Party friends, wartime friends and the dynamics of venture capital relationships  

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Business people shaking hands, finishing up a meeting Dzianis Apolka © / 123RF Stock PhotosDeeper relationships in the venture capital space actually lead to fewer future co-investments, according to a new working paper out of the Hong Kong Polytechnic University and the University of Oxford.

“A lot of people talk about the importance of investors having strong networks, and we thought that this notion of networks is a little overhyped and we were particularly concerned that people don’t understand that a relationship can be a mixed basket,” says Thomas Hellmann, professor of entrepreneurship and innovation at the University of Oxford’s Saïd Business School and co-author of the paper.

Specifically, the research found deeper relationships lead to lower performance and a slowdown in relationship intensity. It also found relationships are weaker when formed in hot investment markets.

“In times when everybody’s investing and everybody’s investing with each other, you make relationships, but those are also the relationships you move away from more quickly because they’re not deep relationships — they’re not really tested relationships,” says Hellmann.

The paper likens this to stronger relationships between wartime friends compared to party friends.

These effects aren’t as bad for venture capital firms that are well-connected through networks. “Another way of saying that is it’s the weaker players which really have this behaviour of engaging and then disengaging with relationship partners,” says Hellmann. “I think it is partly because some of the top players have better and deeper relationships. And they are also maybe slightly less effected by their short-term performance.”

The period of time since relationships also matters, with the research showing the recent past has a positive effect on new co-investment and the more distant past has a stronger negative effect.

“It takes a while before you get tired of your friends,” says Hellmann. “And so, in the very short term, you don’t find that effect. You only see that moving away from your business partners, from the investment partners, over a medium horizon.”

By and large, says Hellmann, institutional investors choose venture capital firms based on their performance, as well as reputation and network positions. But, with this paper in mind, institutional players carrying out due diligence on venture capital firms should look more closely at the quality of the relationships.

“Having some fluidity in these relationships is probably a good sign, and something to look for, for an institutional investor when evaluating a venture capital firm.”

The research focused on the 50 largest venture capital firms in the U.S. and their co-investment decisions between 1985 and 2012.

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