Ulrich Hege

Venture capital financing, moral hazard, and learning

We consider the provision of venture capital in a dynamic agency model. The value of the venture project is initially uncertain and more information arrives by developing the project. The allocation of the funds and the learning process are subject to moral hazard. The optimal contract is a time-varying share contract which provides intertemporal risk-sharing between venture capitalist and entrepreneur. The share of the entrepreneur reflects the value of a real option. The option itself is based on the control of the funds. The dynamic agency costs may be high and lead to an inefficient early stopping of the project. A positive liquidation value explains the adoption of strip financing or convertible securities. Finally, relationship financing, including monitoring and the occasional replacement of the management improves the efficiency of the financial contracting.

Venture Capital and Sequential Investments

We present a dynamic model of venture capital financing, described as a sequential investment problem with uncertain outcome. Each venture has a critical, but unknown threshold beyond which it cannot progress. If the threshold is reached before the completion of the project, then the project fails, otherwise it succeeds. The investors decide sequentially about the speed of the investment and the optimal path of staged investments. We derive the dynamically optimal funding policy in response to the arrival of information during the development of the venture. We develop three types of predictions from our theoretical model and test these predictions in a large sample of venture capital investments in the U.S. for the period of 1987-2002. First, the investment flow starts low if the failure risk is high and accelerates as the projects mature. Second, the investment flow reacts positively to information that arrives while the project is developed. We find that the investment decisions are more sensitive to the information received during the development than to the information held prior to the project launch. Third, investors distribute their investments over more funding rounds if the failure risk is larger.

Workouts, court-supervised reorganization and the choice between private and public debt

This paper investigates the interaction between creditor structure and reorganization law. Private debt offers the advantage of flexible renegotiation out of court. Due to incomplete information and holdout incentives, the out-of-court renegotiation will typically fail for dispersed public debt. The introduction of Chapter 11-style renegotiation will benefit public debt firms and will be harmful for private debt firms. Moreover, Chapter 11 reduces the role of private debt in corporate borrowing in accordance with the US experience. The overall efficiency of a reorganization law is therefore ambiguous. Three prominent shortcomings of Chapter 11--its cost and delay, equity deviations and inefficient continuation--are shown to do little harm or even shown to be welfare-improving as they increase the incentives to renegotiate debt out of court and choose private debt. The effect of a low-cost reorganization procedure is more likely to be positive in a market-based financial system.

Equity and Cash in Intercorporate Asset Sales: Theory and Evidence

We develop a two-sided asymmetric information model of asset sales that incorporates the key differences from mergers and allows the information held by each party to be impounded in the transaction. Buyer information is conveyed through a first-stage competitive auction. A seller with unfavorable information about the asset accepts the cash offer of the highest bidder. A seller with favorable information proposes a take-it-or-leave-it counteroffer that entails buyer equity. Thus, the cash-equity decision reflects seller, but not buyer, information in contrast to the theoretical and empirical findings for mergers. The central prediction of our model is that there are large gains in wealth for both buyers and sellers in equity-based asset sales, whereas cash sales generate significantly smaller gains that typically accrue only to sellers. Our empirical results are consistent with the predictions of our theoretical model.

The Law and Finance of Venture Capital Financing in Europe: Findings from the RICAFE Research Project

This survey article summarises the findings of four research projects on the venture capital industry in Europe and the role played by legal institutions and the legal framework. A study on patent litigation insurance argues that insurance can create a level playing field for small innovators, but that compulsory insurance can only be justified as a transitory scheme. The second study argues that intermediaries from countries with a better legal tradition will provide more governance and value-added services, even when investing abroad. It also provides supportive empirical evidence based on an extensive questionnaire study. The third project investigates the relationship between venture investments and a widely used legality index in thirty-nine countries, finding that better laws facilitate faster deal screening and origination, lead to a higher probability of syndication and also facilitate board representation of the investors. The final study documents a significant performance gap between the European and the US venture capital industry, but argues that the difference can not be attributed to differences in legal origin.

The role of insurance in the adjudication of multiparty accidents

This paper considers the case where adequate negligence standards cannot be defined because actions of defendants before an accident are imperfectly observable. Negligence-based liability rules, which are often considered as the only efficient liability rule in the presence of multiple tortfeasors, are not feasible in this environment. We propose an insurance-based liability rule as a remedy: Damages are apportioned according to the insurance policies of the defendants. The adjudication is made dependent on the requirement that the injurers have taken out insurance coverage setting the right incentives. The liability rule is easy to characterize, efficient, and avoids the use of punitive damages. Insurance-based liability could also be helpful to mitigate the problem of unobservable avoidance costs.

Are Novice Private Equity Funds Risk-Takers? Evidence from a Comparison with Established Funds

This paper explores whether private equity firms that are new to the industry take excessive risks relative to funds from established firms. We use differences between the implicit incentives of managers of experienced and of novice funds as an identification strategy. We find that novice funds invest more slowly than experienced funds, contradicting the risk-taking hypothesis. However, the size of their investments, in value and as fraction of fund size, is larger; this could be consistent with risk-shifting by novice funds but also with alternative hypotheses. We find that the size difference increases over time and is absent from buyout investments. We also find that novice funds tend to underperform most dramatically for early large investments, and that the size of their investments increases after a first successful exit. These and other findings are in conflict with the excessive risk-taking hypothesis, but largely consistent with alternative explanations that emphasize differences in expertise.

Blockholders and Leverage: When Debt Leads to Higher Dividends

This paper explores the use of leverage in pyramids and its relationship to dividend policy. The use of leverage in holding companies widens the disparity between control rights and cash flow rights. We postulate that it also leads to more generous dividend payouts since dividends are needed to service debt in the holding companies. We analyze a comprehensive sample of French pyramidal structures. Consistent with our hypothesis, we find that dividend payouts increase in the disproportionality between control and cash flow rights that is explained by holding company debt. By contrast, disproportionality generated by holding company equity leads to lower payouts. Servicing debt in the holding companies of a pyramidal structure is the primary motive for dividends, as opposed to alternative explanations such as investments or dividend preferences. Finally, the combination of high leverage in holding companies and high dividends negatively affects firm value, consistent with the hypothesis of tunneling by dominant owners.

The Private Equity Secondaries Market During the Financial Crisis and the 'Valuation Gap'

The authors analyze the performance of the private equity secondaries market during the recent financial crisis. They show that the effective market liquidity contracted severely in early 2009 to only a fraction of earlier volume. They suggest a behavioral explanation for the puzzling phenomenon of the valuation gap, the widening gulf between seller and buyer valuations, based on framing and loss aversion. They argue that the particular form of illiquidity in the secondaries market can be best understood as the cumulative effect of these behavioral effects and accounting-based elements. The article documents the quick recovery of the secondaries market that showed no signs of more protracted turbulences than the stock market. The available evidence indicates that the liquidity and the relative resilience of the secondaries market are efficient.