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E-MailBibo Liu is Assistant Professor at PBC School of Finance, Tsinghua University; Xuan Tian is Associate Professor of Finance at Indiana University. This post is based on a recent paper authored by Professors Liu and Tian.
Is the stock market just a sideshow or does it have real effects on economic activities? Conventional wisdom believes that stock prices merely reflect expectations about future cash flows. However, a growing strand of literature challenges this traditional view by arguing that financial markets as a whole have the ability of aggregating different pieces of information possessed by various market players and incorporating them into security price, which could be used to guide managers’ and investors’ real decisions.
Our paper, entitled Is the Stock Market Just a Side Show? Evidence from Venture Capital, aims to answer the above question from a different angle by providing new evidence and examining the relation between VC fund managers’ investment structure, i.e., staging (the stepwise capital infusions from VC investors to entrepreneurial firms) and syndication (the co-investment of VC investors in entrepreneurial firms), and the information they are able to learn from public market stock prices. VC is an ideal setting to test the real effects of financial markets, because 1) VC fund managers have great incentives to learn from the market because their investment in early-stage ventures are characterized as being full of information asymmetry; 2) VC staging and syndication provide a variety of dimensions that allow us to better understand how the information learnt from the public market affects VC fund managers’ investment decisions; and 3) we explore the effect of public market stock price informativeness on VC investments in private ventures, mitigating the concern that venture- or VC-related information is reflected into stock prices.
Our baseline tests show that public market stock price informativeness, proxied by price nonsynchronicity, significantly affects the staging and syndication of VCs. Specifically, if the stock prices of public firms in the same industry of the venture are more informative, VC fund managers finance a venture with a smaller number of financing rounds, with more money invested in the first round, increase round amount, and co-invest with fewer other VCs. Our finding is consistent with the conjecture that VC fund managers learn from public market equity prices and respond by altering the structure of their investment in startup ventures to avoid the costs associated with staging and syndication.
We use two empirical strategies to tackle the potential endogeneity concerns and obtain results consistent with our baseline tests. Our first strategy is to construct an instrumental variable and use the two-stage least squares (2SLS) analysis. The instrument is based on the rationale that airport shutdowns due to extreme weathers or operational difficulties prevent financial analysts’ timely on-site visits to the firms covered by them, which reduces these firms’ stock price informativeness because financial analysts are active information producers about the firms. We also undertake a bunch of robustness checks in the 2SLS framework and ensure that our results are robust to alternative proxies that capture stock price informativeness.
Our second empirical strategy tacking the endogeneity concerns relies on a regulatory change on short-selling constraints, Regulation SHO, which removes the uptick rule restriction for a randomly selected group of Russell 3000 firms (pilot firms). This sudden regulatory change provides a quasi-natural setting that alters short selling costs. To the extent that short sellers, a group of investors who actively collect various pieces of information about the firms, positively contribute to stock price informativeness, Regulation SHO makes stock prices of pilot firms more informative. We find generally consistent results in this setup.
We next explore the heterogeneous effects of stock price informativeness on VC investment structure. We first explore how VCs’ experience alters our baseline results. We distinguish VCs’ industry-specific experience from their general experience, and find if VCs are more experienced in the venture’s industry, they rely less on the information contained in the public market. In contrast, VCs’ general experience does not help them in specific industries to the same extent of their industry expertise.
Our second heterogeneous test explores how physical distance between VCs and their venture firms alters our main results. Our evidence suggests that, if monitoring and information collection become less costly due to close proximity, VCs rely less on the information contained in public market stock prices, and the effect of stock price informativeness is less pronounced.
Our last heterogeneous test explores how the riskiness of VCs’ investment deals (startup ventures) alters our main results. We find that when making investment in risky ventures from research and development (R&D) intensive industries and in early stages, VC fund managers are more likely to stick to costly but powerful monitoring tools, such as staging and syndication, and rely less on learning from public stock prices.
In the final part of the paper, we explore a “bottom line” question: how do VCs’ learning from public markets and investment structure decisions affect their investment outcomes? We find evidence that, while VC staging and syndication increase ventures’ successful exit probability, as documented in earlier studies, these effects are stronger when public stock prices are more informative. Hence, if VCs can learn information from public stock prices more effectively, they rely less on costly stage financing.
In this paper, we have examined the real effects of financial markets from the perspective of VC investors, an important market player that promotes entrepreneurship. We find that VC investors actively learn information from public market stock prices when making their investment structure decisions. The information they acquire from the public market also affects the performance of their investment. Our paper sheds new light on the real effect of financial markets by showing that private equity investors actively learn information from public equity market prices.
The full paper is available for download here.
