Parameterizing Opportunity Set Risk and Search Costs within Venture Capital Markets
71 Pages Posted: 19 Aug 2014 Last revised: 5 Dec 2018
Date Written: December 4, 2018
Abstract
This study develops a theoretical model that parameterizes cross-sectional differences in opportunity set risk within venture capital markets. The theoretical model shows clusters of venture capital activity can be induced by non-monotonic relations that obtain between search costs for projects with the best risk-return profiles, and the opportunity (return) benefit of deal screening. The model generates functional forms for deal screening costs, and consistent with normativeness of ambiguity aversion, provides a formal theoretical rationale for dichotomy of deal screening ability (equivalently, reputation) from portfolio performance. Theoretical predictions demonstrate outcomes typically attributed to either of preferences or ability are endogenously induced by VCs' spatial location, as such provide formal evidence for presence of ambiguity aversion (uncertainty as to sources of VCs' success) in populations of VCs' investors. Without recourse to data on transaction volumes, model parameters successfully rank venture capital markets in states of California, Massachusetts, and New York as three of the most efficient venture capital markets. The study generates two robust empirical metrics, and efficiency parameters for cross-sectional variations in opportunity set risk.
Keywords: Venture Capital, Investments, Opportunity Sets, Search Costs, Risk, Deal Screening, Market Efficiency, Rational Expectations, Equilibrium Prices
JEL Classification: G24, G11, G14
Suggested Citation: Suggested Citation