The Cost of Friendship

by Paul Gompers, Vladimir Mukharlyamov & Yuhai Xuan

Overview — In venture capital, friendship can be expensive. Using the VC industry as a testing ground, the authors seek to answer two questions about collaboration: What personal characteristics influence individuals' desires to work together in venture capital syndication? And given the influence of these personal characteristics, does attraction help or hurt investment performance? After examining the biographical characteristics and activities of more than 3,500 individual venture capitalists from 1975 to 2003, the authors show that people are more likely to collaborate with those who share similar characteristics with them. Findings also show that individual venture capitalists collaborate with other venture capitalists for both ability- and affinity-based characteristics. When they collaborate for ability-based characteristics it enhances investment performance; but when they partner for affinity-based characteristics it dramatically reduces investment returns. Key concepts include:

It is costly for "birds of a feather" to flock together for reasons other than ability.
Collaborating for ability-based characteristics enhances investment performance. But collaborating due to shared affinities dramatically reduces the probability of investment success.
The probability of a successful exit outcome decreases by 18 percent if two venture capitalists who previously worked at the same company partner up in the syndication.
The likelihood of success drops by 22 percent if co-investors attended the same undergraduate school.
The negative effect of shared affinity is even stronger when it relates to ethnicity: Collaborating with someone from the same ethnic minority group comes at the expense of a 25 percent reduction in performance.
This research contributes to the study of working groups, the success implications of social ties, and the ability of venture capitalists to add value.

Author Abstract

This paper explores two broad questions on collaboration between individuals. First, we investigate what personal characteristics affect people's desire to work together. Second, given the influence of these personal characteristics, we analyze whether this attraction enhances or detracts from performance. Addressing these problems in the venture capital syndication setting, we show that venture capitalists exhibit strong detrimental homophily in their co-investment decisions. We find that individual venture capitalists choose to collaborate with other venture capitalists for both 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). Moreover, frequent collaborators in syndication are those venture capitalists who display a high level of mutual affinity. We find that while collaborating for ability-based characteristics enhances investment performance, collaborating for affinity-based characteristics dramatically reduces the probability of investment success. A variety of tests show that the cost of affinity is not driven by selection into inferior deals; the effect is most likely attributable to poor decision making by high-affinity syndicates post investment. Taken together, our results suggest that non-ability-based "birds-of-a-feather-flock-together" effects in collaboration can be costly.