Venture capital and private equity investors, governance, and success of IPOs: Evidence from India

• Published date: 01 June 2023
• Author: Sridhar Gogineni,Arun Upadhyay
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/jfir.12319

Received: 3 June 2021

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Accepted: 20 December 2022

DOI: 10.1111/jfir.12319

ORIGINAL ARTICLE

Venture capital and private equity investors,

governance, and success of IPOs: Evidence

from India

Sridhar Gogineni

1

|Arun Upadhyay

2

1

Department of Finance, Sykes College of

Business, University of Tampa, Tampa,

Florida, USA

2

Department of Finance, College of Business,

Florida International University, Miami,

Florida, USA

Correspondence

Arun Upadhyay, Department of Finance,

College of Business, Florida International

University, Miami, FL 33199, USA.

Email: Arun.upadhyay@fiu.edu

Abstract

In this article, we examine the role of domestic and foreign

venture capital and private equity (VCPE) firms in India. We

find robust evidence that portfolio firms backed by foreign

VCPE firms incorporate effective governance structures

after the initial public offering (IPO). Specifically, these

firms are associated with smaller, more independent, and

gender‐diverse boards. Furthermore, our results suggest

that foreign VCPE firms continue their association with

their portfolio firms in the post‐IPO period by nominating

directors to the boards. Our results also suggest that

portfolio firms backed by foreign VCPE firms are associated

with better long‐term operating performance and profit-

ability. This positive effect is exacerbated by the presence

of independent and female directors. Collectively, our

results support the view that good governance practices

are key to the long‐term success of a business, especially in

economies that lack good legal systems, developed finan-

cial markets, and alternative investment opportunities and

where developing trust between parties in a transaction is

crucial.

JEL CLASSIFICATION

G15, G24

J Financ Res. 2023;46:437–468. wileyonlinelibrary.com/journal/JFIR

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437

© 2023 The Southern Finance Association and the Southwestern Finance Association.

1|INTRODUCTION

Venture capital and private equity (VCPE) firms play a major role in the economy by committing funds to start‐up

firms with high growth prospects in exchange for control rights. The presence of VCPE in start‐up firms is often

viewed as a certification of the quality of those firms (Gompers, 1996; Hogan et al., 2001; Lee & Wahal, 2004;

Megginson & Weiss, 1991). In addition, VCPE firms add value to their portfolio firms by actively monitoring and

extending their expertise and network (Hsu, 2004). In a recent survey, Gompers et al. (2020) find that VCPE firms

focus on the management and governance structures of their portfolio firms to create value. Other studies (e.g.,

Boone et al., 2007; Celikyurt et al., 2014) document that VCPE firms play a significant role in board structuring and

director selection of their portfolio firms.

The third‐party certification and active monitoring provided by VCPE firms have force when information

asymmetries between insiders and outsiders are large, rendering valuations by outsiders difficult. Specific

examples of high‐information‐asymmetry situations include initial public offerings (IPOs) and developing markets

characterized by weak legal protection to minority investors. In the case of IPOs, information asymmetry arises as

IPO firms are hard to value because of incomplete information and uncertainties about their prior performance and

outlook. In the case of developing markets, information asymmetry arises primarily because of multiple agency

problems and potential expropriation of benefits by majority investors, typically entrepreneurs and founding

families.

The overarching contribution of this article is an examination of the role played by foreign VCPE firms in a

setting where information asymmetry is driven by both IPOs and developing markets. Specifically, we focus on a

sample of Indian IPO firms and address the following questions: Do foreign (predominantly US) VCPE firms institute

effective governance structures in the in which firms they invest? Does this result in consistent superior operating

performance in the long run, that is, several years after the IPO? We focus on India because it is a large

emerging market economy characterized by a high degree of information asymmetry, a mixed legal system, and

expanding capital markets. India is the largest democracy that follows a Western‐style legal system and has a

globalized economy, well‐developed governance practices, and active stock market. However, it also suffers from

corruption, delays in decision making, low stock market participation, underdeveloped bond markets, prevalence of

large family ownership of businesses, and concentrated government control over the banking system (Bertrand

et al., 2007; Chakrabarti et al., 2008). Prior studies show how corruption and bureaucratic red tape increase the cost

of doing business at both the economy and firm levels (Fisman & Wei, 2004; Fisman et al., 2008). Given these

circumstances, we believe a comprehensive examination of the role played by foreign VCPE firms in Indian IPOs is

timely and justified.

The importance of the research question is highlighted by the fact that India attracts investment from both

domestic and foreign VCPE firms. For instance, between 2005 and 2012, nearly 40% of all VCPE investment in India

comes from US‐based VCPE firms. A large literature documents the beneficial effects of US‐based VCPE firms on

the performance of US firms.

1

However, we know little about whether US‐based VCPE firms can replicate their

successes in foreign markets, especially in emerging markets. It is also unclear how VCPE firms from non‐US

countries perform in emerging economies. Although the role of VCPE firms in bringing about governance changes

has received attention (e.g., Chemmanur et al., 2021), we go beyond and examine whether the effects vary by the

origin of the VCPE. Also, although Chemmanur et al. (2021) find that the presence of VCPE firms helps Chinese

family firms reshape their management and ownership structures, they do not distinguish between foreign and

1

Sahlman (1990), Kaplan and Strömberg (2003), and Lerner and Schoar (2005) document the structure of venture capital (VC) in

terms of the contracts between investors and venture capitalists, as well as study how the legality in different countries affects the

financial transactions. Gompers and Lerner (1999), Cochrane (2005), Kaplan and Schoar (2005), Lopez de Silanes, Phalippou and

Gottschalg (2015), and Harris et al. (2014) investigate the returns and performance of VC investments. Guler and Guillén (2010),

Bruton et al. (2009), Madhavan and Iriyama (2009), Gu and Lu (2011), Cumming and Knill (2012), and others examine the role of

internalization of VCPE activities.

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domestic VCPE firms. Bustamante et al. (2021) argue that foreign VCPE firms face significant costs in screening

investees in the preinvestment phase and monitoring costs in the postinvestment phase. Focusing on geographical

distance between the VCPE country and the portfolio firm country, Chemmanur et al. (2016) find that VCPE firms

that form a syndicate with local VCPE firms are more likely to succeed in emerging economies. Because of the

complex regulatory, governance, and political systems and sociocultural norms, foreign VCPE firms investing in India

might face difficulties in managing their investments in Indian firms. However, foreign VCPE firms may bring better

operating and management practices, expertise, liquidity, and risk‐bearing and staying capacities. Therefore, the

aggregate effects of foreign VCPE firms (with or without co‐presence with domestic VCPE firms) on Indian firms is

an open empirical question. Our article provides the evidence.

Using unique hand‐collected data on India firms with VCPE investments, we document several findings of

economic significance. We analyze 1889 deals representing the investment activities of 451 VCPE firms belonging

to 31 countries in 1356 Indian firms between January 2005 and December 2017.

2

The aggregate amount invested

by VCPE firms during this period is over $12 billion, with approximately $9 billion invested by VCPE firms from India

and the United States. We find that VCPE firms, particularly foreign VCPE firms, invest more during the expansion

and later stages of a company as opposed to during the seed and early stages. During our sample period, we find

that IPOs are the most popular exit strategy of VCPE firms.

An examination of IPO firms suggests that foreign VCPE‐supported Indian firms tend to have better

governance structures in the post‐IPO period. Specifically, these firms are associated with smaller, more

independent, and gender‐diverse boards. Studies dating back to Jensen (1986) suggest that VCPE firms initiate

governance and operational changes that result in higher profitability. In this regard, our results suggest a spillover

effect in the sense that in the post‐IPO period, firms tend to continue following the good governance practices that

VCPE firms introduced during the pre‐IPO period.

We find that foreign VCPE firms are more likely to continue their association with their portfolio firms in the

post‐IPO period. Specifically, our results suggest that foreign VCPE‐supported Indian IPO firms have a higher

proportion of VCPE‐nominated directors on their boards in the post‐IPO period. Levis (2011) and Bruton et al.

(2010) argue that VCPE firms are often forced to continue their involvement with their portfolio firms in the

post‐IPO period because of lock‐up agreements. Our finding that this behavior is positively associated with the

larger presence of foreign VCPE firms suggests that in countries such as India that have weaker legal protections,

foreign VCPE firms tend to rely more on firm‐specific monitoring and governance mechanisms such as boards. Prior

studies that combine agency research with institutional theory show that differences in national institutions can

affect the effectiveness of corporate governance at the firm level (Aguilera & Jackson, 2003; La Porta et al., 2000).

Therefore, in a country like India where legal systems are weaker because of corruption, instead of using “arms‐

length”monitoring mechanisms, our results suggest that foreign VCPE firms prefer to participate in governance

activities directly. Finally, we find that a larger ratio of foreign VCPE firms is associated with better long‐run

performance in the post‐IPO period. For instance, the presence of foreign VCPE firms is associated with a return on

assets that is higher by 1.2 percentage points on average after controlling for other firm characteristics, year, and

industry controls.

3

One of the challenges we face in this analysis is the likelihood that we are capturing just a set of spurious

correlations. We present results that are consistent with the idea that foreign VCPE‐backed firms enjoy good

management practices, governance systems, and financing and investment policies established by powerful

investors that have strong incentives to do so as they benefit from the reputation of successful investments. One

could argue that these investors choose to invest in firms that already had great systems in place and what

we observe may not be due to the contributions made by foreign VCPE firms. However, it is not clear why

2

Because we examine long‐term performance over a 5‐year post‐IPO period, we limit IPO data to 2012 and analyze operating

performance until 2017.

3

This estimate is based on the results presented later in Model 2 of Table 6.

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