Politician as Venture Capitalist: Politically Connected VC and IPO Activity in China

Transcription

1 Politician as Venture Capitalist: Politically Connected VC and IPO Activity in China Rouzhi Wang & Chaopeng Wu Rouzhi Wang Rutgers Business School Newark & New Brunswick Rutgers University Newark, NJ 07102, USA Telephone: (+1) Chaopeng Wu * School of Management Xiamen University Xiamen , P. R. China Telephone: (0086) wuchaopeng@xmu.edu.cn * Contact: Rouzhi Wang, Department of Finance and Economics, Rutgers Business School, rw488@scarletmail.rutgers.edu; Chaopeng Wu (Corresponding author), Department of Finance, School of Management, Xiamen University, wuchaopeng@xmu.edu.cn. Wu gratefully acknowledge the financial support from the National Natural Science Foundation of China ( , , , , and ) and the Major Research Project of Philosophical and Social Sciences of China Education Ministry (15JZD019). 1

2 Politician as Venture Capitalist: Politically Connected VC and IPO Activity in China Abstract The economic consequences of politician s intervention in venture capital market have attracted little empirical attention. The article investigates how politically connected venture capitalists (VCs) affect the initial public offering (IPO) activities of their portfolio firms. Focusing on China, a politicized and relationship-based economy, we show that firms backed by politically connected VCs are more like to obtain approval for IPOs from Chinese Securities Regulatory Commission (CSRC, China s counterpart to the U.S. SEC) than other firms. We also show that compared to non-politically connected VCs, politically connected VCs acquire target firms equity at a significant discount and are more likely to invest shortly before the firms submit their IPO applications. Further examining the monitoring role of politically connected VCs by using a difference-in-differences approach, we show that the firms backed by politically connected VCs do not experience greater improvements in financial performance, corporate governance, and innovation output subsequent to receiving venture financing than the firms backed by non-politically connected VCs. Finally, the firms backed by politically connected VCs are younger and more underpriced at their IPOs than those of non-politically connected VCs. All the above effects are stronger if the politician who relates to VC firm has currently or previously held a position with more political power, or served in the central government or the CSRC. Our results are robust to tests designed to mitigate concerns of selection bias and omitted variable problem. Overall, our results reveal that the politically connected VCs provide political relationship but not better monitoring for their portfolio firms, and political forces distort the allocation of scarce capital from an economic efficiency perspective. Keywords: Politically connection, Venture capital, Initial public offering, China JEL: G34, G14, M41 2

3 1. Introduction Understanding the economic consequence of government intervention in business activities is an important theme in the economics and finance literature. A large body of research argues that the major objective of government intervention is rent seeking, extraction and protection (see. e.g., Stigler, 1971; Shleifer and Vishny, 1994, 1998; Fan, Wong, and Zhang, 2007). Acemoglu and Johnson (2005) further suggest that government expropriation is more severe in the countries with weaker property rights, which leads to lower economic growth and investment rates, and less developed stock markets in these countries. Focusing on China, a country with a relatively weak property rights institutions and underdeveloped financial systems, this paper examines the effect of politician s intervention in the venture capital (VC) market on the IPO activities of entrepreneurial firms and the efficiency of capital market resource allocation. Anecdotal evidence, for example a recent article in New York Times, shows that China s politicians and their relatives have been involved in venture capital funds and have made huge profits from the IPOs of their portfolio firms. 1 However, there has been scare empirical evidence on whether politicians involvement in venture capital funds could affect the IPO listing process of the entrepreneurial firms they back. In China, IPOs are controlled as a scare resource by the central government. All IPO candidates need to submit an application to the China Securities Regulatory Commission (CSRC, China s counterpart to the U.S. SEC) and only approved firms can then be listed. The IPO regulation leaves government officials with ample opportunities for rent seeking. Therefore, theory predicts that the involvement of politicians in venture capital funds and their influence on the IPO listing process distorts the allocation of scarce capital from an economic efficiency perspective. To empirically examine the theoretical prediction, we capture the involvement of politicians in a VC fund by a measure of VC s politically connections. Following Faccio and Hsu (2017), we classify a VC fund (VC firm) as politically connected if any of the general partners, directors, and senior managers has a major political position (i.e., served as county-head or higher level official) or reported being the 1 Forsythe, M., Alibaba s I.P.O. Could Be a Bonanza for the Scions of Chinese Leaders, The New York Times, July 20, 2014, 3

4 relative of another person in a major political position. Based on the definition, 25.1% of the (687) venture capital firms in our sample are politically connected, and 27.8% of the (1,613) entrepreneurial firms in our sample are backed by at least one politically connected venture capital firm. We further explore, step by step, the role of politically connected VCs in the IPO activities and performance improvement of the entrepreneurial firms that they invest in. We answer the following three questions: First, is the likelihood of a politically connected VC-backed firm receiving approval for an IPO from CSRC higher than that of a non-politically connected VC-backed firm? Second, if the answer to the first question is yes, the next question is why politically connected VCs matter more. Is it because politically connected VCs are able to identify and invest in higher-quality entrepreneurial firms (screening hypothesis), or do they provide more extra-financial value-added services to their portfolio firms than do those of non-politically connected VCs (value-added services hypothesis)? Third, if politically connected VCs do provide firms with better value-added services rather than screening effect, the next question is what value-added services politically connected VCs provide. Do politically connected VCs provide more monitoring activities to improve firm performance, corporate governance and innovation output than those provided by non-politically connected VCs (monitoring hypothesis), or do they provide a better-quality relationship with CSRC official, which influence the IPO approval decisions (political relationship hypothesis)? To provide an empirical investigation on the above three research questions, we collect data on 1,613 entrepreneurial firms that submitted 1,779 applications for an IPO to CSRC during 2007 to The results of our empirical analysis can be summarized as follows. We start by answering the first question, i.e., the impact of VCs political connections on the likelihood of receiving IPO approval. We find that after controlling for time-varying firm characteristics, industry- and IPO application year- fixed effects, the likelihood of politically connected VC-backed firms receiving IPO approval is about 3.5% higher than non-vc-backed firms. However, there is no significant difference in the likelihood of IPO approval between non-politically connected VC-backed firms and non-vc-backed firms. We further divide politically connected VCs into two groups: VCs related to central-government 4

5 officials (central-government connected) and VCs related to local-government officials (localgovernment connected). The central-government connected VCs are more likely to establish political ties with the CSRC officials because of frequent job-related interaction. Indeed, we show that the likelihood of central-government connected VC-backed firms receiving IPO approval is 4.7% higher than that of non-vc-backed firms, while local-government connected VCs have no significant effect on firm s IPO approval rates. Moreover, the politicians who have served in the CSRC or have jurisdiction over CSRC may have greater influence on CSRC s decisions than other politicians, therefore, we divide politically connected VCs into CSRC-connected VCs and non-csrc-connected VCs and examine whether CSRC-connected VCs have a stronger effect on the IPO approval rate than that of non-csrcconnected VCs. We find that the likelihood of CSRC connected VC-backed firms receiving IPO approval is 7.6% higher than that of non-vc-backed firms, while non-csrc connected VCs have a positive but insignificant effect on firm s IPO approval rates. Next, we examine whether the effect of politically connected VC-backing on the IPO approval rate varies with the political power of the politician related to the VC firm. The average IPO approval rate for the firms backed by VCs related to politicians of a national leader, provincial leader, municipal leader, and county leader are are 88.2%, 86.9%, 85.3% and 84.9% respectively, while that of all other firms is 81.2%. It suggests that the IPO approval rate of politically connected VC-backed firms monotonically increase with the political power of the politician related to VC firm. To rule out the possibility that the positive relation between politically connected VC-backing and the likelihood of the firm receiving IPO approval is due to omitted unobserved variables that are both correlated with politically connected VC-backing and IPO approval rates, we re-examine the effect of politically connected VC-backing on the likelihood of the firm receiving IPO approval using a subsample of IPOs with multiple applications. The sample includes 328 IPO applications submitted by 162 firms which apply for listing at least twice. After an IPO application is rejected by the CSRC, the firm usually applies for an IPO again in the following few years. During this short interval, some firms obtain financing from politically connected VCs, which may change their status from non-vc backing or non-politically-connected VC backing into politically connected VC backing. In our analysis, we include the firm fixed effects to explicitly isolate variation within a firm s multiple applications 5

6 observations, and include the sequence of IPO applications to address the concern that firm characteristics may vary over different rounds of applications. We find that the probability of receiving IPO approval for a firm that seek and obtain financing from politically connected VCs after a previous rejection is 4.7% higher than that for a similar firm that does not seek financing from politically connected VCs after a rejection. To answer the second question, namely, why politically connected VCs are able to improve the likelihood of receiving IPO approval rate for firms they invest in, two hypotheses are proposed. The first hypothesis, the screening hypothesis, argues that politically connected VCs do not provide extra valueadded service compared to non-politically connected VCs, but they could select better-quality firms to invest in and therefore, their portfolio firms are more likely to go public. The second hypothesis, the value-added services hypothesis, argues that politically connected VCs can provide more extra-financial value-added services to their portfolio firms, which help their firm to go public. We distinguish these two competing hypotheses by comparing the per-share price that politically connected VCs pay to acquire a firm s equity with the per-share price paid by non-politically connected VCs to acquire the same firm s equity at the same financing round. According to the screening hypothesis, politically connected VCs just select higher-quality firms to invest in and do not provide more value-added service than non-politically connected VCs, therefore we should not observe that politically connected VCs acquire a firm s equity at a discount relative to non-politically connected VCs as they both select the same firm. However, the value-added services hypothesis makes an opposite empirical prediction. Since politically connected VCs could provide more value-added services to their portfolio firms, they should earn a discount in acquiring the firm s equity relative to non-politically connected VCs. The empirical results show that politically connected VCs acquire a firm s equity at a significant discount relative to non-politically connected VCs, and the discount is ever larger for the central-government connected VCs and CSRC-connected VCs, consistent with the prediction of the value-added services hypothesis. To answer the third question, namely, what extra value-added services politically connected VCs provide, two hypotheses are proposed. The first hypothesis, the monitoring hypothesis, proposes that compared to non-politically connected VCs, politically connected VCs could provide more monitoring activities, such as scrutinizing management actions, professionalizing management, providing product 6

7 market support, etc. (see e.g., Lerner, 1995; Hellmann and Puri, 2002; Chemmanur, Krishnan, and Nandy, 2011; Davis et al., 2014). The second hypothesis, the political relationship hypothesis, proposes that compared to non-politically connected VCs, politically connected VCs are more likely to utilize their political force or better-quality relationship with CSRC officials to influence CSRC s IPO approval decision. To examine the two hypotheses, we conduct three sets of tests. First, to directly test the monitoring hypothesis, we apply a difference-in-difference (DiD) approach to examine whether the active monitoring implemented by politically connected VCs leads to a greater improvement in financial performance, corporate governance and innovation output for their portfolio firms than do non-politically connected VCs after the VC investment. We find that both politically connected VC-backed firms and non-politically connected VC-backed firms experience significant improvement in cash holding, corporate governance and innovation output over the two-year period immediately preceding VC investment relative to VC investment year. The improvement for politically connected VC-backed firms, however, is not significantly different from that for non-politically connected VC-backed firms. Therefore, the DiD results are not consistent with the prediction of the monitoring hypothesis. Second, to test the political relationship hypothesis, we examine whether politically connected VCs are more likely to make a last-minute deal, namely, invest within one-year before the IPO application than do non-politically connected VCs. The political relationship hypothesis states that politically connected VCs have stronger bargaining power when negotiating with entrepreneurial firms because they have better-quality relationships with CSRC officials and are more likely to influence the IPO approval decisions. Therefore, owning a scarce political resource, politically connected VCs could reduce their investment risk by investing in the firm until the prospects for this investment become clearer even though the firms are more mature and have less financial need at that time. Indeed, our empirical results show that politically connected VCs are more likely to make a last-minute deal, i.e., invest within one-year before the firms IPO application compared with non-politically connected VCs, and the effect is even stronger for the central-government connected VCs and CSRC-connected VCs. The findings are consistent with the prediction of the political relationship hypothesis. Finally, we further distinguish the two hypotheses by comparing the IPO underpricing of politically 7

8 connected VC- and non-politically connected VC-backed firms. The monitoring hypothesis predicts that if politically connected VCs provide better-quality monitoring activities than do non-politically connected VCs, then the firms backed by politically connected VCs should have less IPO underpricing than those backed by non-politically connected VCs. On the other hand, the political relationship hypothesis predicts that less mature firms have greater demand for the scarce political resource provided by politically connected VCs, therefore, the firms backed by politically connected VCs are less mature and experience more underpricing at their IPO. The empirical results show that politically connected VCs bring companies public earlier than non-politically connected VCs and the IPOs backed by politically connected VCs are associated with greater underpricing, again consistent with the prediction of the political relationship hypothesis rather than that of the monitoring hypothesis. 2. Relations to Existing Literatures Our paper contributes to three strands of literature. First, our paper is related to the literature on the importance of venture capitalists in the development of entrepreneurial firms. Previous studies show that a major feature that distinguishes VC investors from other investors is that they provide value-added services for start-up firms. These value-added services include scrutinizing management actions, improving corporate governance, and productive efficiency, promoting innovation output, etc. For example, Lerner (1995) examines VCs representation on the boards of private firms and analyzes whether this representation is greater when the need for oversight is greater. Hellmann and Puri (2002) find that venture capital is related to a variety of professionalization measures of start-up firms, such as human resource policies, the adoption of stock option plans, and the hiring of a marketing VP. Hochberg (2012) finds that VC-backed firms reduce the extent of earnings management and introduce more independent board structures compared with non-vc-backed firms. Chemmanur, Krishnan and Nandy (2011) find that VCs improve the total factor productivity (TFP) of their firms, and the overall efficiency gains generated by VC backing arise primarily from improvements in sales. Davis et al. (2014) further show that VCs increase TFP of their targets through accelerating the exits of less productive establishments, and greater entry of highly productive ones. Tian and Wang (2014) find that VCs spur 8

9 firm innovations through tolerance for failure. Bernstein, Giroud and Townsend (2016) show that venture capitalists (VCs) on-site involvement with their portfolio companies leads to an increase in both innovation and the likelihood of a successful exit. This paper extends the above literature by showing that VC investors, particularly those with political connections, could provide a new type of value-added service by utilizing their close relationship with the government regulators to improve the likelihood of their portfolio firms receiving IPO approval in an environment with weak property rights institutions. Second, our paper also adds to the existing literature comparing the roles of VCs with different characteristics in helping start-up firms. For example, Hsu (2004) find that offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10 14% discount. Nahata (2008) find companies backed by more reputable VCs are more likely to exit successfully, access public markets faster, and have higher asset productivity at the IPOs. Hochberg, Ljungqvist and Lu (2007) find that better-networked VC firms experience significantly better fund performance and the portfolio companies of better-networked VCs are significantly more likely to survive to subsequent financing and eventual exit. Bottazzi, Da Rin and Hellmann (2008) show that venture capital firms with partners that have prior business experience are more active in recruiting managers and directors, helping with fundraising, and interacting more frequently with their portfolio companies. Chemmanur, Loutskina and Tian (2014) find that corporate venture capital (CVC) backed firms are more innovative than independent venture capital (IVC) backed ones, because CVCs have greater industry knowledge and they are more tolerant of failure. Our paper contributes to this line of research by exploring a new characteristic of VCs, namely, VCs political connection. Very little empirical work has shed light on the role of politically connected venture capitalists or private equity, with one notable exception of Faccio and Hsu (2017). They investigate the impact of politically connected private equity on employment and show that establishments operated by targets of politically connected private equity firms significantly boost employment following a buyout. Our paper complements their findings by providing the first empirical study on how politically connected VCs influence the likelihood of their portfolio firms receiving IPO approval from the CSRC, the per-unit share price paid by VC to acquiring firm s equity, timing of VC s investment, and the IPO underpricing of their portfolio firms. The findings thus extend our knowledge on the role played by politically 9

10 connected VCs in the development of entrepreneurial firms in certain politicized environments. Finally, our paper also relates to the literature on government intervention and political connections. Previous studies show that political connections can bring benefits to firms, including preferential access to credit (Johnson&Mitton (2003), Cull and Xu (2005), Khwaja and Mian (2005), Houston et al. (2014)), lighter taxation (De Soto (1989)), government contracts (Goldman, Rocholl, and So (2013)), government aid (Faccio, Masulis, and McConnell (2006)), relaxed regulatory oversight (Stigler (1971), De Soto (1989), Kroszner and Stratmann (1998)), a lower likelihood of fraud detection (Yu and Yu (2011)), and less severe enforcement outcomes (Fulmer, Knill and Yu(2017)). However, some other research also suggests that CEO political connections have an adverse effect on firm performance in countries with weaker property rights and limited protection against expropriation. For example, focusing on China, Fan, Wong and Zhang (2007) show that firms with politically connected CEOs have poorer three-year post-ipo stock returns, earnings growth, sales growth, and change in returns on sales than those without politically connected CEOs. Different from the prior researches, which mainly focus on examining the benefit and cost of politically connected CEOs, our paper investigates a new form of political connection and explores the benefits and costs of the entrepreneurial firms receiving financing from politically connected VCs. Our research shows that although the firms receiving financing from politically connected VCs could improve the likelihood of their receiving IPO approval from the CSRC, they bear the cost of lower valuation offered by politically connected VCs in their investment and higher IPO underpricing. Most importantly, politically connected VCs bring less-matured firm to go public, which may distort the allocation of scarce resource in capital market from an economic efficiency perspective. 3. Data, Sample Selection, and Variables 3.1. Data and Sample We collect a comprehensive sample of IPO applications submitted to China Securities Regulatory Commission (CSRC) over the period from 2007 to To be included in the sample for analysis, an IPO application must meet the following criteria: (1) the final decision for IPO application is approved 10

11 or rejected, but not review postponed and review canceled, which occur when the firms are requested to submit supplemental materials before being reviewed again, or when the firms themselves decide to withdraw their IPO applications; (2) the IPO applicant is not a financial or financial-services firm. Our final sample consists of 1,779 IPO application submitted by 1,613 firms to CSRC. Of the 1,779 applications, 1,460 are approved and 319 are rejected. It is worth noting that since a firm may fail several times before getting an IPO approval, the number of IPO applications is greater than the number of firms applying. There are 328 multiple applications for an IPO submitted by 162 firms, with 158 firms applying for 2 times and 4 firms applying for 3 times. We manually collect the data on pre-ipo VC investment in the firms submitting IPO applications from their preliminary IPO prospectuses posted on the website of the CSRC, which include the date, the amounts of venture deals, the per-unit share price offered by VCs, and the percentage of shares acquired by VCs. To identify VC financing, we check whether a new shareholder of equity financing is included in VC/PE lists from WIND VC/PE database. We supplement these data with information on the type of VC firm s limited partner (LP), i.e., whether the VC s largest shareholder (LP) is the central government, provincial governments, or others, and the amount under management of the VC firm from the Wind PE/VC database. In total, we identify 687 VCs investing in 727 entrepreneurial companies, which submit 787 IPO applications. The 687 VCs invest in the companies in 910 financing rounds, representing 1,858 observations at the VC-financing round level. Additional information on the CSRC s decisions regarding IPO applications, the date of IPO applications and issues, and the firm s financial data, stock return, and auditor market shares are obtained from the Wind database. The political connection of company executives comes from the CSMAR database. The size of lead underwriters comes from announcements of the Securities Association of China. The marketization index of Chinese provinces comes from Fan et al. (2007, 2010, 2011, 2017) Variable Measurement Identifying Politically Connected Venture Capital Firms We extract biographical information for each individual in the 687 venture capital firms that invest 11

12 in the IPO applying firms to determine whether these VC firms are politically connected. These individuals are primarily the VC firms (general) partners, directors, and senior managers such as vicepresidents, associates and principals. We obtain the biographical information of these individuals from the official website of VC firm, the National Enterprise Credit Information Publicity System 2, news articles and firm s announcement. Each biography includes detailed information about the individual s education, professional experience, and political positions and affiliations. According to the Civil Servant Law of the People s Republic of China, the administrative ranks of government officials are classified as 11 levels (from the most powerful to the least powerful): President (Level-11), Deputy president (Level-10), Governor of Province (Level-9), Deputy governor of Province (Level-8), Mayor of City (Level-7), Deputy Mayor of City (Level-6), County head (Level-5), Deputy county head (Level- 4), Chief of town (Level-3), Deputy chief of town (Level-2), Village head (Level-1). Since the committee members in CSRC who take charge of the IPO issuance approval usually have an administrative rank not lower than Level-5 (County head), the politicians whose administrative rank not lower than Level- 5 are likely to influence the CSRC committee s decision. Therefore, we define a venture capital firm as politically connected if at least one individual (i.e., general partners, directors, and senior managers) in the VC firm currently or previously served as county head (Level-5) or higher-level official, or is reported being the relative of another person in the political positions with administrative ranks not lower than Level-5. Note that because the politically connected individuals may join or leave a VC firm over time, we thus treat political connections as time variant at the VC firm level. If a VC has more than 2 The National Enterprise Credit Information Publicity System is an online resource that provides free information about companies to the public. The system covers companies registered with state or local Administration of Industry and Commerce with their registration information, shareholder information, investment information and other voluntary disclosures according to the Regulation of the People's Republic of China on the Disclosure of Government Information and the Interim Regulation on Enterprise Information Disclosure. 12

13 one politically connected individuals, we define the administrative level of political connection based on the individual with the highest administrative level. Our definition of politically connected VC is similar to that of Faccio and Hsu (2017) on politically connected private equity. Given that the politicians who serve in the central government and those in local government may have a different influence on CSRC s IPO examination decision, we divide the politically connected VCs into central-government connected VCs and local-government connected VCs. A venture capital firm is defined as central-government connected if at least one individual in the VC firm (i.e., general partner, director and senior manager) or a relative of these individuals currently or previously served in the political positions of central governments and has an administrative rank not lower than Level-5, otherwise are defined as local-government connected. Given that the politicians who serve in the CSRC or have jurisdiction over the CSRC may have greater influence on CSRC s decisions than other politicians, we further divide the politically connected VCs into CSRC connected VCs and non-csrc connected VCs. A venture capital firm is defined as CSRC connected if at least one individual in the VC firm (i.e., general partner, director and senior manager) or a relative of these individuals currently or previously served in the CSRC or has jurisdiction over CSRC and has an administrative rank not lower than Level-5, otherwise are defined as non-csrc connected. Among our sample of 687 venture capital firms, 25.1% (172) VC firms are classified as politically connected, 72 (100) VC firms are classified as central-government (local-government) connected, and 41 (131) VC firms are classified as CSRC (non-csrc) connected. A VC-backed firm is defined as politically connected VC-backed firm if it receives financing from at least one politically connected VC investors, otherwise is defined as non-politically connected VC. Based on the definition, 27.8% (448) 13

14 of the (1613) entrepreneurial firms in our sample are classified as politically connected VC-backed firms, 314 (134) firms are classified as central-government (local-government) connected VC-backed firms, and 205 (243) firms are classified as CSRC (non-csrc) connected VC-backed firms IPO Characteristics Variables In the later empirical analyses, we construct the following two dependent variables to capture the IPO characteristics. IPO Approval, is an indicator variable equal to one if the CSRC approves the firm s IPO application, and zero otherwise (i.e., IPO application rejected). IPO Underpricing, is measured as the IPO underpricing adjusted by the market return. Specifically, we use the equation below to calculate the IPO underpricing: IPO Underpricing = P it P i0 P i0 M it M i0 M i0 (1) where, P i0 is the IPO offering price of new issue i. M i0 is the closing value of the corresponding Shanghai or Shenzhen A-share market index on the first trading day of the new issue i. P it and M it are defined differently in the two sub-periods before and after January 1 st, A new rule on IPO are released by the Shanghai and Shenzhen Stock Exchanges in December 13, 2013, which limits the stock return in the first trading day of an IPO to 44% 3 and the daily returns to 10% in the days after the first trading day. The new rule is applied to the new issues after January 1 st, Before the new IPO rule, there is no limit on the IPO s first trading day stock return. Therefore, for the IPO issues before January 1 st, 2014, P it is the closing price of stock i on the first trading day of IPO, and M it is the closing value of the corresponding Shanghai or Shenzhen A-share market index on the first trading day of the stock i. For the IPO issues after January 1 st, 2014, P it is the closing price of stock i on the first day that its closing price does not reach the daily limit, and M it is the closing value of the corresponding Shanghai or Shenzhen A-share market index on the same day VC Investment Behavior Variables 3 See the Notice on Further Strengthening the Regulation on the Trading During the Initial Period of New Issues released by Shanghai Stock Exchange, and the Notice on the Temporary Suspension of the First Trading Day of the IPOs released by Shenzhen Stock Exchange on December 13,

15 In the later empirical analyses, we construct the following two dependent variables to capture the investment behavior of VC firms. First, Relative Share Price, is measured as the share price paid by a VC investor to acquire an entrepreneurial firm s equity relative to the highest share price paid by all VC investors to that firm at the same financing round. This variable incorporates the information about the comparative nature of the financing offers from different VC firms. Second, Last-minute Deal, is a dummy variable equal to 1 if a VC firm invest in a firm less than a year prior to the IPO application day, and zero otherwise Control Variables Based on China s IPO listing rules and the prior literature (see e.g., Chemmanur, He, He, and Nandy, 2016), we include an extensive array of firm- and province-level controls identified as potential determinants of the probability that a firm s IPO application approved by the CSRC. Since that firms may become more experienced and better prepared in the later applications, which could result in a higher IPO approval rate in the later round, we control for the sequence of IPO applications (Application Sequence) in our model. The CSCR requires that to go public, the applicants must meet a certain threshold in net income, total sales, and the proportion of intangible assets 4. We thus control the corresponding financial indicators such as Ln(NI) (the natural logarithm of the sum of net income over the three-year period prior to the IPO application), Ln(Sales) (the natural logarithm of the sum of total sales over the three-year period prior to the IPO application), Sales Growth (the annual geometric growth rate of total sales over the three-year period prior to the IPO application), and Intangible (the ratio of intangible assets over total assets in the year prior to the IPO application). In addition, according to the CSRC s regulations on cash management of IPO applicant, we also control 4 According to the CSRC Measures for the Administration of the Initial Public Offerings and Listings and the Administrative Measures for Initial Public Offering s and Listing on the Growth Enterprise Market, the thresholds on firm accounting performance of IPO applications on the Main Board and the SME are as follows. The net income of the last three fiscal years should all be positive and accumulate to exceed 30 million RMB. The net cash flow of the last three fiscal years should accumulate to exceed 50 million RMB, or the sales of the last three fiscal years accumulate to exceed 300 million RMB. The proportion of intangible assets of the last fiscal years should be less than 20%. The thresholds on firm accounting performance of IPO applications on the GEM are as follows. Either the net income of the last two fiscal year should both be positive and accumulate to exceed 10 million RMB, or the net income of the last fiscal year be positive and last year sales be no less than 50 million RMB. 15

16 for the illegal occupation of company funds by a controlling shareholder,which is measured as Other Receivables (other receivables divided by total assets) following Jiang et al (2010). As the CSRC sets different thresholds for the firms that apply to be listed on the Main Board Market, the Small and Medium Enterprise Board (SME), and the Growth Enterprise Board (GEB, also known as ChiNext), we control for Listing Market (a dummy variable equal to one if a firm intends to list on the SME or the GEB). To isolate the effect of politically connected VC from the effect of politically connected corporate top executives on IPO approval rates (Liu, Tang and Tian, 2013), we control for the political connection of top executives (Political Connected Executives, a dummy equal to one if at least one of the top executives, including CEO, chairman, directors and vice general manager, are politically connected). To control for the impact of the firm s ownership type on IPO approval rates, we add a dummy variable, State-owned (equal to one if the ultimately controlling shareholder of the firm is central or local government, and zero otherwise). As the extent of marketization varies across provinces, which may influence the firm quality and thus affect their IPO approval rate, we thus include the marketization index of the province in which the firm s headquarter is located (Marketization). Moreover, prior studies show that the firms employing IPO underwriters and auditing firms with larger scale and higher reputation are more likely to obtain approval from CSRC (Du and Lai, 2017), therefore, we further control for the Auditor Market Share (the sum of total assets of all IPO applying firms audited by the auditor in a year over the sum of total assets of all IPO applying firms in that year) and Underwriter Reputation (a dummy equal to one if the lead underwriter of the firm is one of the top-10 IPO underwriters with the highest revenue from underwriting stocks in the prior year). We compute all variables for applicant firm i in the year prior to the IPO application review if no otherwise specified. In examining the impact of VCs political connection on the relative share price offered by them to the target firms, we follow prior studies (see e.g., Hsu (2004)) and control for a set of other VC characteristics that may affect the relative share price offered. Funds Raised (the amount of prior funds (in billion RMB) that a VC has raised before this round of VC financing), Financing Offered (the natural logarithm of the amount of capital invested in a target firm (in million RMB) by the VC firm), Equity 16

17 Taken (the percentage of target s equity received by the VC firm as a result of the financing offer). Moreover, considering that the ownership type of VC s limited partnership may affect VC s bargaining power, we further control for two dummy variables: Central-government Owned VC (a dummy equal to one if the VC firm receive the majority of their funding from the central government or centralgovernment controlled business enterprises or both, zero otherwise) and Local-governments Owned VC (t a dummy equal to one if the VC firm receive the majority of their funding from the local-government or local-government controlled business enterprises or both, zero otherwise). Detailed variable definitions are provided in Appendix Table Summary Statistics Table 1 provides summary statistics. Among the 1,779 firm-application level observations, the average IPO approval rate is 82.1%. Among the 732 VC-level observations in the financing rounds with at least two VC investors, the relative share price, i.e., the share price offered by a VC scaled by the highest offered price, is Among the 1,858 VC-portfolio company-financing round level observations, 10.6% of VC-portfolio company pairs reach a last-minute deal, that is the VCs invests in a firm less than one year prior to the IPO application. Among the 646 VC-backed firms that finally go public, the average underpricing of the IPO is 128.5%. In our sample of 1779 IPO applications, 44.2% of applications are submitted by VC-backed firms, 26.8% are submitted by politically connected VC-backed firms, 18.2% are submitted by centralgovernment connected VC-backed firms, 8.6% are submitted by local-government connected VCbacked firms, 11.5% are submitted by CSRC connected VC-backed firms and 15.2% are submitted by non-csrc connected VC-backed firms. On average, a firm submitting an IPO application has total net income of billion RMB, billion RMB of total sales, and 30.4% of annual sales growth over the three years prior to the application. An average firm has an intangible asset ratio of 5.38% and other receivables to assets ratio of 1.7% in the year prior to the application. Only 12.4% of IPO applications are submitted by state-owned firms. 46.1% of IPO applications are submitted by firms with politically connected executives. The average market share of the auditor hired by the applying firm is 3.8%. 25.6% of the applying firms hire a lead 17

18 underwriter that ranks in the top-10 IPO underwriters with the highest revenue in the prior year. 82.9% of the applying firms intend to list on the SME or GEM. The average marketization index of the province in which the applying firms headquarters is located is In our sample of 732 VC financing rounds with at least two VC investors, an average VC firm raises billion RMB of funds before this round of VC financing, invests million RMB and receives 4.8% of target firm equity in the financing round. 4% of VCs in our sample are majority owned by central government and 19.7% are majority owned by local government. 4. Empirical Results and Analysis 4.1 The Likelihood of an IPO application being approved We use various forms of the following logit model to examine the impact of VC-backing and political connected VC-backing on the approval rates of a firm s IPO application. P(IPO Approval=1) = α + βvc Backing + γx + Industry + Application Year + ɛ, (2) where the dependent variable is IPO Approval, an indicator variable for whether the CSRC approves an IPO application submitted by the firm. In the baseline regression, the key independent variable is VC Backing, an indicator variable for whether a firm is backed by a VC investor. X represents a series of control variables of firm-level and local-level characteristics that may influence the IPO approval rate defined in detail in Section The model also includes the industry fixed effect based on CSRC industry classifications, as well as the application year fixed effects to control for the changes of listing rules and economy-wide shocks. We cluster standard errors at the firm level. Our sample in regression analysis includes 1,779 observations of IPO applications, that is, if a firm has submitted IPO applications for N times, there will be N observations for the firm. Table 2 reports the logit regression results. The reported coefficients are logit estimates of the effect of a marginal change in the corresponding regressor on the probability of an IPO application being approved, computed at the sample mean of the independent variables. In Column (1), we report the results for the specifications that include only the control variables. We show that the IPO applications are more likely to get approved in the later rounds of application and when the applying firm has higher 18

19 total net income, hires an auditor with a larger market shares, hires an IPO underwriter with higher reputation, applies to be listed on the Small and Medium Enterprise Board (SME) or the Growth Enterprise Board (GEB), or is located in a province with a higher level of marketization. In Column (2), we present the results when we add our main variable of interest, VC Backing, into our regression model. We find that the estimated coefficient of VC Backing is and is statistically significant at the 5% level, suggesting that the likelihood of the firm receiving IPO approval for VCbacked firms is 2.7% higher than that of non-vc-backed firms. To examine the effect of politically connected VC on the IPO approval rate, we further divide our explanatory variable, VC Backing, into two separate variables based on whether the applicant is backed by a VC firm with political connections: Politically Connected VC Backing and Non-Politically Connected VC Backing. Column (3) show that the coefficient for Politically Connected VC Backing is (P-Value =0.028), while the coefficient for Non-Politically Connected VC is not statistically significant. The difference between the coefficient estimate for Politically Connected VC Backing and that for Non-Politically Connected VC is statistically significant. The results are also economically meaningful. The IPO approval rate of the firm backed by a politically connected VC is 3.5% higher than that of other firms. In Column (4), we further differentiate the effect of central-government connected VC from that of local-government connected VC on the IPO approval rate. As the CSRC is one of the departments in the central government, the government officials who also serve in the central government are more likely to establish political ties with the CSRC officials because of frequent work-related interaction. Therefore, we conjecture that central-government connected VCs have a greater effect on IPO approval rates than local-government connected VCs. To examine this conjecture, based on the specification in Column (3), we further divide the explanatory variable, Politically Connected VC Backing, into two separate variables: Central-government Connected VC Backing and Local-government Connected VC Backing. The results in Column (4) show that only the estimated coefficient of Central-government Connected VC Backing is positive and statistically significant at the 1% level, while that of Local-government Connected VC Backing is not statistically significant. The IPO approval rate of the firm backed by central-government connected VC is 4.7% higher than that of other firms. In Column (5), we consider that the politicians who have served in the CSRC or have jurisdiction 19

20 over the CSRC may have greater influence on the CSRC s decisions than other politicians. Therefore, we predict that CSRC-connected VCs may have a stronger effect on the IPO approval rate than non- CSRC-connected VCs. To examine this prediction, based on the specification in Column (3), we divide the explanatory variable, Politically Connected VC Backing, into two separate variables: CSRC Connected VC Backing and CSRC Connected VC Backing. The results show that the IPO approval rate of the firm backed by CSRC connected VC is 7.6% higher than that of other firms, and this effect is statistically significant at the 1% level. However, the non-csrc connected VCs have a positive but not significant influence on firm IPO approval rates. The results are consistent with our prediction. Furthermore, we examine whether the effect of a political connected VC on the IPO approval rate increases with the political power of the politician who relates to VC. As the political power of politicians increase with their administrative ranks, we further divide the Politically Connected VC Backing into four classes based on the administrative ranks of the politician who relates to the VC: national leader (president and vice-president), provincial leader (governor and vice-governor of province), municipal leader (mayor and vice-mayor), and county leader (county head). In Figure 1, we show that the IPO approval rates of the firms backed by VCs connected with different level of politicians are: 88.2% (national-level leader), 86.9% (provincial-level leader), 85.3% (municipal-level leader) and 84.9% (county-level leader) respectively, while the IPO approval rate of all other firms is merely 81.2%. The results suggest that the IPO approval rates of political connected VC-backed firms monotonically increase with the political power of political connected VC. Overall, the results of this section suggest that the IPO approval rate of the firm backed by politically connected VC is significantly higher than that of other firms even after controlling for a listed of firm-level and local-level characteristics variables. This effect is stronger if the politician who relates to the VC firm has currently or previously served in the central government or the CSRC, or held a position with more political power. 4.2 Controlling for potential omitted variables The last section documents a positive relation between VC s political connections and the IPO 20

21 approval rate of the firms that they back. A potential concern is that the relation may be driven by omitted variables that are both correlated with VC political connections and firm IPO approval rates. For example, an entrepreneurial firm with high-quality manager team might be more attractive for politically connected VCs and might have a higher IPO approval rate in the meantime. This omitted unobserved variable may cause a spurious correlation between politically connected VC backing and the firm s IPO approval rate. To mitigate the omitted variables problem, we re-examine the effect of politically connected VC on IPO approval rate by applying a subsample of IPO multi-application, and include firm fixed effects to remove the effect of time-invariant omitted firm characteristics on our results. Specifically, the subsample includes 328 IPO applications submitted by 162 firms. After an IPO application is rejected by the CSRC, the firm usually applies for an IPO for the next time in the following few years. The average time interval between an application rejection and a new application is 2.2 years. During this interval, some firms obtain new financing from politically connected VCs, which changes their status from non-vc backing or non-politically-connected VC backing to politically connected VC backing. In our sample, there are nearly 1/4 of firms experiencing such change in the status of politically connected VC-backing. In our regression analysis, we include the firm fixed effects to explicitly isolate variation within a firm s multi-application observations, i.e., comparing the IPO approval rate for the same firm before and after obtaining financing from a politically connected VC. Therefore, the effect of politically connected VC backing is unlikely to be an artifact of a selected sample of high-quality firms. Even though firm fixed effects are included to control for the time-invariant firm characteristics, one may be concerned that firm characteristics could vary over different rounds of applications, e.g., firms may become more experienced and better prepared in the later applications, which could result in a higher IPO approval rate in the later round. To eliminate this suspicion, we also control for the sequence of IPO applications (Application Sequence) in our model. We use the similar specification as Eq. (2) to re-examine the effect of politically connected VC on the IPO approval rate. The differences are that we control for the firm-fixed effects and use the linear probability model (LPM) instead of logit model. We follow Dougal, Engelberg, Garcia and Parsons (2012), and adopt LPM specification because our sample size is relatively small and multiple fixed 21