Asymmetric information, capital supply, and the venture capital market
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This dissertation provides an overview of venture capital and the effects that asymmetric information and limited and varying capital supply have on the allocation of venture capital to new projects. I develop and solve a competitive search model where entrepreneurs have projects with different levels of risk and have private information about their projects' quality. The combination of low capital supply and asymmetric information can cause entrepreneurs with high-quality risky projects, which are most affected by asymmetric information, to avoid the venture capital market. Increases in capital supply reduce the cost to entrepreneurs of attracting venture capitalists and can cause increases in the proportion of funded risky projects. Moreover, the average output per dollar of venture capital investment can increase with venture capital supply. I extend the model to examine the effects of heterogeneity in the ability of venture capitalists to screen projects and show that higher ability venture capitalists are more likely to fund risky projects that are subject to higher degrees of asymmetric information. I develop a new source of exogenous variation for the local supply of venture capital by using variation in the returns of state-level pension funds. Using the excess returns of state-level pension funds as a source of exogenous variation, I find results consistent with the model's predictions. Specifically, I find that positive shocks to the local supply of venture capital cause venture capitalists to increase their likelihood of funding companies with higher ex ante and ex post measures of risk and asymmetric information.
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