VC Funds: Aging Brings Myopia

55 Pages Posted: 2 Jun 2006

See all articles by Eugene Kandel

Eugene Kandel

Hebrew University of Jerusalem - Department of Economics; Centre for Economic Policy Research (CEPR)

Dima Leshchinskii

Menlo College

Harry Yuklea

The Technion, IE&M Faculty; Hebrew University of Jerusalem - Jerusalem School of Business Administration; S. Neaman Institute at the Technion

Date Written: May 2006

Abstract

We study the conflict of interests between the limited partners (LPs) and the general partner (GP) in a VC fund with a limited life span. LPs commit money to investments in risky projects, while the GP selects projects and provides unobservable monitoring effort. We assume that midway into the project, the GP privately observes its quality and the estimated time to exit and decides whether to continue investing and monitoring. The limited time horizon of the fund forces the GP to dispose of any unfinished projects when the fund is dissolved. This, combined with the informational advantage of the GP, leads to inefficient decisions during the intermediate investment stages.

This paper presents a simple model that identifies two types of such inefficiency. We show that when unfinished projects are fairly priced in the market, bad projects are always continued. At the same time, under a wide range of parameter values good projects with a somewhat longer expected completion time may be effectively discontinued, when the GP opportunistically decides not to invest monitoring effort in them. We discuss several contractual amendments to alleviate the problem. First, we show that reduction of the GP's stake in all the unfinished projects can significantly weaken his incentives to prolong bad projects. This in turn may induce the GP to put effort into the delay-prone good projects, since their price increases. An outright termination of all unfinished projects, as practiced by some VC funds, is similar in nature, but leads to suboptimal early write-offs of some good projects. We also show that allocating non-vested cash (but not decision) rights in the unfinished projects to the GP has similar beneficial effects. Finally, we provide some evidence that is suggestive of the significant extent of the problem in the post-2000 period.

Keywords: Venture Capital, investment decision, agency problems

JEL Classification: G24, G32

Suggested Citation

Kandel, Eugene and Leshchinskii, Dima and Yuklea, Harry, VC Funds: Aging Brings Myopia (May 2006). EFA 2006 Zurich Meetings Paper. Available at SSRN: https://ssrn.com/abstract=905963 or http://dx.doi.org/10.2139/ssrn.905963

Eugene Kandel (Contact Author)

Hebrew University of Jerusalem - Department of Economics ( email )

School of Business
Mount Scopus
Jerusalem 91905
Israel
+972 2 588 3137 (Phone)
+972 2 581 6071 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Dima Leshchinskii

Menlo College ( email )

1000 El Camino Real
Atherton, CA 94027
United States

Harry Yuklea

The Technion, IE&M Faculty ( email )

Technion City
Haifa 32000, Haifa 32000
Israel

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

S. Neaman Institute at the Technion ( email )

Technion City
Haifa 32000, Haifa 32000
Israel

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