Essays on Law, Finance, and Venture Capitalists' Asset Allocation Decisions

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2005-07-28

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This dissertation consists of three essays. The first essay finds that small firms in poor quality legal environments (poor quality contract enforcement and property rights environments) are more financially constrained relative to small firms in better quality legal environments. Consequently, financial development, that is, the emergence of venture capitalists, has a greater effect on small firms' access to external financing in poor quality legal environments.

The second essay finds that the quality of contract enforcement is a risk factor, while the quality of property rights protection is not. The results indicate that poor quality property rights protection hinders the development of informal capital markets; hence, there exists a greater need for financial intermediation in such environments. These results indicate that venture capital financing should be encouraged in poor quality legal environments and provide one rationale for why capital markets in poor quality legal environment countries tend to be bank-based.

The third essay finds that the demand for growth financing is lower in poor quality legal environments relative to better quality legal environments. The existing literature has focused on the effect that limited supply of external financing has on firm growth rates in poor quality legal environments. This paper indicates that lower firm growth rates in poor quality legal environments may also result from lower demand for growth financing.

The empirical results in all three essays indicate that poor quality legal environments primarily affect the development of informal capital markets. Hence, financial intermediation is of greater importance in poor quality legal environments during the early stages of a firm's growth cycle. This indicates that encouraging the growth of venture capital financing, which is better suited to ameliorating moral hazard problems (investments in small firms and technology intensive ventures) relative to debt or bank financing, will facilitate faster economic growth in poor quality legal environments. Evidence that venture capitalists' asset allocations are significantly and positively associated with long-run country growth rates is provided in the second essay.

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