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Venture capital distributions: short-run and long-run reactions

This paper examines stock distributions by US venture capital firms back to their institutional investors. This is a unique environment in which transactions by informed insiders are exempt from anti-fraud provisions. Here, Josh Lerner and Paul Gompers of Harvard Business School, investigate this legal form of ‘insider trading'.

Investors in private equity funds need to be aware of the issues surrounding stock distributions. Many successful venture-backed companies eventually go public by way of an IPO. Venture capitalists can liquidate their investment by selling shares on the open market and distributing the cash proceeds back to their limited partners. Alternatively, and more frequently, the venture capitalist can distribute the actual shares of the company directly to their limited partners.

Why are these ‘distributions in kind' becoming a more popular form of returning investment? And why should institutional investors be aware of their impact?

It is said that this type of distribution provides limited partners with the flexibility to make their own decisions about selling the stock. There are examples of stock distribution values increasing rapidly on the public markets thereby substantially increasing the limited partners return. Unfortunately, it is more often the case that the stock decreases in value post-distribution, causing a discrepancy in the fund's stated returns and actual returns recorded by the limited partners.  Stated returns are calculated using the closing price of the distributed stock on the day it is declared. If the stock price declines, then the actual price received when the distributed stock is sold may be much lower, resulting in a discrepancy.

In addition, venture capitalists' compensation - carried interest - can be affected by a firm's distribution policy. If the fund has not yet fully distributed committed capital back to its limited partners, then the distribution of over-valued stock has a big impact on stated returns and can take them closer to the point that they can collect a share of the profits.

Few SEC regulations cover distributions by venture capitalists.  Here, Lerner and Gompers present a thorough analysis of the issues, concluding that venture capitalists use inside information to time stock distributions.

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This article first appeared in the Journal of Finance, Vol. LIII, No 6, December 1998 published by Blackwell Publishers

Paul A Gompers is a widely published professor of business administration at the Harvard Business School, specialising in research on financial issues related to start-up, high-growth and newly public companies. His research covers the structure, governance and performance of private equity funds and the relationship between institutional investors and private equity fund managers. Personal Homepage 

Josh Lerner is a prominent academic in the field of venture capital and private equity. His research is highly regarded and widely published and he is a regular speaker at industry conferences. He is an associate professor at Harvard Business School and serves as faculty chair of the Focused Financial Management Series at HBS, designing and teaching an annual executive course on private equity. His research is concentrated on the structure of VC organisations, and their role in transforming scientific discoveries into commercial products. Personal Homepage 
   
The Journal of Finance publishes leading research across all the major fields of financial research. It is the most widely cited academic journal on finance and one of the most widely cited journals in all of economics as well. Published six times a year, the journal is the official publication of The American Finance Association, the premier academic organisation devoted to the study and promotion of knowledge about financial economics. http://www.blackwellpublishers.co.uk

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