Beware of How Venture Capital Firms Team Up

Drew Graham, Managing Partner of Ballast Point Ventures, pointed me in the direction of a great new study by Paul Gompers, Yuhai Xuan and Vladimir Mukharlyamov.  The scholars examined over 3,500 venture capitalists and their investments in over 12,000 start-ups over a thirty-year period.  They discovered, not surprisingly, that venture capitalists tend to invest in deals alongside other venture capitalists who were quite similar to them (in terms of ethnic background, education, employment experience).   What was the effect on performance?  Here's a summary from HBS Working Knowledge:

They found that the probability of success decreased by 17 percent if two co-investors had previously worked at the same company—even if they hadn't worked there at the same time. In cases where investors had attended the same undergraduate school, the success rate dropped by 19 percent. And, overall, investors who were members of the same ethnic minority were 20 percent less successful than investors with different ethnic backgrounds.

Two major factors might be driving this drop in performance.   The venture capitalists might be picking bad deals (perhaps one is convincing the other to invest in a deal that has concerns).   Alternatively, the venture capitalists might be making poor decisions after the deal, in terms of how they influence the firm's strategy and management.  The scholars argue that "groupthink" leads to inefficient decisions after the deals, when venture capitalists are co-investing with folks with whom they share many similar characteristics.  We shouldn't be surprised by this finding, but it certainly offers a warning sign not only for investors, but also for start-ups as they seek funding.