When VCs Invest Together, Does Ability or Affinity Matter?
I woke up to a bunch of VC related things in my twitter stream this morning. I had a nice digital sabbath yesterday so I was a little surprised by how much there was. I tried cranking out a #tweetstorm of them using Little Pork Chop but I found the tweetstream experience to be very unsatisfying and very inauthentic feeling. The links are good, so here they are if you want to get in the headspace for what I really want to talk about.
1/11 Things I Read About VC This Morning I Think You Should Care About In A Compact Little Tweetstorm
2/11 Start with @fredwilson thinking about tweetstorms – https://avc.com/2014/06/tweetstorming/
3/11 Then @msuster on why VC is so much more compelling now – https://bit.ly/1mvIE5C
4/11 and @pmarca on why the IPO is not what it used to be – https://bit.ly/1ljhzlV
5/11 and congrats to @jeff on raising his new fund – https://bit.ly/1m0h6cD
6/11 thx @joshelman to the pointer to the @yoapp hackathon – https://bit.ly/1x0MhbQ
7/11 the #premoney conference recordings will be online soon – https://www.livestream.com/500startups/folder
8/11 the 2nd seed round trend @Mattermark by @DanielleMorrill – https://bit.ly/1iQTCI2
9/11 I end with Haiku
10/11 Tweetstorms perplex me a lot
11/11 Do you enjoy them
The response to 11/11 was generally “no” although a few people suggested that tweetstorming while a soccer game was going wasn’t a particularly useful test.
After I thought I was done I ran across a really interesting set of articles which didn’t make it into the tweetstorm. The first article, In Venture Capital, Birds of a Feather Lose Money Together, was a summary that let to the second article, The Cost of Friendship, which led to the actual article behind the annoying SSRN paywall. After reading the abstract, I decided to buy and read the article, especially since Paul Gompers, one of the great academic researchers on the VC industry, was the lead author.
I was once a Ph.D. student at MIT Sloan School studying innovation. Specifically, my doctoral advisor was Eric von Hippel. Eric was very kind to me, but I was a horrible Ph.D. student because I was also running a company at the time and had no interest in being an academic. Eventually I got kicked out well before I got my Ph.D.
Nonetheless, I learned how to more or less read an academic paper and some social science rubbed off on me. Actually, a lot rubbed off on me – enough for me to know that the headlines written about academic papers and studies rarely capture the essence of what is going on in the paper. Instead, reading the abstract and the carefully reading the non-analysis part of the paper, with a goal of putting yourself in the researchers’ shoes to understand what they are trying to figure out, will help you understand the punch line.
So when I read the first article, it was easy to conclude “VCs who are like each other do less well investing together.” Or, “VCs who like each other perform more poorly when investing together than those who don’t like each other.” This is consistent with the callout from the first article which says “The more affinity there is between two VCs investing in a firm, the less likely the firm will succeed, according to research by Paul Gompers, Yuhai Xuan and Vladimir Mukharlyamov.”
I read the summary, which is kind of the “PR piece” for the article, but I didn’t find it satisfying. It generalized too quickly and I kept wondering how affinity was defined. The hint was that it had to do with ethnicity, educational background, and employment history, which wasn’t how I was defining affinity when reacting to the title “In Venture Capital, Birds of a Feather Lose Money Together.”
Next, I read the executive summary of the paper. This was clear and felt fine to me. It separated affinity and ability. The punch line of the paper is:
“Collaborating for ability-based characteristics enhances investment performance. But collaborating due to shared affinities dramatically reduces the probability of investment success.”
Much different than the marketing piece about the paper that I read first. Basically, if you choose your co-investor because you think she is a great investor, that’s good, but if you choose your co-investor because you like him, that’s bad. But that felt too simple to me – no way that’s the basis for a HBS academic study. So I bought and read the paper, which was pretty easy until I got stuck in analysis stew on p.22. I hung in there and got through it, but once again was reminded of another reason I was a shitty Ph.D. student – I dislike reading academic papers.
I learned that affinity was narrowly and precisely defined, but not in the way I thought it was. Affinity to me meant that the two VCs liked each other, or had an “affinity” for one another, but instead affinity was based on biographic data, specifically gender, ethnicity, educational background, and employment history.
“The education dummy variables Top College, Top Business School, Top Graduate School, and Top School equal one if a venture capitalist holds, respectively, an undergraduate, business, graduate, or any degree from a top university and zero otherwise. Ethnic Minority takes the value of one if a venture capitalist is East Asian, Indian, Jewish or Middle Eastern. Dummy variables East Asian, Indian, Jewish and Middle Eastern pin down a venture capitalist’s ethnicity; the dummy variable Female identifies an individual’s gender.”
Also, success was defined as a company having an IPO (the data range for the study was 1975 – 2003). Now, I’m not going to argue the performance variable, but as someone who has had a lot of financial success with exits that were not IPOs, I’d be curious what happens when the analysis is done where success is defined by “at least 10x return on capital for the VC.”
The big reveal is buried in the middle of p.18.
“On one hand, people display greater inclination to work with similar others. Similarities may be in terms of ability (e.g., whether individuals hold degrees from top academic institutions) or affinity (e.g., whether individuals share the same ethnic background). On the other hand, these two sets of pairwise characteristics affect performance in opposite ways. Teams with more able participants are more likely to result in a successful investment outcome. On the contrary, investments are more likely to fail when groups are formed based upon similarities between members along characteristics having nothing to do with ability.”
Go read that again. If you pair up two people based on ability, they have better results than if you pair them up on affinity, where affinity is defined by “each went to the same school, each are the same ethnic minority (including Jewish), or each worked together in a previous company.”
Unless I missed something (and it’s entirely possible that I did), the message is “choose to work with people who have ability.”
I kind of feel like this applies to life in general!
It’ll be interesting to see how this paper gets interpreted, or misinterpreted over the next few weeks, assuming anyone else goes beyond the summary and reads the paper, no thanks to SSRN.
Just another reminder to look beyond the headlines. And don’t co-invest with someone who has no ability just because you went to the same school, are the same ethnicity, or once worked together.