Historically, venture capital (VC) firms have sourced investments mostly from local networks within narrow geographic boundaries, but are increasingly investing internationally, with significant heterogeneity across firms in terms of scope, location, and success.
A research paper by Sarath Balachandran and Exequiel Hernandez, “Mi Casa Es Tu Casa: Entrepreneurial Migrants as Pathways to Foreign Venture Capital Investments,” explains why these companies differ in the location and success of these international investments.
As the authors note, the success of venture capital firms depends on their ability to obtain information about high-potential startups and to access those startups with a certain degree of exclusivity; But the quality of startups is difficult to gauge and competition from other investors can undermine access to promising deals.
To combat problems of information scarcity and competition, venture capital firms have historically relied on network links with other investors, entrepreneurs, and members of the business community to access potentially attractive deals. Because trust is an essential component of knowledge transfer, these networks tend to be strongly localized; Hence VCs have mostly invested in startups that are geographically close (which is also more likely to be profitable because deals are better informed).
However, venture capital firms are increasingly investing in startups located outside their home countries. Not only does this go against the “proximity rule,” but it appears to add additional risks (cultural, legal and institutional complexities) to the uncertainty around investing in a startup, which is already high.
Understanding the phenomenon of “cross-border” venture capital surge is more complex due to the fact that some venture capitalists invest more abroad than others, and they differ widely in terms of location and the success of their efforts. This indicates that the factor driving the internationalization of venture capital is thus company-specific, not industry-specific, and linked to strategic calculations of individual risks.
Thus, the questions arise: What are the strategic considerations that motivate companies to invest outside of their domestic environment, and why does this lead to a divergence in terms of venture capital investment behaviour?
Balachandran and Hernandez suggest one mechanism that helps explain these key questions: the differences in the local relationships of venture capital firms with immigrant entrepreneurs. The theory is based on the assumption that some of the local startups in which the venture capital firm invests locally will be established by immigrants, who then become part of the venture capital network, and that more links with immigrant entrepreneurs from a particular country gives venture capital access Bigger to venture capital. Knowledge of the home country and the relationships of these entrepreneurs, enabling subsequent investments in that country for the venture capital firm – a geographic extension of the network mechanism on which venture capital usually depends.
The fact that the process does not produce similar results across companies can be explained by the fact that some venture investors are exposed to immigrant entrepreneurs more than others, including immigrants of different nationalities. Over time, this difference in exposure leads to a variation in the strength of VC firms’ relationships with immigrant entrepreneurs from different countries, affecting how much and where VCs invest in foreign startups.
Research design and context
Using data on US venture capital firms, the authors found that the more relationships they had with Indian immigrant entrepreneurs, the more they invested in Indian startups.
This effect is amplified by the “push” and “pull” factor. The push effect arises as the venture capital firm faces strong local competition, which creates pressure to look for alternative investment sites. The attraction effect relates to the quality of the immigrant entrepreneurs’ knowledge and relationships in their home countries; The paper finds that relationships with Indian immigrants simultaneously help US enterprising investors to make more successful investments in India and enhance the odds of a successful exit from those investments.
The authors chose India and the United States as the contexts for their study because there are large numbers of immigrant Indian entrepreneurs in the United States, including many who immigrated recently; Hence, there were sufficient numbers of first-generation immigrants to the United States with established ties to India. (Another factor in contextualization is that Indian names have unique traits that allowed the authors to “demystify” Indian immigrants from those of other races.)
The results were based on an elegant data-collection design:
- Investments information was collected from VentureXpert, which provides information on the portfolios of the 100 largest venture capital firms in the United States from 2006 to 2019;
- The success of venture capital investments in India has been measured on the basis of an acquisition or public offering (IPO);
- The study selection was based on entrepreneurs of Indian origin in each of the 7,875 startups (from around 100 venture capitals selected);
- The first generation of immigrants was distinguished from the second generation of immigrants on the basis of having a degree from an Indian university.
The investment link between the United States and India
Assuming that venture capital would have been more likely to invest in an India-based startup if a senior member of an existing venture was also from India, the authors find that this is indeed the case: additional investment in an Indian immigrant in the United States resulted in an average increase of 9% in the number of investments in India over the next five years.
The researchers also looked at the mechanism behind this phenomenon; For example, whether it is caused by the network (referrals through the Indian “id”) or simply because the venture capital has retained its interest in India and thus discovered a good opportunity. Here, they assumed that first and second generation immigrants maintained the same primary interest in India, but only first generation immigrants had a network there. The differentiation between first-generation and second-generation immigrants allowed the authors to conclude that the dominant mechanism of referral was through the network effect.
The paper also sought to discover whether the impact was greater in sectors where there was high competition for investment opportunities; On the grounds that investors would be more open to looking at opportunities outside the usual ‘fishing field’ if they found competition to be significant (inflating pre-money valuations), and found that to be the case again.