Study Disputes The Value of VCs “Buying Local”

Venture capital outperformance is correlated to a portfolio company’s distance from a a VC firm’s office, according to new research from The Harvard Business School. But not in the way you might think.

Specifically, the paper found that VC firms based in San Francisco, Boston and New York generally return more money on investments outside of their local geographies than on investments close to home. This isn’t to say that such firms do badly on their local deals – a Palo Alto-based firm still does better on a typical Menlo Park deal than would a Cleveland-based firm – nor does it take into account organizational costs (travel, etc.). But, again, that Palo Alto-based firm will probably generate a higher return on a Cleveland-based portfolio company than on one based in Menlo Park.

The paper suggests that this differential could be caused by VC firms using higher hurdle rates for long-distance deals. Such portfolio companies may require a higher level of managerial/monitoring effort, so more thought is given before offering up a term sheet.
“A takeaway might be that firms should think very carefully about their decision-making process in terms of geographic criterion,” says HBS professor Josh Lerner, who co-authored the study with Henry Chen, Paul Gompers and Anna Kovner. “I think there’s a mental trap in saying that because a company is so nearby, it’s not as costly to do the transaction.”

The paper also found that a VC firm’s outperformance on distance deals will lessen if the firm opens a satellite office in that new location. Again, the theory is that the burden of proof has been lowered, now that the firm has a staffer nearby.

Finally, Lerner et all took a look at satellite office performance by firms based in the big three markets — SF, Boston and NYC – when they open shop in another of the big three (i.e., a Palo Alto firm expanding to Cambridge): “We thought we’d see a big difference in success, because of a home court advantage, but we couldn’t find anything along those lines.”

We’ve posted the entire working paper, for your reading pleasure:

Buy Local- The Geography of Successful and Unsuccessful Venture Capital Expansion.06152009