Disciplining Delegated Monitors: Evidence from Venture Capital

Abstract

Information-based theories of financial intermediation focus on delegated monitoring. However, there is little evidence on how markets discipline financial intermediaries who fail at this function. This paper uses the venture capital (VC) market to address this gap in the empirical literature by looking at how VC’s reputations are affected when they fail in their monitoring role to prevent fraud by their portfolio firms. We find that VCs who fail to prevent fraud experience greater difficulty in taking future portfolio firms public, and that the negative effect prevails over ten years after the fraud surfaces. In addition, reputation-damaged VCs interact differently in the future with their limited partners, other VCs in the community, and their IPO underwriters because they are perceived by these groups as inefficient monitors