Conservative banks vs. aggressive venture capitalists

Roman Makienko

Student thesis: Master thesis

Abstract

In this paper I analyze two types of financial intermediaries that finance entrepreneurial firms: Banks and Venture Capital firms. The core of this work is a new mathematical model that explains why Venture Capital firms focus on financing high-risk firms with high growth potential in knowledge-intensive, high-tech industries. And why Banks, on the other hand, tend to be more conservative and focus exclusively on low-risk, stable, more mature firms. In my model an endowed financial intermediary has a choice to structure either as a Bank or a Venture Capital firm. The advantage of structuring as a Bank is the higher monitoring effort the intermediary will exert when monitoring her investment portfolio. This benefit comes from the fact that Banks are financed by short-term demand deposits and are prone to bank runs if their claim holders observe a deteriorating performance. The advantage of structuring as a VC is the fact that this type of intermediary is not subject to bank runs because it is financed by long-term depositors. This long-term financial structure leads to lower monitoring effort on part of the Venture Capital firm, but the risk of inefficient liquidation is nonexistent. This trade-off drives the intermediary’s choice. The results of my work state that intermediaries presented with low-risk investment projects will structure as Banks and intermediaries presented with high-risk ones will structure as Venture Capital firms. At high levels of risk the benefit of increased monitoring effort is simply overshadowed by the increased chance of inefficient liquidation.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2011
Number of pages39