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FIIE-15: Private Equity and Venture Capital
Capital Gains Tax, Venture Capital and Innovation in Start-ups
1University of Exeter, United Kingdom; 2University of Cincinnati
We examine the effect of staggered changes in state-level capital gains tax rates on Venture Capital (VC)-backed start-ups and show that an increase in tax rates reduces patent quantity and quality. The results are consistent with a reduction in VC effort: VC-level tax increases lead to incrementally lower patent production by start-ups located out-of-state, and not linked by a direct flight to the VC investor. We also find evidence of a change in entrepreneurs' incentives: after a tax increase entrepreneurs decrease innovation risk, and stay invested for longer (the lock-in effect).
Value Creation and Persistence in Private Equity
1European Bank for Reconstruction and Development, United Kingdom; 2Darmstadt University of Technology; 3Stockholm School of Economics and CEPR
We study how private equity (PE) firms generate returns for their investors, by estimating the effects of PE funding on portfolio companies’ operational efficiency and market power. We confirm prior findings that PE funding leads to operational efficiency: both labor productivity and total factor productivity improve as PE-backed companies ramp up investment, employment, and sales. We find no evidence that PE-backed companies increase their market power. In fact, the PE-backed companies in our sample reduce their price markups by 6%, which allows them to gain substantial market shares. Using detailed confidential information obtained from inside PE firms, we show that the PE firms in our sample push for operational improvements and that these improvements are the main drivers of the returns investors receive from PE funds. We find that the majority of the operational improvements instigated by PE firms persist even after they fully exit their investments. These findings are consistent with PE firms’ ability to create long-lasting value as opposed to maximizing short-term returns at the expense of portfolio companies.
Volatility and Venture Capital
Tulane University, United States of America
The performance of venture capital (VC) investments load positively on shocks to aggregate idiosyncratic (cross-sectional) return volatility. I document this novel source of risk at the asset-class, fund, and portfolio-company levels. The positive relation between VC performance and volatility is driven by the option-like structure of VC investments, especially by VCs' contractual option to invest in subsequent (follow-on) rounds. At the asset-class level, shocks to aggregate volatility explain a substantial fraction of VC returns. At the fund level, consistent with the follow-on investment channel, this exposure is concentrated in years two through four of fund life and in early-stage VC funds, which have more embedded follow-on investment options. For VC-backed portfolio companies, volatility shocks correlate with faster and more frequent follow-on investment. The level of volatility at the time of initial investment has no relation with future performance, consistent with competitive markets. These results imply that the option-like features of VC investments are first-order determinants of risk in VC.
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