Venture capital and private equity funds are important equity investors in private companies (Hand 2005; Stromberg 2008; Kaplan and Stromberg 2009), and their investments are characterized by an extensive search process that imposes significant upfront costs for the funds (Chen et al. 2010; Teten and Farmer 2010; Gompers et al. 2016, 2019).[1] We hypothesize that private companies’ public financial statements (and the information therein) can mitigate these costs by providing a relatively less costly screening tool to identify potential targets at the pre-investment stage. In particular, public financial statements can help VC and PE funds to identify potential investment candidates (e.g. Teten and Farmer 2010, p. 39 and Exhibit 3), and the information in the financial statements can be used to screen potential targets into a subsample (say of a certain size, growth rate, or profitability) to narrow the set of candidates before funds approach target firms and start due diligence. We test whether financial statements mitigate these search costs despite VC and PE funds having access to significant, alternative private information sources, including direct management communications and financial intermediaries (such as investment banks), which supplement public financial information with in-house research and expertise. We use two alternative settings in Europe, where (i) private firm financials are publicly available (unlike in the U.S.), and (ii) two complementary regulatory settings provide plausibly exogenous variation in the extent of private firm financial reporting.
In the first setting, following Bernard (2016) and Breuer et al. (2018), we study a regulatory change that increased the public availability of German private limited-liability firms’ financial statements starting in the fiscal year 2006 as a result of increased enforcement of public reporting. We compare the change in VC and PE investment activity in German limited liability firms around the increase in enforcement with the change in VC and PE activity in similar EU countries where there was no such increase in financial statement availability. We find an overall increase in the number of German VC deals of 8-10 percent across a variety of specifications. We do not find a significant increase in the number of PE deals during the same period, consistent with VC funds investing in smaller firms for which public financial statements most increases the chances of entry into the VC funds’ screening pool. We further find that the documented effects are concentrated in deals involving small target firms (i.e., with assets below €1M), for whom search costs are likely to be even higher.
In the second setting, we exploit size-based reporting exemption thresholds among the EU’s member countries (e.g., Bernard et al. 2018, Breuer 2021). We compare deal incidence for private firms above and below each country-year’s size-based financial reporting threshold using country-year and industry fixed-effects. Across many different specifications, we find that firms that are above the country-specific size threshold, i.e. those facing more financial reporting requirements, are more likely to raise PE financing. In contrast, we do not observe a similar effect for VC deals. Overall, these results are consistent with PE funds benefitting from the additional financial reporting requirements above the financial reporting thresholds, potentially because PE funds invest in later stage firms for which demonstrated profitability is more important (e.g. Gompers et al. 2016).
Finally, we provide evidence on the implications of our results for VC and PE funds’ investments. We find that, in both settings, the number of deals increases largely in industries with more VC or PE deals in the pre-treatment period (i.e., an intensive margin effect). We also find that public financial statement availability and transparency are associated with more deals being undertaken by VC or PE funds with low experience or reputation (which likely face higher search costs) and, in the EU setting, PE deals are less likely to rely on investment banks as information intermediaries when more public information is available.Our study provides evidence of the role of public financial statements in the early stages of private firms. Our results suggest that financial statement reporting plays a role at a much earlier stage of a private firm’s life than has been studied in prior literature (e.g. Ball and Shivakumar 2008, Katz 2009), namely the VC or PE financing decision stage. Indeed, we show that, even when there is a relatively high amount of alternative (private) information available, public financial statements can facilitate private firms’ access to financing. Our paper also highlights the role that mandatory public financial reporting can have on the pre-investment VC or PE process and ultimately influence funds’ decision making.
ENDNOTE
[1] In 2014, PE funds raised over $1 trillion in global funds (KPMG Private Equity Forum November 2016).
This post comes to us from Brian K. Baik, a PhD candidate at MIT’s Sloan School of Management, and professors Natalie Berfeld at Boston College’s Carroll School of Management and Rodrigo S. Verdi at MIT’s Sloan School of Management. It is based on their recent paper, “Do Public Financial Statements Influence Venture Capital and Private Equity Financing?,” available here.