Convertible securities and optimal exit decisions in venture capital finance

We study the interaction between exit decisions and contract design in venture capital finance. One of the main characteristics of venture capital funds is that they need to divest their holdings in the portfolio firms after a limited period of time. However, venture capitalists and entrepreneurs often have diverging interests with respect to different exit solutions (e.g., IPOs or trade sales). We show that with convertible securities, the ex-ante agreed optimal exit policy can be implemented. Thereby, we give an explanation for the widespread use of convertible securities in venture capital finance.     

Portfolio optimization with a defaultable security

In this paper we derive a closed-form solution for a representative investor who optimally allocates her wealth among the following securities: a credit-risky asset, a default-free bank account, and a stock. Although the inclusion of a credit-related financial product in the portfolio selection is more realistic, no closed-form solutions to date are given in the literature when a recovery value is considered in the event of a default. While most authors have assumed some recovery scheme in their initial model set up, they do not address the portfolio problem with a recovery when a default actually occurs. Given the tractability of the recovery of market value, we solved the optimal portfolio problem for the representative investor whose utility function is a Constant Relative Risk Aversion utility function. We find that the investor will allocate larger fraction of wealth to the defaultable security as long as the default-event risk is priced. These results are very intuitive and reasonable since it indicates that if the default risk premium is not priced properly the investor purchases less defaultable securities.     

The effects of dividend yield and dividend policy on common stock prices and returns

This paper suggests that it is not possible to demonstrate, using the best available empirical methods, that the expected returns on high yield common stocks differ from the expected returns on low yield common stocks either before or after taxes. A taxable investor who concentrates his portfolio in low yield securities cannot tell from the data whether he is increasing or decreasing his expected after-tax return by so doing. A tax exempt investor who concentrates his portfolio in high yield securities cannot tell from the data whether he is increasing or decreasing his expected return. We argue that the best method for testing the effects of dividend policy on stock prices is to test the effects of dividend yield on stock returns. Thus the fact that we cannot tell, using the best available methods, what effects dividend yield has on stock returns implies that we cannot tell what effect, if any, a change in dividend policy will have on a corporation's stock price.     

IPOs,acquisitions, and the use of convertible securities in venture capital

This paper provides a new explanation for the use of convertible securities in venture capital. A key property of convertible preferred equity is that it allocates different cash flow rights, depending on whether exit occurs by acquisition or IPO. The paper builds a model with double moral hazard, where both the entrepreneur and the venture capitalist provide value-adding effort. The optimal contract gives the venture capitalist more cash flow rights in acquisitions than IPOs. This explains the use of convertible preferred equity, including automatic conversion at IPO. Contingent control rights are also important for achieving efficient exit decisions.     

Mutual fund portfolio trading and investor flow

I estimate the extent to which mutual fund portfolio trading of securities is triggered by investor flows into and out of the funds, and find that this liquidity-induced portfolio trading activity is smaller than previously estimated by Edelen (1999). I obtain estimates from a much larger and broader sample of funds than Edelen’s (1999) sample. Portfolio managers of international funds trade a smaller fraction of investor flow than do those of domestic funds. Index funds invest a larger fraction. A funds’ usage of futures contracts does not have a statistically significant effect on how it trades in response to investor flows, but the unpredictability of investor flow weakly affects the trading response to flow.     

我国证券投资者权益保护问题研究

目前,我国证券市场对证券投资者保护的法规尚不健全,法律的执行力不够;证券市场监管机制也不完善,上市公司特殊的股权结构,以及投资者自我维权意识的不足,使得投资者的权益容易受到侵害。本文认为,要有效保护证券投资者权益,应进一步加大证券市场投资者保护法规建设力度,加强外部行政、司法干预及行业监管,建立行业自律和投资者赔偿机制,从多层面改善证券投资者保护现状。     

Contrasting Worldviews at Bank and Securities Market Regulators

Bank and securities regulators operate with different attitudes about the appropriate regulation of financial institutions and markets. Bank regulators’ prudential oversight protects depositors from worrying about the repayment of their bank claims. In contrast, securities market regulators tend to presume that security markets (almost) always clear quickly at prices close to the asset's fundamental value. These regulators seek to assure full disclosure of information, which facilitates active securities trading. In the United States, the Securities and Exchange Commission's (SEC) investor protection duties are tailored to the financial sophistication of individual investors.     

Venture capital investment practices in Europe and the United States

This article focuses on the investment practices and contract behavior of venture capitalists in relation to their portfolio companies. Using a unique self-collected data set, we provide new evidence on the venture capital industry in Europe and the United States. Important differences are identified between the two, particularly with respect to the use of convertible securities, replacement of former management, stage financing, deal syndication, and duration of exit stage. The most striking difference involves the use of convertible securities, which are used far less often in Europe than in the United States. These differences suggest that European venture capitalists engage in less monitoring and thus adopt a more hands-off approach to their portfolio companies as compared to US venture capitalists.

Optimal portfolio choice and the valuation of illiquid securities

Traditional models of portfolio choice assume that investorscan continuously trade unlimited amounts of securities. In reality,investors face liquidity constraints. I analyze a model whereinvestors are restricted to trading strategies that are of boundedvariation. An investor facing this type of illiquidity behavesvery differently from an unconstrained investor. A liquidity-constrainedinvestor endogenously acts as if facing borrowing and short-sellingconstraints, and one may take riskier positions than in liquidmarkets. I solve for the shadow cost of illiquidity and showthat large price discounts can be sustained in a rational model.     

A theory of strategic venture investing

Some venture capital investors seek purely financial gains while others, such as corporations, also pursue strategic objectives. The paper examines a model where a strategic investor can achieve synergies, but can also face a conflict of interest with the entrepreneur. If the start-up is a complement to the strategic partner, it is optimal to obtain funding from the strategic investor. If the start-up is a mild substitute, the entrepreneur prefers an independent venture capitalist. With a strong substitute, syndication becomes optimal, such that the independent venture capitalist is the active lead investor and the strategic partner a passive co-investor. The expected returns for the entrepreneur are nonmonotonic, lowest for a mild substitute, and higher for a strong substitute as well as for a complement. The paper also explains why a strategic investor often pays a higher valuation than an independent venture capitalist.     

Requiem for a market: an analysis of the rise and fall of a financial futures contract

Futures contracts often include a variety of delivery optionsthat allow participants flexibility in satisfying the contract.These options have the potential to broaden the appeal of thecontact. However, if these options are valuable, they may reducethe hedging effectiveness of the contract. This article analyzesthe GNMA CDR futures contract that appears to have failed becauseof flaws in the contract's design. For the first 6 years followingits introduction, the contract attracted significant and increasingvolume, but, subsequently, the volume declined to almost zero.Over the years during which the volume experienced its mostdramatic decline, the Treasury-bond futures contract provideda better hedge for current coupon GNMA securities than did theGNMA CDR futures contract. And, over this same period, the valueof the quality option embedded in the contract often exceeded5 percent of the futures price and reached a level of 19 percentat one point. We interpret the evidence to indicate that thecontract failed because the delivery options reduced the hedgingeffectiveness of the contract for current coupon mortgage securities.     

养老基金参与风险投资问题探讨

本结合中外风险投资的融资现状，指出了一国的金融体制对其风险投资发展具有重要的影响，讨论了养老基金参与英美风险投资业的原因，得出了养老基金是风险投资的天然资本供给以及我国的养老基金必将成为我国风险投资业的主要投资的结论。     

Czech Mate: Expropriation and Investor Protection in a Converging World

This paper examines the expropriation of a foreign investorby a local partner and the subsequent resolution of the casethrough international arbitration in favor of the investor.Despite the investor's 99% interest in the joint venture, thelocal partner managed to divert the entire value of the underlyingentity for his personal benefit. This clinical examination ofan expropriation and its aftermath illustrates the interactionof property and contract rights in a global setting, how corporatecontrol is shaped by geography, and how multinational firmsmay be advantaged by availing themselves of stronger investorprotections than local firms.     

新证券法下“投资者适当性义务”的实现路径——从“规则监管”到“原则监管”的转变

新证券法有关“投资者适当性义务”的规定反映了近年来国际上重视金融消费者保护的“行为监管”趋势。行为监管要求将原有单纯满足监管规范要件的“形式合规”转向以实现金融消费者保护为结果目标的“实质合规”,由此金融消费者保护方式呈现出从“规则监管”向“原则监管”的转向。同样地,本次修法将以往中国证监会具体、细化的投资者适当性规则上升为抽象的法定义务,这就决定了券商在销售证券或者提供服务的过程中不能完全以所谓的“程序合规”作为其完成“投资者适当性义务”的标准,而应以“程序合规+实质合规”来证明其对“投资者适当性义务”要求的满足。新证券法在投资者保护方面呈现出一种明显的“以结果为导向”的原则监管新思路。     

Investment barriers and international asset pricing

In this article a multicountry model of international asset pricing is developed. This model incorporates a more general representation of the degree of segmentation in the international capital market. Specifically,N types of investors andN classes of securities are postulated. In general, thenth (n=1, 2, 3, ...N) type of investor has access to all security markets up to and including thenth class. Using the standard mean-variance framework, closed form equilibrium risk return relationships are obtained for all classes of securities. It is also shown that class 1 securities are priced as if markets are integrated, classn (n=2, 3 ...N) securities commandn different risk premia. Finally, the nature of the model specification allows us to investigate the effects of partial integration on investor welfare. It is shown that, in general, all investors prefer full integration to any form of partial integration.     

Derivative mortgage securities: An overview

Derivative mortgage securities have proliferated since planned amortization and floating rate CMO classes were introduced in late 1986. Other recently created derivative securities include reverse floaters and deep-discount bonds of CMOs, CMO residuals, and stripped and senior/subordinated passthroughs. These securities, which are derived from fixed-rate mortgages, were created to meet investor demands for maturity certainly, interest rate and prepayment hedging, and enhanced credit. The rapid growth of derivative securities reflects expansion of the investor base for fixed-rate mortgages. It also suggests that these mortgages will continue to be a viable housing finance instrument in a volatile interest rate environment. For the future, the increased creation of derivative securities will make the secondary mortgage market more efficient, facilitating the funding of fixed-rate mortgage originations.The substance of this paper was originally written in late 1987 and many of the specific data reflect that time period.     

Rational Beliefs and Security Design

This article studies the security-design problem of a cash-constrainedfirm facing investors with diverse beliefs. Investor "rationalbeliefs" are modeled as varying and yet rational in the senseof Kurz (1994a). With two investors, optimal designs are similarunder rational beliefs and rational expectations. With manyinvestors, however, optimal securities under rational beliefsmaximize investor differences of opinion, while under rationalexpectations optimal designs minimize disagreements. We demonstratethat the common practice of issuing multiple securities backedby a single asset is optimal under rational beliefs but notunder rational expectations. Researching market beliefs cancreate substantial value for firms.     

Institutional affiliation and the role of venture capital: Evidence from initial public offerings in Japan

The presence of venture capital in the ownership structure of U.S. firms going public has been associated with both improved long-term performance and superior “certification” at the time of the initial public offerings (IPOs). Many of the major venture capital firms in Japan are subsidiaries of securities firms that may face a conflict of interest when underwriting the venture capital-backed issue. In Japan, we find the long-run performance of venture capital-backed IPOs to be no better than that of other IPOs, with the exception of firms backed by foreign-owned or independent venture capitalists. When venture capital holdings are broken down by their institutional affiliation, we find that firms with venture backing from securities company subsidiaries do not perform significantly worse over a 3-year time horizon than other IPOs. On the other hand, we find that IPOs in which the lead venture capitalist is also the lead underwriter have higher first-day returns than other venture capital-backed IPOs. The latter result suggests that conflicts of interest influence the initial pricing, but not the long-term performance, of IPOs in Japan.     

Convertible Securities and Venture Capital Finance

This paper offers a new explanation for the prevalent use of convertible securities in venture capital finance. Convertible securities can be used to endogenously allocate cash‐flow rights as a function of the state of the world and the entrepreneur's effort. This property can be used to induce the entrepreneur and the venture capitalist to invest efficiently into the project. The result is robust to renegotiation and to changes in the timing of investments and information flows. The model is consistent with the observations that conversion is often automatic and that convertible securities are rarely used by outside investors.     

Optimal design of derivatives in illiquid markets*

Abstract

The aim of this paper is to determine the optimal structure of derivatives written on an illiquid asset, such as a catastrophic or a weather event. This transaction involves two agents: a bank which wants to hedge its initial exposure towards this illiquid asset and an investor which may buy the contract. Both agents also have the opportunity to invest their residual wealth on a financial market.

Based on a utility maximization point of view, we determine an optimal profile (and its value) such that it maximizes the bank's utility given that the investor decides to make the deal only if it increases its utility. In the case of exponential utility, we show that the pricing rule is a non-linear function of the structure and that the bank always transfers the same proportion of its initial exposure. In the general case, an additional term appears, depending only on the relative log-likelihood of the two agents' views of the distribution of the illiquid asset.