For allocators, more venture capital firms investing in the same company is a good thing.
New research shows that additional VC investors can increase the transparency — and reduce the potential manipulation — of company valuations. This is especially true when venture capital firms operate near one another, and when their investors are also local.
These are the findings of a recent Purdue University study conducted by Shrijata Chattopadhyay, a finance Ph.D. candidate. Her work comes at a time when private equity firms’ valuation practices are under the microscope.
Allocators’ recent public market losses have yet to translate into their private market investments, thanks to a lag in investment reporting, as well as the view held by some that valuation processes are more of an art than a science.
Venture capital funds in particular invest in new, innovative companies that are difficult to value. As Chattopadhyay noted in her paper, this leaves reported valuations up to a fund manager’s discretion. However, the presence of fellow investors can reduce that discretion.
“Syndicate partners can act as peer monitors and reduce misreporting by funds,” the paper said. “First, they can limit the GPs’ discretion in valuing their portfolio companies by being another source of valuation for these illiquid assets. Second, syndicate partners can highlight discrepancies in [the] reported valuations, prices, capital structure, and ownership structure of the portfolio companies to the LPs.”
Chattopadhyay used data from VentureXpert’s private equity investments module, the Preqin cash flow database, and the Preqin limited partners commitment database for the research. She restricted the data to funds with vintage years from 1985 to 2016, noting that data before 1985 is sparse, while data beyond 2016 doesn’t include a long enough history of performance data. The total analysis covered 1,344 venture funds from 534 firms.
To measure manipulation, she calculated the absolute value of the decline in net asset value that is not accounted for by net cash outflows from the fund. On average, the research showed that average portfolio manipulation is 1.32 percent. The author noted that in market run-ups — such as the dotcom bubble — there was a spike in portfolio value manipulation.
When a new syndicate partner joins a fund, it reduces performance manipulation by 49 basis points. According to the author, a company’s updated valuation resulting from the new fundraise does not entirely explain this reduction. In follow-on fundraises, the effect is similar: New syndicate partners reduced manipulation by 31 basis points, according to the paper.
The issue of manipulation, importantly, isn’t just one of inflating asset valuations. According to the author, some established funds may mark down investments earlier than they should, reporting conservative net asset values. The presence of more GPs lowers this “downward bias,” leaving LPs with more investment transparency.
The research showed that more established firms, measured by fund rank and age, lead to a greater reduction in manipulation. The same is true for syndicate partners that are closer geographically. According to the author, this is likely because they may interact with each other more frequently, and they may also approach the same limited partners.
“The results highlight [the need for] LPs [to] better monitor VC funds with fewer syndicate-partners,” according to the paper. “Currently, the responsibility of allocating investors’ money lies [with] the LPs, and the LPs have been shown to have limited ability in picking funds that outperform their peers. My findings suggest that LPs should pay more attention to performance measures of VC funds with fewer syndicate partners before investing in their follow-on funds.”