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RESEARCH
Venture Capital Syndication
Pays off — and not just for the VC
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Research
Venture-capital syndication pays off — and
not just for the venture capitalist
Prof. Raffi Amit concludes that venture capitalists are oxen, not vultures: they pull their weight helping manage companies in which they invest.
Venture capitalists often band together in groups to invest in companies. Conventional wisdom says they engage in this practice, called syndication, to better screen potential investments. More eyes, the thinking goes, yield better investments.
But Raphael "Raffi" Amit, Wharton's Robert B. Goergen Professor of Entrepreneurship, says that's wrong. Venture capitalists syndicate because each one has different skills and information, so each can add value to an investment in different ways.
Amit, who's
also academic director of the Wharton's Goergen
Entrepreneurship Program, came to this conclusion by studying the Canadian
venture-capital industry with Prof. James A. Brander and Prof. Werner
Antweiler, both of the University of British Columbia. Their findings
were published in the fall in the Journal of Economics & Management
Strategy in an article titled "Venture-Capital Syndication: Improved
Venture Selection vs. the Value-Added Hypothesis."
"What we found is that syndication pays off — if you do it to add
value," Amit says. "But if you do it to help select companies,
it's not a good idea."
In Canada, syndicated investments yielded significantly higher returns than those by a single venture capitalist. Amit and his co-authors found that "standalone investments had average [annual] rates of return on the order of 15% to 20% whereas the syndicated investments had average returns of about 35% to 39%," their paper says. That contradicts the conventional view, called the selection hypothesis, which says standalone investments should have the highest returns.
Here's the logic: When investments are obvious winners, venture capitalists don't need second opinions, nor would they want to share their returns. Likewise, when investments are obvious duds, they can reject them without consulting colleagues. It's the ones with unclear prospects that induce a venture capitalist to seek out a colleague's review. Thus they end up sharing the investment by syndicating.
But this suggests that syndicated investments should have lower returns than standalones, and, of course, Amit and his co-authors found that they don't. That led them to what they call the value-added hypothesis.
"From the lead venture capitalist's point of view, the benefit of seeking syndication is that the value of the project rises if other venture capitalists become involved," the paper says. Think of the venture capitalist as a carpenter who can work a lot more efficiently if a partner holds up the other end of a plank.
How does a venture capitalist add value to a company? "He can provide contacts and referrals," Amit says. "He can help recruit professionals and introduce the firm to potential clients. He might help get business with big companies by bringing credibility. "If Goldman Sachs is backing me, that's a signal that my venture is serious. Goldman wouldn't put its reputation on the line to back a loser."
Entrepreneurs sometimes
carp about the tough terms — the big slugs of stock,
the preponderance of board seats — that venture capitalists demand
in exchange for their money. "Some people say VC means ‘vulture
capitalist' because
VCs claim such high returns," Amit says.
But his study says that venture capitalists get paid a lot because
they do a lot. They're not just handing over their money. They're also providing
expertise and assistance.
"[Our analysis] suggests that management rather than selection is at the heart of venture capital activity," the paper says. Venture capitalists syndicate for other reasons, too, though these don't contradict the study's main hypothesis.
Syndication, for
example, lets them to share risk and diversify their portfolios — Amit
found some evidence of that. Banding together might also give them
a stronger bargaining position vis-a-vis the companies in which they invest;
Amit and his
co-authors didn't test whether this was a motivation.
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