When Do Firms Risk Shift? Evidence from Venture Capital

Abstract

This paper studies the agency costs of debt and the role of risk shifting as firms face financial distress. The Small Business Investment Company (SBIC) program is a novel setting to evaluate the importance of these costs. It provides participating venture capital funds with debt financing from the U.S. government at a negligible premium to the 10-year Treasury Note. Economic mechanisms that might prevent risk shifting, such as covenants and reputation concerns, are primarily not present in this program. Using a difference-in-differences setting, I find that managers of distressed funds invest in firms with lower credit scores, sales, employment and patenting activity, and are more likely to use equity investments. Distressed funds reallocate capital to riskier firms in their portfolio, rather than searching for new investments. Equityholders respond positively to riskier investments for distressed funds and debtholder losses increase, consistent with the prediction that risk shifting transfers wealth from bondholders to equityholders.