Research

How financial firms choose partners

Finance Professor Laura Lindsey and her co-authors say that they are the first — to the best of their knowledge — to formalize an empirical model for testing economic theories concerning the formation of ties between firms. The findings can potentially help entrepreneurs identify which attributes to consider when evaluating a VC firm.

2014-11-05

If you flip to the business section of a newspaper on any given day, there’s a good chance you’ll see a headline about a strategic alliance, joint venture or other form of firm partnership. Maybe it’s Apple teaming up with AT&T for launch of the iPhone, or perhaps PepsiCo has partnered with Starbucks to bottle and distribute packaged beverages. For financial companies, fostering such ties is particularly common, leading to the formation of elaborate co-investment networks that can affect a firm’s access to capital. While there’s a wealth of literature on these business ties, most previous studies tend to describe characteristics of the parties involved or focus on outcomes. Researchers had not yet explored in a rigorous way the underlying motives that might lead organizations to choose particular partners. That’s the question W. P. Carey finance professor Laura Lindsey set out to answer. Along with co-authors Yael V. Hochberg (Rice University and the National Bureau of Economic Research) and Mark M. Westerfield (University of Washington), Lindsey co-authored a paper entitled “Resource Accumulation through Economic Ties: Evidence from Venture Capital,” which is currently in the process of publication. Lindsey and her co-authors say that they are the first — to the best of their knowledge — to formalize an empirical model for testing among economic theories of tie formation. As Lindsey notes, “Observing two large firms in a syndicate doesn’t necessarily mean that they selected one another based on size. One has to think through what patterns competing explanations may generate in the data.” The paper opens up new avenues for researchers to explore, but it has implications for entrepreneurs, too. Lindsey says this research may provide entrepreneurs with a different way of viewing VC firms. “Our findings can potentially help entrepreneurs identify which attributes to consider when evaluating a VC firm and other potential members in a syndicate,” she says. Using venture capital to find a solution When it came to investigating the roots of tie formation, Lindsey and her colleagues turned to venture capital firms to help find answers. Forming ties is of critical importance in the VC world. “We know from prior work that the networks formed from co-investment ties are an important predictor for VC success,” Lindsey says. Further, the unique characteristics of VC firms made them the ideal subject for this kind of research. “VCs are a nice environment to use as a laboratory,” says Lindsey. “There is a lot of interaction between firms and there are lots of new ties. Other settings tend to have fixed constraints. For example, in the pharmaceutical industry, there may be exclusivity agreements that prevent multiple ties and the ability of a researcher to identify competing motives for collaboration. Instead, VC firms face only loose constraints. Plus, venture capital is interesting in its own right since the nature of the networks formed by co-investment ties could have important implications for entrepreneurial firms.” Lindsey has a wealth of experience when it comes to analyzing the world of venture capital. In 2008, she published both “Blurring Firm Boundaries: The Role of Venture Capital in Strategic Alliances” in the Journal of Finance, as well as “Building Relationships Early: Banks in Venture Capital” (co-written with Thomas Hellmann and Manju Puri) in the Review of Financial Studies. For their research, Lindsey and her co-authors utilized over 20 years of data from Thomson Reuters’ VentureXpert database, which covers the universe of VC investments by firms that raise money from large institutional investors. As a first step, Lindsey and her co-authors used a statistical technique called factor analysis to distill the differentiating characteristics of VC firms. The analysis pointed to four easily interpreted dimensions of variation. The first factor is experience, which measures both a firm’s overall time in existence and in a particular industry sector. The second is capital, which captures both the amount of money invested and remaining to deploy. Investment scope is the third factor, which measures the diversity of a firm’s investments across geography, industry and stage of development. Finally, access, which takes into account aspects of a firm’s networking, such as the number of companies in which a firm has recently invested and the proportion of other VCs with which it has worked. Together, these underlying factors explain over 95 percent of observable variation across VC firms. The fact that these four factors are statistically independent of one another allowed Lindsey and her co-authors to easily separate them when it came time for their analysis. Defying previous assumptions When considering why organizations choose the partners that they do, one might expect similarity to play a significant role, as it often does in social settings. When ties are formed across economic networks, businesses might seek others that are similar in order to avoid potential conflicts. But as Lindsey and her co-authors point out, similarity is not driving VC partnerships, though it’s easy to see why such thinking persisted, she says. “Looking at the syndicates formed by VCs, one could come to the conclusion that firms are seeking similarity based on the observation of similar partners,” says Lindsey. “But, it is important to recognize that each firm seeking the best-networked partner, for example, will lead to observing two highly-networked partners in a syndicate. A more subtle point is that a firm attempting to fill a shortcoming in one resource area by trading with another firm can lead to the observation of similarity in a third area.” The researchers developed an empirical model in order to disentangle seeking-similarity behavior versus behavior that seeks a highly or differently endowed partner. The model captures whether increasing the resources of the greater- or lesser-endowed partner of the pair results in more frequent ties and simultaneously allows for trading motives. Lindsey explains, “The intuition behind our approach is that both seeking similarity and seeking the most of a particular resource will result in observing ties between firms that have a generous endowment of a particular resource factor. So, we focus on the relative incidence of ties that involve firms with less of the particular resource in question. If we observe these firms tying with one another, similarity is likely at play. If instead we observe more ties between differently-endowed pairs for a particular factor, resource accumulation is the more likely explanation.” A surprising finding of their work is that, while resource trading appears to be a motive for tie-formation, the value-added resources of experience, access and scope do not trade with one another; rather, they trade only with capital. This suggests that capital can exist outside of a firm and still be exploited effectively. They also find that firms seek the best available partner in terms of access and investment scope. The fact that similarity does not appear to be a driving force across any of the resource dimensions of VC firms implies that the traditional explanations for seeking similarity in organizational ties do not apply in the VC setting. The paper raises new questions for researchers to explore. For instance, whether or not the patterns they identify prevail in other economic networks is an open question, especially in networks where interaction between parties is less frequent. The research methods can also be used to investigate ties in social, rather than economic, networks. First published in W. P. Carey magazine, Autumn 2014.

Finance Venture Capital & Private Equity