Investment stage drifts and venture capital managerial incentives

- We study the effect of compensation schemes on VC investment stage drifts.
- When stock markets are performing well, managers tend to increase funds' risk.
- A higher hurdle rate discourages VC managers from lowering funds' risk.
- More reputable managers are less likely to increase risk by downward stage drifting.
- Managers with a poor past performance are less keen to perform upward drifts.

This paper investigates VC investment stage drifts as explained by the outcomes of managerial incentive schemes under different financial market conditions and past return performances. We exploit a unique dataset containing data for all of the venture capital funds in Europe that received financial support from the European Investment Fund (EIF) during the years 1998-2007. The dataset includes 149 VC funds that invested in 1925 companies. We find that a higher hurdle rate produces a compensation incentive that discourages VC managers from lowering funds' risk. We also observe that more reputable fund managers are less likely to increase risk by downward stage drifting and more likely to play it safe by following upward stage drifting strategies. Finally, managers of funds with a poor past performance appear to be less keen to perform stage drifts towards less risky stages, relative to well-performing fund managers. The latter evidence is more significant in periods of bull financial markets.