VC Partner Selection (MY Recommended Reading)

(Matt Yglesias tweeted that there were interesting papers on the NBER home page today, so I checked them out. Here’s a summary of one of them.)

In Oct. 2005, Alan Blinder (Princeton) and John Morgan (Berkeley) published a paper1 in which they argued that, among other things, small groups are better data analysts and decision-makers with the same data than individuals, and the quality improvement is larger than can be attributed to an individual’s abilities within the group. That is, basically, there is something unique about being in a group that produces better outcomes than either learning by doing or working on one’s own.2 Blinder and Morgan, though, had artificial group homogeneity — they had a collection of students — while in practice, that homogeneity may not exist. Whether it does or not, we can ask the question of whether that loss of homogeneity is likely good or bad.

An NBER working paper from Paul Gompers, Vladimir Mukharlyamov, and Yuhai Xuan investigates the value of intragroup similarity. They break similarity down into two categories: “ability-based characteristics (e.g., whether both individuals in a dyad obtained a degree from a top university) and affinity-based characteristics (e.g., whether individuals in a pair share the same ethnic background, attended the same school, or worked for the same employer previously)” (Gompers 2). Then, looking at the venture capital industry, they investigate whether each type has a positive or negative effect on investment success.

Before questioning how group selection affects results, they began with the obvious prior question of how group selection occurs, and the results were not really surprising:

two venture capitalists that both hold degrees from top universities (potentially indicating high ability) are 8.5% more likely to co-invest together than individuals not similar in terms of being graduates of top academic institutions. An even stronger effect is documented with respect to non-ability-related, affinity-based characteristics. A pair of venture capitalists who graduated from the same university are 20.5% more likely to partner on a deal, and even more strikingly, the probability of collaboration between two individual venture capitalists increases by 22.8% if they are part of the same ethnic minority group. Partnership is also more likely to happen if the two venture capitalists worked at the same company earlier in their careers. These results on syndication decision represent strong evidence of homophilic selection in collaboration. [Gompers 6]

Surprise, surprise, people tend to select people like them in some superficial way, but at least the group decision-theoretic literature gives us the term “homophilic selection” to use to sound intelligent when talking about it.

There are reasons, of course, that affinity-based or ability-based selection could have positive or negative effects. Affinity-based selection could increase success if prior knowledge of a potential co-investor revealed valuable information to a venture capitalist about the follow-on investor’s risk preferences, analytical abilities, etc., but could decrease the likelihood of success if that prior knowledge were illusory. Gompers et. al. also suggest that personal utility from working with familiar people may decrease rate of return thresholds and encourage low-value investment . Ability-based selection may foster the creation of power couples VC dyads with outstanding discernment and business knowledge, but may also encourage groupthink and an increased desire for unanimity (4).

The investigating group found that ability-based selection improved the likelihood of success, while affinity-based selection gave strong evidence for a “cost of friendship.” Defining “success” as taking a company public, the researchers found that ability-based selection increased the likelihood of success significantly, with the first VC’s top degree worth an extra ~9% and the second worth an extra ~11%. They also found a huge cost of friendship: an 18% decline in the likelihood of success from having worked previously at the same company, 22% decline if a dyad attended the same undergraduate school, and a 25% decline if two VCs are members of the same ethnic minority. What’s strangest about this is that, despite the apparent huge costs of affinity-based selection, “affinity-based similarity not only determines people’s attractions to work together for the first time, but also increases their frequency of repeated collaborations” (Gompers 7).

The news on affinity-based selection isn’t conclusive though, since determining whether the cost is due to selection or treatment effects is difficult. Selection effects would arise in the investment choices that high-affinity VC pairs made. If selection effects were the source of the decreased likelihood of success, we could attribute the decline to a lower bar from personal utility gains, more difficulty in attracting low-affinity investors into groups for riskier investments, or “worse” portfolio companies having a harder time attracting low-affinity VCs because of the portfolio company’s inferiority (Gompers 22). If treatment effects were the source, the cost would come from the decisions the VC groups made after investing. By explanation,

Venture capital investors provide significant value-add to their portfolio companies beyond the supply of capital. Post-investment, they make important decisions and offer invaluable advice on a variety of issues: hiring and firing the CEO, the senior management team, and the board of directors; identifying customers or partnering opportunities; and devising a viable overall strategy, all of which are critical to moving the venture forward along the path to success. Thus, any inefficient decision-making post investment induced by homophily among high-affinity venture capitalists will negatively impact the success of the portfolio company they oversee. In other words, the lower likelihood of success of co-investments between venture capitalists that share similar characteristics is triggered by their making inefficient decisions or even mistakes that they would otherwise avoid with more diverse boards. [Gompers 23]

The researchers caution that the two stories have different implications. If the selection story is right, then it is the choice of investment with a particular group that fixes the likelihood of success. If the treatment story is right, then there is room for efficiency gains post-investment that suggest that the choice of VC partners is important not only ex ante, but continuing through the life of the investment (Gompers 23). Using Heckmann’s two-stage correction,3 they found evidence that a substantial percentage of the costs of affinity-based selection come from poor post-investment decisions.

The researchers conclude with levity that “to paraphrase Ralph Waldo Emerson, you cannot afford to be stupid with old friends when you are venture capitalists co-investing together” (Gompers 32).

The study may not be robust across industries. Affinity-based selection outside of the VC industry, in political collaboration (running mates, cabinet members, etc.) for instance, may be positive on success, and of course success would have to be measured differently. Regardless, the paper contributes to understanding how groups of a size between microeconomic individuals and firms and macroeconomic actors function.

We could, by the way, make the jump from the Blinder/Morgan paper and the Gompers/Mukharlyamov/Xuan paper to an indictment of the myth of individualism or an extension of “You didn’t build that” to the private sphere, but that’s a problem for another day.

1 – Never again will I so strongly urge reading the whole paper. It’s fascinating and does solid work at a level between micro and macro.

2 – Take that, individualists!

3 – Someday I’m going to learn all of the statistics. Wikipedia page is included for perusal, rather than because you need to understand Heckmann’s two-stage correction right now.

Page numbers refer to page in .pdf of paper, not pages listed on the bottom of the scan that constitutes the .pdf

Blinder, Alan, and John Morgan. “Are Two Heads Better Than One?: Monetary Policy by Committee.” Journal of Money, Credit, and Banking, vol. 37(5). The Ohio State University Press: Oct. 2005.

Gompers, Paul, Vladimir Mukharlyamov, and Yuhai Xuan. “The Cost of Friendship.” NBER Working Paper Series. Cambridge, MA: June 2012.