Download - Investor Value-Added

© Cumming & Johan (2013) Venture Capital Investing

Investor Value-Added

Cumming and Johan (2013 Chapter 14)

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Chapter Objectives

• Overview chapter for Part IV on Investor Effort

• Summarize topics covered in Chapters 15-18 and related research

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Issues in this Chapter

• Investor value added may be viewed as involving the following issues:

– The relation between venture capital and private equity and innovative activity, jobs, productivity

– Contract terms and investor value-added

– Location of investee firms relative to investors

– Optimal portfolio size / manager

– Fund size

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VC and Innovation

Kortum and Lerner (2000 Rand Journal of Economics) “Assessing the Contribution of Venture Capital to Innovation”

Masako and Hirukawa (2008a Working Paper, University of Wisconsin, Madison) “Venture Capital and Industrial 'Innovation‘”

Masako and Hirukawa (2008b Working Paper, University of Wisconsin, Madison) “Venture Capital and Innovation: Which is First?”

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Issue in Kortum and Lerner (2000)

• Does venture capital finance lead to an increase in R&D spending?

• Does venture capital finance lead to an increase in patenting? (and an increase in patents that are cited)

• Or does R&D and patents lead to venture capital finance (i.e., the reverse causality)?

• Data considered: patents issued to 20 manufacturing industries between 1965 and 1992

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Findings in Kortum and Lerner (2000)

• VC averaged less than 3% of corporate R&D from 1983 – 1992, VC’s share of US industrial innovations was 8%

• By 1998 venture capital funding accounted for 14% of US innovative activity

• $1 of venture capital gives rise to an increase in patenting by 3 times

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Masako and Hirukawa (2008a)

• They extend sample period of Kortum and Lerner (1965-1992) to 2001• Confirm that this positive impact continued to be present and became even

stronger in late 90s during which VC industry experienced an unprecedented growth.

• But they do not find that VC investment affects total factor productivity growth.

• Overall: at industry level, VC investment increases the patent propensity but may not necessarily improve the productive efficiency.

• However, at the firm level Chemmanur et al. (2007) show venture capital enhances total factor productivity among a sample of venture capital- versus non-venture capital-backed firms in the US.

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Masako and Hirukawa (2008b)

• Venture capital investments stimulate innovation ("VC-first hypothesis")• Innovations induce venture capital investments ("innovation-first hypothesis")

• They analyze this causality issue of venture capital investments and innovation in the US manufacturing industry using both total factor productivity (TFP) growth and patent counts as measures of innovation.

• They find that TFP growth is often positively and significantly related with future VC investment, which is consistent with the innovation-first hypothesis.

• They find little evidence that supports the VC-first hypothesis. • One-year lagged VC investments are often negatively and significantly related

with both TFP growth and patent counts.

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Private Equity Funds are Locusts?

• Growing concern in media around the world that private equity and buyouts in particular should be regulated.– E.g., NY Times 2006 – LBOs should be illegal– Economist 2007 – PE funds need regulation

• PE firms characterized as ‘locusts’ by Franz Müntefering (Germany)– "We support those companies, who act in interest of their future

and in interest of their employees against irresponsible locust swarms, who measure success in quarterly intervals, suck off substance and let companies die once they have eaten them away…”

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MBOs and Total Factor Productivity

• Management buyouts significantly improve productivity– Lichtenberg and Siegel (1990) US data

• Lichtenberg and Siegel used United States Census Bureau's Longitudinal Research Database which contained data on more than 19,000 mostly large United States manufacturing plants for the years 1972to 1988.

– Harris et al. (2005) UK data• Harris et al. studied longitudinal data for approximately 36,000 United

Kingdom manufacturing establishments, and found MBO plants experienced a substantial increase in productivity after a buyout (+70.5% and +90.3% more efficient in the short and long run, respectively).

– MBO plants had enhanced total factor productivity relative to representative establishments in the same industry after the MBO. This enhancement in economic performance could not be attributed to reductions in R&D, wages, capital investment, or layoffs of blue-collar personnel.

– Overall, the evidence is consistent with the view that MBOs are a useful mechanism for reducing agency costs and enhancing economic efficiency.

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Private Equity and Jobs

• UK Evidence: MBOs in the U.K. and the Netherlands found higher levels of employment, employee empowerment, and wages– Summary of findings here: Wright, M., M. Jensen, D.J. Cumming,

and, D. Siegel,, 2007. “The Impact of Private Equity: Setting the Record Straight” Corporate Financier, Issue 94 (July/August 2007) pp. 5-7. http://www.nottingham.ac.uk/business/cmbor/impact.pdf

• US Evidence: consistent– Steve Davis, John Haltiwanger, Ron Jarmin, Josh Lerner and Javier

Miranda “Private Equity and Employment” (2008 Working Paper, HBS).

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http://www.nottingham.ac.uk/business/cmbor/impact.pdf


Even if you did believe in “locusts”...

• Making LBOs illegal is not a good idea, as the Italian case shows

• Cumming and Zambelli (2010 JBF, 2013 JBF)• PE funds make these deals anyway• Deals are less efficient in terms of contracting and

structuring• Deals perform worse

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Do VC Contract Facilitate Investor Effort?

• Contract terms between VCs and entrepreneurs were driven by agency considerations (Chapters 2, 10-13)

• But in practice do contract terms actually matter to advice, monitoring and conflicts between the investor and investee?

• This issue is empirically considered in Chapter 15

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How Important is Home Bias?

• Stross, Randall, “It’s not the people you know. It’s where you are.” The New York Times, 10/22/2006.– “Venture capital is not about the people you know

but rather where you are: “FIBRE networks cross the world. Data bits move at light speed. The globe has been flattened, and national boundaries obliterated. Yet…physical distance is very much on the minds of the investors who provide venture capital.”

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Evidence on Home Bias

• US evidence: Chapter 16– Larger venture capital firms, older venture capitalists,

and venture capitalists with more previous investment experience exhibit stronger local bias.

– Two-sided selection process in venture capital markets (entrepreneurs chose their investor, and investors chose their entrepreneurs).

– Distance matters for the eventual performance of venture capital investments, in that local investments tend to perform better.

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Home Bias in the Venture Capital IndustryThis table summarizes the percentage of same state investments by venture capitalists in the over the period 1980-2000.

(Source: Cumming and Dai, 2007)

US State

Percentage of Investments in the

Same State US State


Same State US State


Same State

Idaho 87.70% Tennessee 53.05% New Mexico 35.75%

Vermont 86.61% Kentucky 50.75% Delaware 33.91%

South Carolina 71.81% Colorado 50.47% Maryland 32.34%

Maine 70.54% Georgia 50.21% New Jersey 30.11%

North Carolina 65.46% Nebraska 50.08% New York 28.86%

California 64.50% Montana 47.21% Illinois 28.19%

Hawaii 64.30% Pennsylvania 46.35% Alabama 26.98%

Rhode Island 61.57% Virginia 45.78% Kansas 26.87%

Massachusetts 60.13% Texas 45.69% Michigan 25.42%

Washington 58.86% Ohio 43.82% Iowa 25.30%

Arizona 56.77% Connecticut 42.89% Arkansas 24.09%

Minnesota 56.34% Louisiana 40.72% Montana 23.90%

Oregon 56.18% Washington DC 39.58% West Virginia 10.33%

Utah 55.97% South Dakota 38.70% Wyoming 3.60%

New Hampshire 54.86% Indiana 38.03% Nevada -3.32%

Wisconsin 54.81% Florida 35.96% Mississippi -19.27%

Oklahoma 54.68% 16


Portfolio Size

• # Investees / Manager should be important to value-added provided by investor– Theory: Kanniainen and Keuschnigg (2003, 2004),

Keuschnigg (2004), and Bernile et al. (2007)

• Chapter 15: evidence on effect of portfolio size / manager on investor effort

• Chapter 17: determinants of portfolio size

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Fund Size

• Do Larger Funds Pay More (pre-money valuation)?

• Do Larger Funds Perform Worse?

• Some insights in graphs next slides• … more in Chapter 18

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Pre-Money Valuations and Venture Characteristics

Pre-Money Valuation and Market Conditions

Pre-Money Valuation and Fund Characteristics

Fund Size and Portfolio Size

Fund Size and Portfolio Diversity


Investment Duration

• Length of VC investment suggestive of how much effort and certification provided by the investor– Megginson and Weiss (1991 Journal of Finance) “Venture

Capitalist Certification in Initial Public Offerings”– Find longer VC investment duration implies less IPO

underpricing

• More in Chapter 20: Duration depends on benefits and costs of maintaining the investment in the portfolio

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Conclusion / Summary

• VC and PE funds get significant cash flow and control rights (Chapters 10-13)• Important that they provide not just money, but also something more in terms of

value-added• Evidence on causality in value-added is mixed, as reviewed in this chapter

• Proxies for value-added include– Advice, Monitoring, Conflict (Chapter 15)– Location (Chapter 16)– Portfolio Size (Chapter 17)– Fund Size (Chapter 18)

– Duration (Chapter 20) also proxies effort, and of course directly tied to exits, the subject of Chapters 19-22

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