The Illiquidity Puzzle: Theory and Evidence from Private Equity
This paper presents a theory of liquidity where we explicitly model the liquidity of the security as a choice variable, which enables the manager raising the funds to screen for "deep pocket" investors, i.e. these that have a low likelihood of a liquidity shock. By choosing the degree of illiquidity of the security, the manager can influence the type of investors the firm will attract. The benefit of liquid investors is that they reduce the manager's cost of capital for future fund raising. If inside investors have fewer information asymmetries about the quality of the manager than the outside market, more liquid investors protect the manager from having to return to the outside market, where he would face higher cost of capital due to asymmetric information problems. We test the predictions of our model in the context of the private equity industry. Consistent with the theory, we find that transfer restrictions on investors are less common in later funds organized by the same private equity firm, where information problems are presumably less severe. Contracts involving the close-knit California venture capital community - where information on the relative performance of funds are more readily ascertained - are less likely to employ many of these provisions as well. Also, private equity partnerships whose investment focus is in industries with longer investment cycles display more transfer constraints. For example, funds focusing on the pharmaceutical industry have more constraints, while those specializing in computing and Internet investments have fewer constraints. Finally, we investigate whether the identity of the investors that invest in a private equity fund is related to the transferability of the stakes. We find that transferability constraints are less prevalent when private equity funds have limited partners that are known to have few liquidity shocks, for example endowments, foundations, and other investors with long-term commitments to private equity
|Date of creation:||27 Jan 2003|
|Date of revision:|
|Contact details of provider:|| Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA|
Web page: http://mitsloan.mit.edu/
More information through EDIRC
|Order Information:|| Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Shleifer, Andrei & Vishny, Robert W., 1986.
"Large Shareholders and Corporate Control,"
3606237, Harvard University Department of Economics.
- David S. Scharfstein & Jeremy C. Stein, 1997.
"The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment,"
NBER Working Papers
5969, National Bureau of Economic Research, Inc.
- David S. Scharfstein & Jeremy C. Stein, 2000. "The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment," Journal of Finance, American Finance Association, vol. 55(6), pages 2537-2564, December.
- Gompers, Paul & Lerner, Josh, 1996. "The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements," Journal of Law and Economics, University of Chicago Press, vol. 39(2), pages 463-98, October.
- Bhide, Amar, 1993. "The hidden costs of stock market liquidity," Journal of Financial Economics, Elsevier, vol. 34(1), pages 31-51, August.
- Pittman, Russell, 1992.
"Specific Investments, Contracts, and Opportunism: The Evolution of Railroad Sidetrack Agreements,"
Journal of Law and Economics,
University of Chicago Press, vol. 34(2), pages 565-89, October.
- Pittman, R., 1990. "Specific Investments, Contracts, And Opportunism: The Evolution Of Railroad Sidetrack Agreements," Papers 90-6, U.S. Department of Justice - Antitrust Division.
- Diamond, Douglas W & Dybvig, Philip H, 1983.
"Bank Runs, Deposit Insurance, and Liquidity,"
Journal of Political Economy,
University of Chicago Press, vol. 91(3), pages 401-19, June.
- Shleifer, Andrei & Vishny, Robert W, 1997.
" The Limits of Arbitrage,"
Journal of Finance,
American Finance Association, vol. 52(1), pages 35-55, March.
- Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
- Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
- Gompers, Paul & Lerner, Josh, 1999. "An analysis of compensation in the U.S. venture capital partnership," Journal of Financial Economics, Elsevier, vol. 51(1), pages 3-44, January.
- Sanford J. Grossman & Oliver D. Hart, 1980. "Takeover Bids, the Free-Rider Problem, and the Theory of the Corporation," Bell Journal of Economics, The RAND Corporation, vol. 11(1), pages 42-64, Spring.
- Holmstrom, Bengt & Tirole, Jean, 1993. "Market Liquidity and Performance Monitoring," Journal of Political Economy, University of Chicago Press, vol. 101(4), pages 678-709, August.
When requesting a correction, please mention this item's handle: RePEc:mit:sloanp:1803. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann)
If references are entirely missing, you can add them using this form.