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Why do venture capital firms exist: An institution-based rent-seeking perspective and Chinese evidence

Abstract

This paper is a theory development to Amit, Brander, and Zott (1998, Journal of Business Venturing, 13: 441-466) on the nature of venture capital firms. In their paper, the authors argue that venture capital firms exist because they fill a market niche by developing the ability to overcome extreme information asymmetry embedded in high-risk entrepreneurial firms. However, this theory encounters difficulties in explaining a variety of organizational and behavioral divides among venture capitalists in different contexts and over time. In this paper, we apply the institution-based view to reveal the nature of venture capital. We argue that it is the venture capitalists’ capability to capture economic rents from the institutional environment that distinguish them from other financial intermediaries. We show the connection of our perspective with the conventional view as well as the usefulness of this theory in explaining the development of the venture capital industry in China.

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Figure 1

Notes

  1. 1.

    By a simple example, Zider (1998) showed that only 10–20% of portfolio companies need to be winners in order to achieve the targeted rate of return. The larger the pool of funds managed by venture capitalists, the less time they can spend on each investee. In fact, the best and the worst performers require minimal time. Venture capitalists spend most of their time on the middle portfolio companies.

  2. 2.

    The concept of “economic rents” has been heavily used in economics and related disciplines since its development by Ricardo in the 1800s. While its precise meaning differs across authors, the term “economic rents” has been employed widely to mean above-normal economic returns in the market (Khan, 2000; Rumelt, 1984).

  3. 3.

    Note China did not have a stock market until 1990, did not have a Company Law until 1994, and did not have Contract Law and Securities Law until 1999. The launching of the Shanghai and Shenzhen stock markets in the 1990s were designed to finance the restructuring process of large and medium sized state-owned enterprises (SOEs) rather than to finance the high-tech and high-growth ventures.

  4. 4.

    In the past, most foreign VC adopt a “two-head-out” strategy (also known as the “red chip” route) to invest in China. Namely, the initial investment as well as the final exit (“two heads”) both took place outside China. In practice, Chinese private enterprises sought overseas listing followed an established model to set up an offshore special purpose vehicle (SPV). The SPV set up a wholly foreign-owned enterprise in China to acquire the domestic business. The SPV then applied for overseas listing thereby effectively evading any China-related government approvals.

  5. 5.

    See Interim Provisions on the Takeover of Domestic Enterprises by Foreign Investors (Promulgated by the Ministry of Commerce of the People’s Republic of China, August 8, 2006, effective on September 8, 2006, http://www.lawinfochina.com/Law/displayModeTwo.asp?id=5420&keyword=)

  6. 6.

    The various requirements include, among other things, that the business of the investee must be in line with the government’s industry development plan, the investee must have its core technology or innovative business model, and have high growth potential. Trust companies are also required to report the detailed investment plan and risk control mechanism to the CBRC. See Notice of China Banking Regulatory Commission on Issuing the Guidelines for Trust Companies to Operate the Trust Private Equity Investment Business (Promulgated by China Banking Regulatory Commission, June 25, 2008, effective on June 25, 2008, http://www.lawinfochina.com/NetLaw/display.aspx?db=law&sen=rLdDdW4drhdDdWcdrLdydW4drDdGdWfd9DdxdWdd/LdTdWudrDdxdWfd9ddYdWhd9hdYdWud&Id=7069&).

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Correspondence to Yi Tan.

Additional information

The authors wish to thank Dr. Seung-Hyun Lee and the two anonymous reviewers for their insightful comments and extensive inputs to this article. This research has received the grant from the Hong Kong RGC Direct Allocation (A-PB0Y) and the National Nature Science Foundation of China (70903046 and “NETWORK SYNDICATION AND INVESTMENT PERFORMANCE OF VENTURE CAPITAL IN CHINA”).

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Lu, H., Tan, Y. & Huang, H. Why do venture capital firms exist: An institution-based rent-seeking perspective and Chinese evidence. Asia Pac J Manag 30, 921–936 (2013). https://doi.org/10.1007/s10490-011-9262-8

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Keywords

  • Venture capital
  • Institutions
  • Rent-seeking
  • Strategy
  • China