Secondly, we showed that lack of competition in financial markets can trans-
late into lack of competition in product markets. It is surprising that, such an
important implication has previously received so little attention in the litera-
ture. The result confirms economists’ previous intuition as to the centrality of
the efficient operation of financial markets to a well-functioning economy.
Thirdly our model suggests that this vertical extension of market power is
hampered by a Coasian commitment problem if investors cannot hold equity
finance, yielding strong implications for the regulation of banks in imperfectly
competitive financial markets. Equity-holding by banks in such markets should
be limited - except where considerations of competition are to be subordinated
to goals of faster growth which may come from monopoly power.
Fourthly, we extend the basic model to allow us to better understand ven-
ture capital finance. We present evidence that venture capitalists have market
power in the provision of finance to entrepreneurs. We argue that they are
particularly vulnerable to the Coase problem, since in the process of funding
incumbent firms they learn about the prospects for new entrants to the indus-
try. This makes them more tempted to fund new entrants than they otherwise
would be (since they avoid much downside risk). We use these two features of
venture capital finance to explain why venture capital claims are frequently in
the form of automatically convertible debt. The reasons for automatic conver-
sion were previously something of a puzzle. In existing models, conversion was
always optimal for the venture capitalist on attainment of the signal, so it was
not obvious why he should need to commit himself to this strategy. The time-
inconsistency inherent in the Coase problem provides a clue to the reason. Ex
ante, the venture capitalist would like to commit not to fund future entrants
in order to give sufficient reward to the first firm it funds. But ex post, once
the venture capitalist has learned that funding new entrants will be profitable,
he may prefer to retain debt in the first firm and fund entrant firms. Therefore
he needs to commit himself to instead holding equity when the good signal
arrives, and thus having little incentive to introduce competition. When the
signal is bad, however, he retains debt in order to maximize entrepreneurial
incentives. Thus the optimal claim is debt converting to equity automatically
on attainment of signals of high profitability.
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