Antecedents of Financial Instrument Choice by VC/PE Funds: Using the Theory of Adverse Selection

Abstract

This article examines the choice of financial instruments of venture capital/private equity (VC/PE) funds in Indian infrastructure sector. Using a sample of 690 VC/PE investment transactions in Indian infrastructure sector over a period of fifteen years, the findings indicate that the choice of financial instrument by VC/PE funds in Indian infrastructure sector is largely influenced by the ability to mitigate information asymmetry and adverse selection faced by the fund. The evidence provides insights about the type of uncertainty faced by VC/PE funds in different types of Indian infrastructure financing transactions. Results show that the VC/PE funds are less able to screen growth stage firms and, therefore, utilize convertible securities to reduce the cost of adverse selection. Regression analysis provides empirical evidence about the determinants of VC/PE funds choice of financial instrument in Indian infrastructure sector. VC/PE funds face higher risk when an infrastructure firm expects greater variability of returns at early and growth stages and for new investments in any stage.

TOPICS: Private equity, other real assets, emerging markets

Key Findings

• • VC/PE funds use more common equity than other financial instruments for making investment in the Indian infrastructure sector.

• • When VC/PE investors are not able to mitigate information asymmetry and adverse selection cost, convertible securities are more likely to be used.

• • VC/PE funds face higher risk when any infrastructure firm expects greater variability in return at early stage, growth stage firms and for new investment in any stage.