The smooth double Pareto distribution – A model of private equity returns

New working paper:

Whether returns of venture capital and private equity investments exhibit fat tails, particularly in the upper tail, affects how entrepreneurs and investors view the attractiveness of such investments. Using fund performance data, we propose and test a random growth model with a random initial valuation of funds to explain the observed distribution of funds’ residual-value and payout multiples. This model endogenously generates power-law tails in the cross-section from a lognormally distributed diffusion process and lognormally distributed birth valuation. We find that the resulting smooth double Pareto distribution fits the data better than competing lognormal or double Pareto models and generally performs well, apart from a small region around a valuation multiple of one. The divergence of the fitted distribution from the empirical one can be explained by an excess number of funds without distributions to investors – funds that may not have made or revalued any investments yet.

Available at SSRN:

Endogenous financial constraints and innovation

with Andrea Mina

Industrial and Corporate Change, 2020, full version available from the journal.

Abstract: We investigate which indicators of a firm’s innovation activities are associated with financial constraints and analyze the nature and direction of causal links between innovation and financial constraints. By estimating simultaneous bivariate probit models on data from the UK Innovation Surveys, we show that among innovation inputs, research and development (R&D) activity increases the likelihood that firms face financial constraints. Among innovation outputs, only new-to-market products generate financial constraints. Reverse effects on innovation appear limited to external R&D.

Early indicators of fundraising success by venture capital firms

with Timothy E. Trombley

Journal of Corporate Finance 65, full paper available here.

Abstract: In this paper, we show how a venture capital firm’s fundraising is affected by its investment choices. We investigate three leading indicators that are calculated from the types of investments the venture capital firms make: style drift investments, follow-on investments, and investments in which the venture capital firm is not the lead investor in the portfolio company. We find that these investment characteristics are associated with lower fundraising. Characteristics and the reaction of fundraising to characteristics are both moderately stable through time. We also find some evidence that information about investment characteristics is more important for fundraising during bad states of the world and that ex-ante characteristics are related to eventual exit outcomes and financial performance.

The impact of business accelerators and incubators in the UK

BEIS Research Paper Number 2019/009

with Jonathan Bone, Juanita Gonzalez-Uribe and Christopher Haley

  • The fast-developing ecosystem of accelerators and incubators has positive effects on startups and the wider economy.
  • Most startups (over 60%) consider the contribution of the incubator or accelerator they attended to have been significant or even vital to their success.
  • Of startups surveyed, 75% perceived direct funding as very useful, followed by office space (59%) and lab space or technical equipment (58%).
  • Our research revealed the large diversity of accelerator and incubator programmes in the UK, both in terms of support offered to startups and their impact.
  • Impact of such programmes is mainly generated by the direct funding offered through these programmes and help with the formation of entrepreneurial teams, although many other channels exist.
  • Our findings suggest levers for public policy to support startups in the UK through accelerators and incubators. However, there is no size that fits all because programmes often target specific types of startups.

The report is available from the Department for Business, Energy & Industrial Strategy.

The Pecking Order of Innovation Finance

with Andrea Mina; available at SSRN.

Abstract: This paper examines the relationship between firms’ innovation activities and the hierarchy of financing behaviours. We analyse the role of innovation inputs (R&D), intermediate outputs (patents) and outcomes (product and process innovations) as sources of information asymmetry in financing decisions. Our focus on mainly unlisted companies allows us to study the effects of information asymmetries in the context where they are most severe, that is, among small and medium sized firms. We identify the effect of innovation, alongside the size of the firm, its age and its human capital, on the order of directly observed external capital allocations. Our results show that innovation is negatively associated with the standard pecking order of increasing agency costs, and that the more uncertain the innovation signal, the stronger its effect on the pecking order.