitivity of investment stage choices to macroeconomic uncertainty and

credit market conditions.

The paper is structured as follows. In the next section, we present the relevant theoretical

background and derive testable hypotheses. Section II contains data sources, variables, and

methods of analysis. In Section III, we present univariate statistics on the long run trends of

European VC markets. Section IV provides our main results, which are further discussed in

Section V in relation to the financial crisis. Section VI extends our analysis to consider the role

of country-specific effects. We conclude by summarizing the main contributions of the paper and

by reflecting on the long-term challenges of the VC investment model.

I. Theory and Hypotheses

The market climate for initial publicofferings (IPOs) is often cited, theoretically and empirically,

as the main determinant of VC investments (Black and Gilson, 1998; Gompers et al., 2008). The

profitability of initial investments relies on successful exits to distribute the proceeds to the fund’s

investors before the end of the fund’s lifetime, typically within ten years. The expectation is that

during periods of narrow IPO markets, we will observe fewerlate stage deals as these rely on the

possibility of floating the portfolio firm within a short time after the investment. For seed and

early stage investments, exit channels can be equally important, although there is a recent trend

toward longer holding periods that sometimes exceed the fund’s lifetime.3

In a study of liquidity risk in VC markets, Cumming et al. (2005) theorize that in times of

actual or anticipated illiquidity, venture capitalists invest relatively more often in early stage

deals in order to exit much further in the future. They argue that fund managers trade off this

exit risk for technological risk by investing in less mature businesses that will take longer to

generate profits through successful exits. These investments are realized when markets become

3IPO valuations appear to have a positive effect primarily on the volume of new funds raised by private equity firms

(Gompers and Lerner, 1999; Jeng and Wells,2000) and especially by younger firms (Kaplan and Schoar, 2005).