Why VCs are increasingly investing internationally
New research shows that domestic investment links with immigrant entrepreneurs facilitate future VC investments in the immigrants’ homelands
Venture capital (VC) firms have historically sourced investments predominantly from local networks within tight geographic bounds, but are increasingly investing internationally, with substantial heterogeneity across firms in extent, location and success.
A research paper by Sarath Balachandran and Exequiel Hernandez entitled ‘Mi Casa Es Tu Casa: Immigrant Entrepreneurs as Pathways to Foreign Venture Capital Investments’, sets out to explain why these firms differ in the location and success of such international investments.
As the authors note, the success of VC firms depends on their ability to obtain information about high-potential startups and access to those startups with some degree of exclusivity; but the quality of startups is difficult to measure and competition from other investors can undermine access to promising deals.
To combat these problems of information scarcity and competition, VC firms have historically relied on network ties to other investors, entrepreneurs and members of the business community to gain access to potentially attractive deals. And because trust is central to the knowledge transfer involved, these networks tend to be strongly local; hence VC firms have predominantly invested in geographically proximate startups (which are also more likely to be profitable as the deals are better informed).
However, VC firms have increasingly been investing in startups located outside their home countries. This not only runs counter to the ‘proximity rule’, but would seem to add additional risk (cultural, legal and institutional complexities) to the uncertainty of investing in a startup, which is already high.
Understanding the phenomenon of this increasing VC ‘cross-border’ investing is further complicated due to the fact that some VCs invest abroad more than others, and differ widely in terms of the location and success of their efforts. This suggests that the factor driving VC internationalisation is thus firm-specific, rather than industry-specific, and linked to the strategic calculations of individual VCs.
Thus, the questions arise: what strategic considerations motivate firms to invest beyond their local environment, and why does this lead to variance in terms of VC investment behaviour?
Balachandran and Hernandez propose one mechanism that helps explain these key questions: differences in VC firms’ local ties to immigrant entrepreneurs. The theory rests on the assumption that some of the domestic startups in which a VC invests locally will be founded by immigrants, who then become part of the VC’s network, and more ties to immigrant entrepreneurs from a particular country give the VC greater access to the home-country knowledge and connections of those entrepreneurs, enabling subsequent investments in that country for the VC firm – a geographical extension of the network mechanism that VCs usually rely on.
That the process does not lead to similar outcomes across firms can be explained by the fact that some VCs are exposed to immigrant entrepreneurs more than others, including immigrants of different nationalities. Over time, this difference in exposure leads to variance in the strength of VC firms’ ties to immigrant entrepreneurs from different countries, affecting how much and where VCs invest in foreign startups.
The research design and context
Using data on US VC firms, the authors find that the more ties to Indian immigrant entrepreneurs a firm has, the more it subsequently invests in Indian startups.
This effect is amplified by a ‘push’ and a ‘pull’ factor. The push effect originates where the VC firm faces strong domestic competition, which creates pressure to look for alternative investment locations. The pull effect relates to the quality of the immigrant entrepreneurs’ knowledge and connections in their homelands; the paper finds that ties to Indian immigrants both help US VCs make more successful investments in India and enhance the odds of successful exit for those investments.
The authors chose India and the US as the contexts for their study because there are large numbers of Indian immigrant entrepreneurs in the US, including many who have emigrated quite recently; hence there were sufficient numbers of first-generation immigrants to the US with extant ties to India. (Another factor in deciding the context is that Indian names have unique features that allowed the authors to ‘disambiguate’ Indian immigrants from those of other ethnicities.)
The findings were based on an elegant data-collection design:
- Information on investments was collected from VentureXpert, which gives information on the portfolios of the ~100 largest US VCs over 2006 to 2019;
- Success of VC investments in India was measured on the basis of acquisition or going public (IPO);
- Study selection was based on those entrepreneurs of Indian background in each of the 7,875 start-ups (from the ~100 VCs selected);
- First-generation immigrants were distinguished from second-generation immigrants on the basis of having a degree from an Indian University.
US-India investment correlation
Hypothesising that a VC was more likely to invest in an India-based start-up if a senior member of an existing venture was also originally from India, the authors found that was indeed the case: additional investment in an Indian immigrant in the US led to a 9% average increase in the number of investments in India over the next five years.
The researchers also looked at the mechanism behind this phenomenon; i.e., whether it resulted from the network (referrals through the Indian ‘introducer’) or merely because the VC had maintained an interest in India and thus simply spotted a good opportunity. Here, they assumed that first and second-generation immigrants maintained the same underlying interest in India, but only first-generation immigrants had a network there. Differentiating between first and second-generation immigrants allowed the authors to conclude that the dominant mechanism for referral was through the network effect.
The paper also sought to discover whether the effect was greatest in sectors where there was high competition for investment opportunities; on the basis that investors would be more open to considering opportunities outside their normal ‘hunting ground’ if they found that competition was great (resulting in inflated pre-money valuations), and again found this to be the case.
“VCs are in competition for attractive ventures. When they pay too much for them, they need to forage more widely – and are more likely to invest non-domestically, where competition is less”
With regard to the performance of the Indian ventures, the authors hypothesised that the more ties a VC firm establishes with immigrant entrepreneurs through its domestic investments, the more successful will be the VC firm’s subsequent investments in the immigrant’s home country. The reason for postulating such an effect is that investors contribute more than just money to an investment – they also bring valuable local resources. Being connected to immigrants with experience and connections can be helpful in procuring resources for the India-based venture post-investment and thus make it more successful – and again the authors found this to be the case.
Implications for entrepreneurs
While it is often not apparent to cash-hungry entrepreneurs, VC investors are in competition with each other for good investments, especially in ‘hot’ business areas. And investors often hear about, or are actively referred to, potential deals through their professional and social networks, which tend to be local, and through the senior teams of their current portfolio ventures whom they know and trust, and which act to reinforce the local bias.
The default local bias is further reinforced because of the information asymmetry that is inherent in early-stage ventures: it’s much easier to find background information on the venture and its managers informally, which again is easier through existing contacts.
This effect works against entrepreneurs who are geographically distant from investors, and works against investors seeking to be introduced to investigate promising ventures from an entirely different pool, where they will be up against less competition from other investors.
Where a non-local (‘immigrant’) entrepreneur is successful in raising funds, it is because they have physically moved into the locus of the investor and thus become part of their network.
And, because entrepreneurs are well aware of the benefit of ‘warm’ leads to investors, they will often contact the founder of an existing (funded) venture in their sector for advice and connections. Those founders will filter these opportunities and will happily refer the best of them to investors who are more likely to meet with the new entrepreneur because they trust the judgement of the founder.
Implications for investors
The paper’s findings reinforce the importance of the network effect in VC investments: VCs source investment opportunities through their networks, rather than through ‘cold’ contacts. Senior managers of existing portfolio ventures are a particularly rich source, acting both as a portal for hopeful entrepreneurs and as an effective filter.
VCs are in competition for attractive ventures. When they pay too much for them, they need to forage more widely – and are more likely to invest non-domestically, where competition is less.
This is not to suggest that a VC would invest in a first-generation immigrant venture purely to gain access to its network and increase deal flow. However, such investments open doors to promising investments – and that means there is potentially a case for investing in non-domestic founders as a means to an end, as well.
