The Hindu Business Line : Venture capital deals that markets may get squarely wrong

Chennai March 22 How do acquisitions of VC (venture capital)-backed companies fare? Contrary to what markets tend to believe, the answer is a happy one, according to Mr Paul A. Gompers and Mr Yuhai Xuan of Harvard Business School.

"Acquirers of venture capital-backed companies are high performing, high growth opportunity, and high investment companies both prior to the acquisition and after," they write in their research paper titled `The Role of Venture Capitalists in the Acquisition of Private Companies', which is among recent posts on www.ssrn.com, the site of Social Science Research Network.

"Unlike other companies, young, private VC-backed companies have values that are primarily based upon real options, i.e., future investment opportunities," explain the authors. "For most companies, their values may be determined more by assets in place. VC-backed companies, on the other hand, are generally small with relatively minor sales, but substantial technology and intellectual property."

Large, public companies may be motivated to purchase such companies because they represent potential future investment opportunities, or because the young start-up may be a future competitor of the firm, reasons the paper.

Though start-up and growth companies, which the VCs scout for, are prone to `information gaps', and `have little history of revenues and cash flows,' what acts as a positive, according to the researchers, is `the intensive involvement of the VC'. The hands-on approach of VCs `alleviates some of the information gaps' and as a result, `these firms are likely to be better organised and perform better while still private than similar firms financed with other sources of capital'.

VCs keep the entrepreneurs on a tight leash through staged capital infusions; and they usually make investments with other investors, point out the authors. "One venture firm will originate the deal and look to bring in other VC firms." Such syndication `allows the VC firm to gain additional insights and advice about the firm' and also lets the VC `diversify his portfolio across a greater number of investments'.

A key finding of the paper is that acquirers of VC-backed companies are `more likely to use pure equity transactions and to purchase companies in related industries'. This phenomenon of using equity is, however, `not seen as positive attribute' by the market. Strangely, therefore, `the market reacts more negatively to the purchase of VC-backed companies,' as the research notes.

There can be alternative explanations for such adverse reaction. Such as: "that the market either believes that venture capitalists are better at negotiating higher prices for their companies in the public market or that the adverse selection problem from purchasing real options is higher than for purchasing assets in place." Alas, the market may be wrong!

For, the long-run performance of these acquisitions is quite different from the announcement period returns, discovers the study. "Long-run buy-and-hold abnormal returns are very negative for acquisition of private non VC-backed companies. These acquirers appear to not be able to meet market expectations for further improvements in performance for these existing assets in place although operating performance remains above industry peer performance both prior to and after the acquisition."

The story of the acquirers of VC-backed companies is brighter, in comparison. They appear to have `substantially better performance'. Predictors of `superior long-run performance' are `the use of stock in the purchase and the acquisition of related companies,' wraps the research.

Worth doing a similar study of deals closer home.