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1 April 2018 CFA Institute Journal Review

Skin in the Game: General Partner Capital Commitment, Investment Behavior and Venture Capital Fund Performance (Digest Summary)

  1. Marla Howard, CFA
Exploring the incentive effect of managerial ownership, the authors find that general partner (GP) capital commitment in the Chinese venture capital (VC) sector is positively related to fund performance. Investment behavior—measured by specialization, distance of investments from a VC office, and speed of investment—has an inverted U-shaped relationship with GP ownership. The monitoring intensity of limited partners also influences GP behavior.

What’s Inside?

In the authors’ sample of Chinese venture capital (VC) funds, performance improves with greater general partner (GP) capital commitment. Increased GP capital commitment affects investment behavior, but the behavior changes at 11%–14% GP ownership. Before this inflection point, the increased effort by GPs dominates the risk considerations, but as GP ownership increases, risk aversion causes managers to be more cautious with their investment decisions. The impact of GP ownership on investment behavior is more pronounced when there is less monitoring by limited partners (LPs). The authors argue that their findings might be generalizable to other markets.

How Is This Research Useful to Practitioners?

The authors report that GP ownership has an inverted U-shaped relationship with time to investment, distance of portfolio firms from the VC office, and the degree of industry specialization. With up to 11%–14% GP ownership, the managers exert more effort in finding and seizing investment opportunities, even when an opportunity is geographically distant. Increased GP ownership also leads to more specialization, with managers seeking to differentiate themselves from and outperform competitors in a specific sector. In addition, results show that institutional LPs prefer specialization.

As GP ownership increases beyond 14%, the investment behavior becomes more conservative. Risk considerations may influence GPs to choose local investments, to devote more time to due diligence, and to pursue diversification of investments.

The authors expect that stronger performance should result from the greater effort, quicker reaction to opportunities, and specialization that comes with increases in GP capital commitment. They find that greater GP capital commitment is associated with higher fund performance, but the relationship is linear.

Dividing the sample by LP ownership concentration, the authors find that GP ownership significantly affects investment behavior when LP ownership is dispersed but does not demonstrate a significant effect in the more concentrated LP ownership subsample. They also divide the sample according to busy and non-busy LPs and find that the GP ownership effect on investment behavior is significant when LPs invest in several funds simultaneously. Capital commitment has more impact on GP behavior when there is less LP monitoring.

With a deeper understanding of the role of GP ownership on fund performance, LPs can negotiate the terms of GP ownership as an incentive for better investing and stronger performance in their VC investments.

How Did the Authors Conduct This Research?

The authors take advantage of the unique disclosure requirements for VC limited partnerships in China. The data used are from a research institute for China’s VC industry. The effect of the partnership structure on investment behavior and fund performance is examined for 115 Chinese VC funds established between 2007 and 2011.

Using regression of GP ownership on investment behavior (measured by speed of investment, investment distance, and industry specialization) and adding a squared term of GP ownership to capture the nonlinear relationship, the authors find that GP capital commitment has an inverted U-shaped relationship with investment behavior. They also conduct a regression of GP ownership on fund performance, again using a squared term for GP ownership. Fund performance, measured by the proportion of portfolio companies with successful IPOs and trade sales, increases with GP capital commitment. The authors confirm the previously documented evidence that managerial ownership can align GP interests with those of investors.

The authors note that the small sample size and specific geographical region are limitations of their work. Nevertheless, to make the results relevant for other markets, they control for fund characteristics that differ between US and Chinese VC funds, including the size of the funds and the composition of LPs, with US funds having a greater number of institutional investors. The results of the Chinese VC sample are not driven by fund size or institutional investor ownership.

Abstractor’s Viewpoint

Although the dataset used is small and geographically limited, the authors offer support that investment behavior and fund performance vary with GP ownership. Extending the research geographically may not be feasible because of the scarcity of available information on VC funds. Also, one might question how government involvement in Chinese business affects GP behavior, financial reporting, and fund performance. Furthermore, because performance is measured by fund exit ratios, comparing the process of mergers and acquisitions and IPOs in China with those in countries with a longer history of free capital markets would be useful.

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