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E-MailGordon Phillips is C.V. Starr Foundation Professor of Finance and faculty director of the Center for Private Equity and Entrepreneurship at Dartmouth College Tuck School of Business; Alexei Zhdanov is Assistant Professor of Finance at Penn State University Smeal College of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes: Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups by Jessie Fired and Brian Broughman (discussed on the Forum here).
In this paper, we investigate what happens to venture capital investments when M&A activity is regulated. The paper studies the interaction between venture capital (VC) activity and M&A activity in 40 different countries around the world. Venture capital funding is important to many small innovative firms, allowing them to survive and prosper. In this paper, we study the interaction of the merger market with venture capital in a sample of 48 countries around the world. We argue that active M&A markets promote innovation investments and make it easier for venture capitalists to monetize their investment by selling their portfolio companies to potential acquirers. We examine VC investments following M&A activity and also VC investments subsequent to passage of pro-takeover and anti-takeover legislation. While mergers of firms that are horizontally competing may indeed reduce innovation, general policies where a large firm is prevented from buying a smaller firm may have deleterious effects on the ex ante incentives to conduct R&D by the smaller firm, as has been emphasized by Phillips and Zhdanov (2013). This argument is further supported by Bena and Li (2014), who show that large companies with low R&D expenditures are more likely to be acquirers, and argue that synergies obtained from combining innovation capabilities are important drivers of acquisitions.
The initial idea for this paper came from an interesting story told to us by a venture capitalist in France. The venture capitalist had arranged for a sale of a company, in which he had invested, to IBM. However, he was having a hard time getting the deal to close. Both parties were willing. It was the French government that put hurdles in front of the deal. The country has laws and regulations that made acquisitions of French firms difficult. The government’s fear was that too many mergers and acquisitions would lead to industry consolidation, which would have deleterious effects on competition. However, such laws sometimes have unintended consequences. “It’s the last investment I’ll ever make in France,” the venture capitalist told Phillips.
Most venture capital investments are made with one of two expectations in mind: that the company receiving the VC funds will either go public via an initial public offering (IPO), or that it will be acquired by a larger company. IPOs were once a hot exit strategy, but increasingly less so. A company is more than six times more likely to be acquired than it is to go public over the period we analyze – and exit via strategic sale is even relatively more likely than exit via IPO today. This fact makes M&A regulations, which tend to make acquisitions more difficult, an increasingly important factor that venture capitalists consider in deciding where to invest. The overall logic is that if companies have a decreased chance of being acquired by bigger companies, the venture capitalist may not have fund it, because they know they selling it is much more difficult. We test this logic, through a series of statistical analyses that examines VC investments surrounding legal changes to the M&A market, and find it to be true.
The central challenge of correlating VC investments and M&A activity is controlling for outside forces on these activities, such as demand shocks and technological changes. To do this, we perform three analyses: correlating cross-border M&A activity with local currency depreciations; examining the effect of country-level pro-takeover legislation on subsequent VC activity; and examining the effect of state-level anti-takeover business combination laws on VC investments in U.S. states that enact the laws. In all three cases, there is a close connection between M&A activity and lagged VC investments.
The paper also examines the indirect impact of currency depreciations given depreciations make cross border acquisitions less costly, but currency depreciations may also mean the investment opportunities for VC may decrease. However, the paper’s results show that that currency depreciations result in more cross-country M&A deals. The increases in M&A activity, in turn, have a positive effect on the VC market. The paper also directly examines the impact of takeover acts—laws intended to reduce barriers to mergers and acquisitions—and finds that the laws had the desired effect – increasing M&A activity – and that they also stimulate VC activity. This pattern goes in the opposite direction as well: anti-takeover laws in U.S. states reduce M&A activity in these states, and they also have the indirect effect of slowing down VC investments.
Overall, the paper shows that M&A activity is linked to subsequent VC investment. Given venture capitalists have a lot of flexibility in where they will invest, they are more likely to put their money into the countries and states where exit through M&A is more likely.
The complete paper is available for download here.
