Disciplining Delegated Monitors: When Venture Capitalists Fail to Prevent Fraud by Their IPO Firms

Abstract

Information-based theories of financial intermediation focus on delegated monitoring. However, there is little evidence on how markets discipline intermediaries who fail at this function. We exploit the direct link between corporate fraud and monitoring failure and examine how a venture capital (VC) firm’s reputation is affected when it fails to prevent fraud in its portfolio companies. We find that reputation-damaged VCs interact differently in the future with their limited partners, other VCs, and IPO underwriters because they are perceived as ineffective monitors. In addition, VCs that fail to prevent fraud experience greater difficulty in taking future portfolio companies public.

Keywords: Corporate Fraud, Initial Public Offerings, Financial Intermediaries, Reputation, Venture Capital

JEL Classification: D01, D85, G2, G24, G3, K4