For VCs, Investing Closer to Home may Hurt Performance

(MoneyWatch)  Among tech entrepreneurs, it's common knowledge that venture capitalists like to invest locally. Focusing on nearby startups makes it easier for VCs to monitor their portfolio firms, huddle with company founders and broker introductions to useful industry contacts, among other benefits. And that produces more successful businesses and, for investors, a bigger bang for the buck. But a recent study suggests that such geographic clustering may in fact have the opposite effect.

Indeed, researchers from Harvard University and the New York Fed found that VCs get higher returns investing in startups in cities outside their home region. Examining more than 2,000 VC firms' results over roughly 30 years, they conclude that investments in areas where they have a branch office, or no presence at all, succeed 17 percent of the time, while investments in the region where the firms are based have only a 14.5 percent success rate. This performance gap holds true whether the investment is in an early-stage startup or a more mature company.

That's counterintuitive, given the conventional wisdom. Why should VCs do worse investing in local companies? The study suggests a few possible explanations.

For one, VCs may demand a higher rate of return for investments in distant startups to make up for the challenges and greater costs of overseeing such deals. "Travel to other geographies is costly and will be undertaken only when an investment offers prospects for a high enough return to, in expectation, compensate the venture capitalist for the additional time and money associated with monitoring a distant investment," the authors said.

Meanwhile, VCs doing farther flung deals also may be more likely to swing for the fences in those investments, rather than accepting more modest returns in their home regions, where deal flow is higher.

Another reason VCs' more distant investments fare better than the local ones may have to do with the impact of repeatedly investing in the same geographic region. A VC firm that has invested in a startup in a given area is less likely to succeed the next time it puts money into a company in that same locale, according to the study.

Perhaps that's because VCs lower the bar on a new investment if it's less difficult and expensive to visit the company. A general partner might be more willing to back a less promising startup in, say, Silicon Valley or Cambridge, Mass., since the investor regularly swings through town to visit some of the firm's other portfolio companies based in these tech meccas.

The study's not perfect. In measuring the "success" of VC investments, for instance, the researchers only consider whether a firm's exit, whether in an IPO or M&A transaction, made money and ignores return multiples on the deal. Still, for VCs and entrepreneurs it raises questions about the presumed merits of investing close to home.