Advanced economies are ever more dependent on innovation and entrepreneurship for their sustained growth (Bottazzi, Da Rin, and Giavazzi (2001), OECD (2001), Scarpetta et al. (2000)). The literature on venture capital increasingly recognizes the importance of venture capital as a specialized form of intermediation suited to support the creation and growth of innovative companies (Hellmann and Puri (2000), Kortum and Lerner (1998)). Yet, we know very little about what forces determine venture capital investment. This is an important issue for economists, as our understanding of how this specialized form of intermediation generates growth, while increasing, is still limited. Research on the economics of venture capital has substantially advanced in recent years. In particular, we are now starting to comprehend how venture financing provides control and support services to innovative companies (Bottazzi, Da Rin, and Hellmann (2003), Casamatta (2003), Landier (2002), Lindsey (2003), and Schiendele (2003)). However, we are still far from grasping how venture capital’s contribution to unfolding the growth potential of individual firms translates into economic growth.
Understanding what drives venture capital investment is obviously relevant for policy, too. To the extent that growth depends on innovation and creative destruction, one could think of fostering productivity by channeling more funds into venture financing of technologically innovative companies. This reasoning has in fact held sweeping influence on the way policy-makers think and act to support technological innovation. In the 1980s it influenced the pioneering Small Business Innovation Research (SBIR) programme in the US (Gans and Stern (2003), Lerner (1999)). Over the last decade, it inspired policies in Europe and in emerging economies. In 2001, for instance, the European Commission transformed the European Investment Fund (EIF) into Europe’s largest venture investor (EIF (2002)), making the increase of the supply of risk capital one of its priorities (European Commission (1998, 2003). Large programmes aimed at fostering venture investing have been implemented in Canada, France, Germany, Israel, Sweden, and the UK, among other countries (see Avnimelech and Teubal (2003), Ayiayi (2002), Cornelius and Isaksson (1998), French Ministry of Industry (2003), German Federal Ministry for Economics and Technology (1999)). Public programmes aimed at venture capital have also been implemented in several emerging economies (Carter, Barger, and Kuczynski (1996), Lerner and Schoar (2003)).
The economics foundations for these policies are however still unchecked. While the mentioned studies suggest that venture-backed companies may be particularly innovative and dynamic, it remains to be seen whether more funds would translate into more high-growth companies. Theory warns about the value reducing effects of increasing the supply of funds to the venture capital industry when competition for good projects is high (Inderst and Müller (2003)). In such an environment, promoting innovation by increasing research and development (R&D) expenditure would be more effective than stimulating the funding of the venture capital industry. Recent empirical work also casts doubts on the possibility of applying Say’s law to finance. Looking at US sector-level data, Hirukawa and Ueda (2003) argue that, at the aggregate level, it may be innovation activity to lead the development of venture capital, and not vice versa. Gompers and Lerner (1998) emphasize the role of demand factors such as R&D expenditure in the development of the US venture capital industry. Some casual empiricism also suggests the relevance of demand factors: the first venture capital firm was founded in 1946 in the US to exploit new technologies developed during World War II (Gompers (1994)).
In this paper we contribute to the economics of venture capital by investigating what drives the structure of private equity investment. Private equity is a broad class of investments in unlisted companies which consists of two main segments: venture capital–investment in entrepreneurial companies at early stages of development–and non-venture private equity–management buy-outs (MBOs), turnaround, and other forms of restructuring of established companies. We proceed in two steps. First, we provide a simple theory of how demand and supply factors affect the structure of private equity investment, defined as the distribution of financing between venture capital and non-venture private equity, and between early stage and late stage (and high-tech and low-tech) venture capital investements. We believe our model is the first to provide such analysis, which extends the seminal article of Holmstrom and Tirole (1997) mainly by accounting for the possibility of an excess supply of funds.
As in the original model, firms are heterogeneous in their ability to pledge collateral against borrowing. We also assume that this ability is higher for firms that possess (relatively) more tangible assets, which are accepted as collateral more often than intangible assets. As firms mature from start-ups to late stage ventures, they make larger use of tangible assets. This creates a ’pecking order’ in firms’ ability to pledge collateral against loans.
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