VCs Benefit from Big Backyards

A new report from Harvard this month examines locality as a factor for the success of both venture capital firms and their portfolio companies. Its key finding is that VCs seem to get higher returns when investing in deals outside their top hubs for venture deals. According to the article, “Much of the VC outperformance in these venture capital centers [Silicon Valley, Boston, and New York] arises from the non-local investments. This finding is counterintuitive, since venture capitalists might be expected to be the most involved and add the most value to the geographically closest companies.” The article postulates that non-local deals may have higher hurdle rates to reflect the higher cost of monitoring. The article also states, even understates, the implications of “economically meaningful geographic differences in the availability of venture capital.”

We’re not sure it’s so counterintuitive or that they got it right when hypothesizing the reason for these results. It reminds us of something from the book The Millionaire Next Door. That book finds that most of the wealthy people in the country are not lawyers, doctors, and other professionals. The wealthy tend to be individuals who own non-sexy companies that sell things like concrete and trash removal services and similar products or services. One of the reasons is because they tend to not spend as much money on things like cars and country clubs as the professionals. But the other key reason was that they tend to have less competition. The book suggests that it’s really hard to set yourself apart as a top lawyer in New York because the competition is so high, but it’s not nearly as hard to be the best lumber distributor in the Midwest since the competitors presumably will not be as hard driving as the Manhattan attorney set. It seems the same principle may be in play in the Harvard study. There is a lot of competition to fund hot start ups in Palo Alto while a solid company in Oklahoma may be getting overlooked. That would lead to better deal terms for the VC, and some operational advantages for the company. The company would have less competition when hiring, lower operating costs, etc. The result would then follow that returns are enhanced with out of market deals. We have no evidence to support this. Just seems to make some sense.