Adverse Selection, Capital Supply, and Venture Capital Allocation
This paper develops a model to explore how the interaction of adverse selection and search frictions affects the allocation of venture capital. Entrepreneurs have projects with different levels of risk and private information about their projects' quality and compete in a search market to attract investors. The combination of low capital supply and information frictions can cause entrepreneurs with high quality risky projects to avoid entering the venture capital market. An increase in capital supply reduces the distorting effects of search and information frictions causing entrepreneurs with high quality risky projects to enter the market and venture capitalists to increase their allocations to riskier projects. These effects can persist even if riskier projects are more valuable, meaning the average output per dollar of venture capital investment can increase with venture capital supply. Several other model predictions are also consistent with empirical findings.
Non-pecuniary Benefits: Evidence from the Location of Private Company Sales (with Mark Jansen)
We estimate how the non-pecuniary benefits related to the quality-of-life (e.g., clement weather) of a target firm's location affect its acquisition price. Using new data on private firm acquisitions, we find that firms in cities with a higher quality-of-life sell for a 16% premium over comparable firms in cities with a lower quality-of-life. Using a historical measure of quality-of-life to instrument for the contemporaneous proxy, we show that the premium for non-economic characteristics of a city is in addition to any premium for the orthogonal trade-production amenities (e.g., agglomeration economies and navigable waters) that affect firm fundamentals.
A Signaling Theory of Derivatives-Based Hedging (with Fernando Anjos)
We model a commodity producing firm that has private information about future volume and requires outside financing to fund a growth opportunity. Due to costly financial distress, a firm's first-best strategy is to sell forward its future production, avoiding any price risk. Low-volume firms, however, have an incentive to mimic, which in equilibrium distorts the hedging strategy of high-volume firms. Under certain conditions, high-volume firms signal their type by hedging more than they would under their first-best strategy. In general, high-volume firms signal by taking on excess risk through derivative positions. When allowing firms to use multiple types of derivatives, we show that high-volume firms use both options and forwards, while low-volume firms only use forwards. The model suggests that heterogeneous and prima facie non-optimal hedging policies may be due to signaling and not speculation or risk shifting.