Venture Capital Contracting and Syndication: An Experiment in Computational Corporate Finance

This paper develops a model to study how entrepreneurs and venture-capital investors deal with moral hazard, effort provision, asymmetric information and hold-up problems. We explore several financing scenarios, including first-best, monopolistic, syndicated and fully competitive financing. We solve numerically for the entrepreneur's effort, the terms of financing, the venture capitalist's investment decision and NPV. We find significant value losses due to holdup problems and under-provision of effort that can outweigh the benefits of staged financing and investment. We show that a commitment to later-stage syndicate financing increases effort and NPV and preserves the option value of staged investment. This commitment benefits initial venture capital investors as well as the entrepreneur.

Agency conflicts in financial contracting with applications to venture capital and CDO markets

Thesis (Ph. D.)--Massachusetts Institute of Technology, Dept. of Economics, 2005.Includes bibliographical references.In these papers I examine efficient financial contracting when incentive problems play a significant role. In the first chapter (joint with Z. Fluck and S. Myers) we focus on the venture capital industry. We build a two-stage model capturing moral hazard, effort provision, and hold-up problems between entrepreneurs and investors. Across multiple financing scenarios we solve numerically for optimal decision policies and NPV, finding significant value losses from first-best. A commitment to competitive syndicate financing increases effort and NPV and benefits all parties. However, syndicate financing raises potential information problems, and the fixed-fraction participation rule of Admati-Pfleiderer (1994) fails with endogenous effort. We find that debt financing is often less efficient than equity financing, for while it improves effort incentives it worsens hold-up and debt overhang problems in later-stage financing. In the next chapter I turn to the collateralized debt obligation or "CDO" market. CDOs are closed-end, actively-managed, highly leveraged bond funds whose managers typically receive subordinated compensation packages. I develop a model of manager trading behavior and quantify under-investment and asset substitution problems, calibrating to market parameters.(cont.) Compared to prior studies, I find similar value losses to senior investors and significantly higher increases in debt default risk and spread costs. However, for even extremely conservative effort assumptions, the ex-ante benefit of greater effort incentives outweighs risk-shifting costs, rationalizing observed contracts. I also analyze the ability of various payout policies and trading covenants to curtail risk-shifting. Excess interest diversions, contingent trading limits, and coverage test "haircuts" of lower-priced assets are effective measures and increase allowable leverage and equity returns. In the final chapter I examine the empirical relationship between CDO trading, manager compensation, and fund performance from 2001-2004. Using a large panel data set, I find a statistically significant relationship between trades which add volatility to the portfolio and the level of subordinated manager compensation. Worse deal performance increases risk-shifting behavior so long as subordinate investors are still in-the-money. Tendencies to group trades and the effect of managerial reputation are also considered.by Kedran R. Garrison.Ph.D