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ANALYTICAL BACKGROUND

This paper examines first–stage equity financing by venture capital firms in management buy–outs and buy–ins in the UK. It does not consider second or later stage financing (cf Lerner,1994, Admati and Pfleiderer, 1994) since it is relatively unusual in this type of investment. There are two major classes of theory which might explain the decision of venture capital firms to syndicate such first stage deals:

Risk sharing and risk avoidance – risk sharing through syndication is a means of avoiding risk (Wilson, 1968) and is an aspect of the diversification of its portfolio by the venture capital firm. The performance of a fund is a major factor in establishing and maintaining reputation and generating the ability to attract investors (Lakonishok, et al, 1991, Gompers, 1996). Syndication is a way through which the venture capital firm can seek to ensure that it does not seriously under–perform its rivals and hence jeopardise its fund–raising activities. However, funds that are performing relatively badly may have an incentive to increase the risk in an attempt to boost their performance (Chevalier and Ellison, 1995).

The decision to syndicate for risk sharing reasons will, therefore, depend on the utility function of the venture capital firm, the relative performance of its existing funds and future plans for new fund–raising. Hence, one might expect significant differences between venture capital firms in their propensity to syndicate and there is no clear relationship between e.g. the age of the fund and syndication (Lerner, 1994).

Superior selection of investments – a major insight was provided by the work of Sah and Stiglitz (1986) who specifically examined the efficiency of individual and joint decision–making within hierarchies and polyarchies. In particular, they showed that the selection of projects which are accepted only after agreement between 2 or more independent decision–makers may be more efficient that where the outcome depends on the judgement of a single decision–maker acting alone. Thus, the inclusion of one or more additional partners in a syndicate may be a means of improving project selection. Pence (1982) and Perez (1986) emphasise the importance of checking investment decisions against the accumulated expertise of other venture capital firms, which is achieved through syndication. It should be noted that there may be a venture capitalist who underwrites a deal, ie agrees to finance the project, but then syndicates it down. Kunze (1990) argues that the comparison of knowledge in this way gives real potential benefit in the case of first–stage financing, which does not necessarily hold for follow–up deals. Indeed, for second–stage financing incoming syndicate partners may be at an informational disadvantage compared to the initial venture capitalists. Admati and Pfleiderer (1994) provide a theoretical model to show that this contracting issue can be dealt with.

These two arguments are essentially complementary: the greater the degree of risk the greater the incentive to diversify and the greater the incentive to seek security in numbers through looking for support for the decision through syndication with others.

As Pfeffer and Salancik (1978) argue, the degree to which firms are inter–connected is a function of the amount of uncertainty in their environment. Syndication is one aspect of the interconnectedness of venture capital firms which involves both resource flows and the exchange of information across a network and the analysis of these networks forms part of this paper. Previous work by Bygrave (1987,1988) has shown that the links between venture capital firms are based on both a desire to spread financial risks and a need to share information to reduce uncertainty.

Empirically, therefore, the analysis suggests a model of the following form: Syndication = f(risk, characteristics of the venture capital firm, other control factors)

In addition to the econometric analysis, the extent of networking through syndication is examined as well as a consideration of the views of leading Chief Executives in the industry.

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