Vulture or venture? These VCs are all right

A study looks at the contributions of "high-quality" investors from among a community that often are held in some disrepute.


CFOworld –

To many in the business community they are "vulture capitalists," not venture capitalists. VCs -- their critics contend -- seize opportunities improperly, and exploit the weaknesses they detect in people they are dealing with. But a recent study at Northwestern University Kellogg School shows some in a more favorable light, suggesting that "high-quality VCs" can substantially improve financial reporting in the critical period surrounding an IPO, for example.

The study, by Wan Wongsunwai, defines a high-quality VC as having the ability to exercise influence over managerial behavior at the private companies they are transforming. His research attempts to distinguish them from VCs lacking that ability. Still, trying to measure the quality of VCs is hardly straightforward, he says.

While previous research attempted to use VC financial performance as a measure of quality, this researcher says that approach was complicated by difficulties in obtaining accurate information. VCs, it seems, often are required to disclose this information only to their investors --- not outsiders at places like Kellogg.

One method of analysis Wongsunwai uses looks at syndication activity: how many times a VC attracts investors in a project, and how VCs are perceived by peers. "The idea is, VCs will know who the better ones are amongst themselves," Wongsunwai told Kellogg Insight. "If we see a successful VC going to syndicate often with another VC, chances are they think that other VC is a quality VC."

Wongsunwai also focuses on how VCs impact two kinds of earnings management: real earnings manipulation -- such as when a company, nearing the end of a quarter, postpones a marketing campaign, to meet earnings expectations -- and accrual-based manipulation, a form of "cooking the books." According to the researcher, "The problem with (real earnings manipulation) is that it has implications for long-term future performance. If I cut down on my marketing today, I am likely to make fewer sales tomorrow." In accrual-based manipulation, "you go ahead and do the marketing activities as planned, but you misreport it. Instead of saying that you spent $20 on marketing, you use some accounting tricks to make it look like it is only $5. There are many ways companies can do this kind of thing."

He uses Thomson Financial's Venture Economics database to identify 1,226 VC-backed companies that conducted IPOs between 1990 and 2004, together with the names of the VCs who provided first-round financing. Companies backed by higher-quality VCs, he finds, engaged in less aggressive financial reporting, as reflected in lower abnormal accruals and lower real activities manipulation.

"This research is about why people do the things they do," Wongsunwai explains. "If people running a company have their wealth tied to the price of the company stock, they will resort to a lot of ways to keep the stock prices as high as they can." If companies are trying to inflate prices, "the VCs might be tempted to let their monitoring role lapse a little bit," he points out, because if stock prices go up, the VC benefits as well. The highest-quality VCs though, have a counter-incentive: their reputations. "If VCs don't have the skills needed to influence managerial decisions, or if they choose not to apply their skills at the time their companies are going public," he concludes, "then we will see negative consequences."

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