Venture capital certification and customer response: Evidence from P2P lending platforms

Highlights

• P2P platforms' lenders and facilitated loans increase after VC investment announcements.

• This effect increases with VCs' reputation and the extent of information asymmetry.

• This effect is beyond the effect of news, advertising, and funding.

• VC-backed platforms are less likely to default.

Abstract

This paper examines whether the certification effect of VCs extends to firm's potential customers, and whether, by certifying firms' values to potential customers, VCs provide value to firms. Using weekly trading data from P2P lending platforms in China, we find that the amount of loans facilitated and the number of lenders increase significantly by 25.7% and 49.3%, respectively, immediately after announcements that P2P lending platforms obtain VC investment. We find that this certification effect increases with measures of VC reputation and measures of information asymmetry between P2P lending platforms and potential customers. A difference-in-differences analysis provides consistent results, which are robust after controlling for the effects of news, advertising, and funding. We also document that VC-backed platforms are less likely to default than non-VC-backed platforms. This result provides indirect evidence that VC backing has long-term benefits beyond the news and advertising effects.

Introduction

The role of VC financing in value creation for entrepreneurial firms has been widely discussed in both academic and practitioner literature. Researchers argue that, in addition to providing financing, VCs can offer other services that considerably enhance private firms' likelihood of success through screening and monitoring (see, e.g., Chemmanur et al., 2010, 2014; Casamatta, 2003; Hellmann, 1998). VCs are also considered to reduce the information asymmetry between entrepreneurs and public investors in capital markets by certifying the value of securities issued by relatively unknown startups (Megginson and Weiss, 1991). Industry practitioners argue that, in addition to funding private firms and reducing information asymmetry in capital markets, VCs contribute to the success of firms in many other ways. For example, a VC's reputation and network can facilitate firms' access to potential customers in the product market.

We examine whether the certification effect of VCs extends to firm's potential customers, and whether, by certifying firms' quality to potential customers, VCs provide “extra-financing” value to firms. The empirical question of whether VCs provide certification to customers has not yet been investigated in the literature, perhaps because there is a lack of data on private firm customers.

We conduct a novel sample study with several existing and hand-collected databases to examine the role of VCs in mitigating the information asymmetry between start-ups and their potential customers. We use a unique proprietary customer level database, which includes startup companies with similar business models and products in the P2P lending industry in China.¹ For each startup company, we collect weekly data associated with the company's customers (both lenders and borrowers), such as the amount of loans facilitated, number of lenders, and number of borrowers.

The context and data applied in this study have two key advantages that provide us with a rare opportunity to study whether VCs provide a certification effect to potential customers of relatively unknown companies in a market characterized by high information asymmetry between corporate insiders and their customers. The first key advantage is that our high-frequency data allow us to measure immediate customer responses to VC investment announcements. This overcomes some of the difficulties associated with the use of low-frequency survey data, which is the typical practice among researchers when measuring individual economic activities (Gelman et al., 2014). Specifically, our data consist of both pre-VC investment and post-VC investment customer responses in a real economy, which are difficult to obtain. The second key advantage is that the products from each startup company in our setting, P2P loans, are relatively homogenous from the perspective of the customer (P2P lender). Most Chinese P2P lending platforms have similar business models and lending procedures. In our sample period, almost all platforms provide a principal guarantee² that protects lenders' principal once borrowers default. Therefore, from the perspective of P2P lenders, P2P loans on different P2P lending platforms are relatively similar fixed income investments with the primary difference being the interest rates, maturities, and default risk associated with the platforms.³ This advantage mitigates the potential biases caused by the heterogeneous features of products in other startup companies.

We answer three questions concerning the role played by VCs in certifying the value of the startup platforms in which they invest. First, do VCs provide a certification effect to potential customers and attract more of them (e.g., P2P lenders) immediately after VC investment announcements? Second, are the start-ups that receive investment from highly reputable VCs more likely to attract customers compared to those who receive investment from VCs with poor reputations? Third, is the magnitude of the certification effect associated with the degree of information asymmetry between platforms and their customers?

The results of our empirical analysis can be summarized as follows. We first find that the proxies for customer response of the amount of loans facilitated and number of lenders increase significantly by 25.7% and 49.3%, respectively, after the announcement of the first round VC investment in those startup platforms, while the number of borrowers does not change much. This result is consistent with the existence of the VC certification effect for potential customers. In our examination of the differences between high-reputation and low-reputation VCs, we find that the VC certification effect for customers is positively associated with the VC's reputation.⁴ In the end, we show that the VC certification effect for potential customers decreases with platform age, a proxy that is negatively correlated with the information asymmetry between the companies and outsiders. We also find that the VC certification effect is prominent for the platforms' new lenders, who have greater information asymmetry with startup platforms compared to existing lenders. These results are consistent with Focarelli et al. (2008), who point out that the certification effect increases with information asymmetry. In addition, we examine customer response to VC investment announcements using propensity score matched pairs of VC-backed platforms and platforms that have never received VC investment and find consistent results.

Chemmanur and Yan (2009) note that advertising can be a signal that reduces information asymmetry associated with advertiser firms. This advertising effect can potentially explain an increase in customer response. To alleviate this concern, we first explore the dynamics of the number of news events around the time of VC investment announcements to provide indirect evidence of the advertising effect on customer response. We also find that VC investment size is not associated with customer response. Therefore, the supporting evidence shows that our baseline results cannot be entirely driven by the effects of news, advertising, or funding. Given the recent collapse of the P2P market in China, we document that VC-backed platforms are less likely to default than non-VC-backed platforms. This result provides indirect evidence that VC backing has long-term benefits for portfolio firms.

This study is the first to examine the role of VC certification by exploring whether VCs certify the quality of start-ups by reducing information asymmetry between start-ups and their potential customers. The study also contributes to the understanding of venture capital financing's role in creating value for entrepreneurial firms in general by documenting the certification role played by VCs in customer response. In addition, our study adds to the growing literature on venture capital financing's value creation for start-up firms in emerging markets. The certification effect in capital markets has been well documented since 1990 (Barry et al., 1990; Megginson and Weiss, 1991). VC backing may provide valuable certification to outside investors and reduce IPO underpricing. In addition to the certification effect, VCs can improve efficiency (Chemmanur et al., 2011), provide mentoring services to firms (Hsu, 2004; Cochrane, 2005), play an administrative role in VC-backed firms (Barry et al., 1990; Lerner, 1995; Hellmann, 1998), stimulate innovation (Bernstein et al., 2016), and improve the timing of IPOs (Lerner, 1994). VCs can also create product market value and financial market value for portfolio firms by forming syndications (Tian, 2011). In emerging markets, Cheng and Schwienbacher (2016) investigate the choice of Chinese VC-backed companies between listing on the domestic market or foreign stock markets. They find that companies backed by foreign VCs are more likely to list on foreign stock markets. Johan and Zhang (2016) provide evidence that a better business and legal environment is associated with successful exits of PE (private equity) managers. In countries with higher levels of corruption, PE managers can increase the probability of exits through IPOs. Cumming and Zhang (2019) find that relative to PE/VC funds, angel investors are more sensitive to economic conditions. Investee firms funded by angels are less likely to successfully exit in either an IPO or acquisition. Our paper focuses on the certification effect of VCs for start-up firms by certifying their value to customers in an emerging market rather than the role VCs play in the exit choice or performance of start-up firms in emerging markets.

Second, our study contributes to the literature on the real effects of signaling or the certification role played by financial institutions. In general, existing studies find that certification of financial institutions, such as debt rating agencies, investment banks, and commercial banks, has an important real effect for firms. For example, Sufi (2007) shows that rating agencies help firms increase the use of debt, asset growth, cash acquisitions, and investment in working capital. Titman and Trueman (1986) demonstrate that higher quality auditors and investment bankers signal a higher value of issuing firms and reduce issuance costs. Puri (1996) finds that bank underwriters also certify the issuing firm's value, leading to lower issuance costs. Slovin and Young (1990) argue that bank debt or credit lines signal the good value of firms and hence lower IPO underpricing. Our study finds new evidence supporting the positive real effect of financial institutions' signaling and certification.

Finally, our study is also related to the growing literature on P2P lending. Duarte et al. (2012) find that P2P borrowers that appear more trustworthy have a higher likelihood of funding probability and a lower default rate. Lin et al. (2013) show that lenders are more likely to fund borrowers who have stronger online social networks. Lin and Viswanathan (2015) show that P2P lenders have local bias in borrower selection. Wei and Lin (2016) find that, in P2P lending, the posted-price mechanism leads to a higher likelihood of funding, higher interest rates, and a higher default rate. Jiang et al. (2019) examine how P2P lenders select from thousands of P2P lending platforms using cross-platform data, and find that platforms that are backed by state-owned enterprises have larger facilitated loan amounts, attract more lenders, and pay lower interest rates to lenders. Our study complements this growing strand of literature by highlighting the roles of VCs in P2P lenders' investment decisions.

The rest of the paper is organized as follows. Section 2 presents institutional features. Section 3 describes our data and proxies. Section 4 introduces our methodology and empirical results, and Section 5 concludes.