Since Krueger’s (1974) seminal work, numerous attempts have been undertaken to estimate the value of PTs. It has been shown that politically connected companies are more likely receive preferential access to bank loans (e.g., Chen et al., 2011; Zhou, 2009), preferential treatment by state-owned enterprises (Backman, 1999), relaxed regulatory oversight (Li and Zhou, 2015), and tax breaks or even government bailouts at hard times (e.g., Li et al., 2008; Siegel, 2007). There is also evidence in the literature that PTs destroy firm value. For example, Cheung, Jing, Raghavendra, Stouraitis (2005) and Fan, Wong, and Zhang (2007) show that PTs are detrimental to minority shareholders, a conclusion that is consistent with Shleifer and Vishney (1994)’s ‘grabbing hand’ model of government. Johnson et al. (2000) find that in countries where corruption is high, firms are more likely to hide output so as to reduce appropriation. Okhmatovskiy (2010) argue that firms with PTs experience significant constraints and costs associated with government official’s involvement in the corporate governance process.
China’s fast economic development has not been coupled with political liberalization and the government remains firmly in control of information and resources (Chen et al., 2011; Shi et al., 2014). In such an economy, the benefits associated with PTs are more likely to overweigh the costs (e.g., Sun et al., 2012; Shi et al., 2014). Peng and Luo (2000) argue that the positive effects of PTs are greater for private and smaller firms than their state-owned and larger peers, because resources obtained from PTs are more valuable for the former group due to the significant liabilities of newness, smallness, and privateness in transitional economies. Zhou (2013)
shows that PTs facilitate entrepreneurial reinvestment through better property rights protection. Liu, Luo, and Tian (2015) show that connections with government officials enable Chinese non-SOEs to increase their M&A activities, merge more local targets, and pay less M&A premium. In the similar vein, VCs with PTs are likely to obtain these invaluable resources, and thus enjoy greater success.
In addition, China’s IPO regulatory process is often subject to lobbying and political influence (Aharony, Lee, and Wong, 2000; Hung, Wong, and Zhang, 2012). Under China’s merit review regulatory regime, the government is a critical determinant of the accessibility of stock markets to individual companies (Huang, 2011; Li and
Zhou, 2015). As VCs generate most of their returns from successful exits via IPOs in
China11 (Ernst and Young, 2011), they have strong incentives to help portfolio firms
succeed in the IPO screening process. VCs with PTs may help obtain valuable insights into the IPO regulatory process through their ties with the government authorities, and help their portfolio firms better prepare for IPO applications (Humphery-Jenner and Suchard, 2013a). Li and Zhou (2015) show that firms with PTs receive preferential treatments from regulatory authorities and are less likely to be selected for pre-IPO on- site auditing in Chinese mainland stock markets. Also, they are likely to lobby more effectively for favourable regulatory decisions on behalf of their portfolio firms (Yang, 2013).
11 The administratively-controlled IPO process in China has led to an abnormally high IPO offer price and
even higher secondary market price in its stock markets (e.g., Lu et al., 2013). The launch of the SME and Venture Boards provides an opportunity for VCs to join this IPO wealth creation campaign. For example, during the first half of 2010, the average capital gain achieved by the venture capitalists was nearly 15 times for IPOs conducted on the domestic stock exchanges. This is compared to a mean return of 2.82 times for IPOs conducted overseas during the same period (Zero2IPO, 2010).
While VCs with PTs may enjoy greater success in domestic markets, PTs may play a limited role in facilitating a successful exit via foreign stock markets. Foreign developed markets are typically well established and have strong regulations. VCs with PTs may not have institutional knowledge about foreign markets or connections with key intermediaries in that market who can navigate the international listing process. For example, Mata and Freitas (2012) find that entrepreneurial firms suffer from the liability of foreignness when attempting to raise capital in developed markets. Such problems could be especially severe for firms operating in poor information environments (Moore, Bell, and Filatotchev, 2010). Connections with top-tier lawyers, investment banks, and accountants, rather than with the government, should be more important for VCs to facilitate international listings (Humphery-Jenner and Suchard, 2013b).
Overall, the above discussion suggests that VCs with PTs may enjoy greater success in exiting their investments in China. Consequently, we hypothesize that:
H1: PTs facilitate successful VC exits, particularly through mainland IPOs and
M&As.
The contingent perspective suggests that PTs are not uniform in their effects on firm performance, but rather vary across different types and composition of PTs (e.g., Sun et al., 2012; Wu et al., 2013).
Types of PTs. PTs can be classified into two types- ownership- and management- level ties (Faccio, 2006; Sun et al., 2011). The majority of VCs in China are either government-controlled, with natural connections with government, or have an executive with personal connections with the government (Liu et al., 2013). Most recent studies have focused on the direct government ownership on VC performance in developed markets. For example, Grilli and Murtinu (2014) use the VICO dataset and show that
private VCs are more effective than government-managed VCs in spurring the growth of portfolio firms in Europe. Based on the same database, Cumming, Grilli, and Murtinu (2015) find that private VC-backed companies have better exit performance than government-backed companies. Brander, Du, and Hellman (2015) examine firms funded by government-sponsored VCs in 25 countries and document a positive association between mixed government and private VC funding and VCs’ successful exits. However, it is unclear whether these findings are generalizable to VCs in a transitional market that is often characterized by significant political and economic
risks12, which PTs might help to mitigate (Cao, Humphery-Jenner, and Suchard, 2013).
According to the political connections hypothesis (e.g., Chen et al., 2011; Li and Zhou, 2015; Liu et al., 2013), VCs with ownership-level PTs may have a competitive advantage relative to private VCs due to their inherent government connections. This would be especially the case in transitional economies where many important aspects of business operations are significantly influenced by various government agencies. However, the incentive hypothesis (Shleifer, 1998; Lerner, 2010) suggests that VCs with ownership-level PTs underperform private VCs due to the agency problems associated with direct government ownership. Such VCs are likely to be burdened with public or political objectives to support innovative start-ups whose risk and return prospects are not attractive (Zhang, Gao, White, Vega, 2008). Further, they are less likely to adopt high-powered incentive compensation contracts (Chen, Guan, and Ke, 2013; Ke and Wang, 2015). Therefore, managers might not have strong incentives to acquire private information to select or closely monitor their portfolio firms.
12 Political and economic risks include the uncertainty in government regulations and the legal
Compared with VCs with ownership-level PTs, VCs with management-level ties aim primarily for profit maximization. Although they may not receive all the benefits enjoyed by VCs with ownership-level PTs (e.g., exemptions from regulatory requirements, less privilege to obtain government funds, and less likely to help firms gain legitimacy), VCs with management-level PTs are able to maintain autonomy and attenuate the inefficiencies and costs while still helping firms access other valuable resources (e.g., Okhmatovskiy, 2010; Chen et al., 2011; Liu et al., 2013). Thus, VCs with management-level PTs are likely to enjoy greater success as compared to VCs with ownership-level PTs. Consequently, we develop the following hypothesis:
H2: Ownership-level PTs have less positive effects on VC exits than management-
level PTs.
Compositions of PTs. PTs can be classified into two levels- ties with the central government (central PTs) and ties with local governments (local PTs). Early studies find that central PTs have a more distinct impact on firm performance for two reasons (Qian and Li, 2010; Wu et al., 2013). First, central PTs confer more timely information and can transmit a stronger and more legitimate signal to other investors. Second, due to the hierarchical system in China, central PTs help firms obtain resources and administrative support from local governments. However, the ongoing reallocation of administrative power in China has empowered local governments to make the majority of economic decisions (Chen et al., 2011). Since central government’s interest may not align with those of local governments, firms with central government ties may be unable to obtain critical resources controlled by local governments.
During the recent years of VC development, local governments have been major direct and indirect players in regional VC markets in China. In addition to establishing local government VCs, municipal governments such as Beijing, Shanghai, Tianjin, and Shenzhen have enacted local rules to support the establishment of VC funds, because new ventures were seen as contributing to the local economic development. The local government support includes relaxed formation procedures, tax reduction, cash bonus on the establishment, and lower capital requirements as specified by the central government (China Business Review, 2009). While VCs with central PTs may enjoy timely policy information, VCs with local PTs are likely to benefit from resources provided by the local governments. Consequently, the net effect of central and local PTs on VC success is not clear. In this study, we propose that local PTs have greater positive effects on VC exits:
H3: Local PTs have greater positive effects on VC exits than central PTs.