Good friends can make bad business partners

A new NBER working paper suggests that similar venture capitalists (VCs) are worse at making or managing shared investments:

This paper explores two broad questions on collaboration between individuals. First, we investigate what personal characteristics affect people’s desire to work together. Second, given the influence of these personal characteristics, we analyze whether this attraction enhances or detracts from performance. Addressing these problems in the venture capital syndication setting, we show that venture capitalists exhibit strong detrimental homophily in their co-investment decisions. We find that individual venture capitalists choose to collaborate with other venture capitalists for both ability-based characteristics (e.g., whether both individuals in a dyad obtained a degree from a top university) and affinity-based characteristics (e.g., whether individuals in a pair share the same ethnic background, attended the same school, or worked for the same employer previously). Moreover, frequent collaborators in syndication are those venture capitalists who display a high level of mutual affinity. We find that while collaborating for ability-based characteristics enhances investment performance, collaborating for affinity-based characteristics dramatically reduces the probability of investment success. A variety of tests show that the cost of affinity is not driven by selection into inferior deals; the effect is most likely attributable to poor decision-making by high-affinity syndicates post investment. Taken together, our results suggest that non-ability-based “birds-of-a-feather-flock-together” effects in collaboration can be costly.

Given that homophily rather than heterophily remains the norm, it seems these investors are not learning this lesson, or value working and affiliating with similar peers over maximising profits. All very well for them. But if you have a project that you truly want to succeed, you may be better off doing it with a talented stranger rather than the college mates you clicked with on day one. And if you are letting others invest on your behalf, you should beware of handing your money over to a homogeneous friendship group.

I wonder if this kind of research influences the institutional investors who often fund VCs? If not, it would suggest that even this highly competitive investment market is falling short of its potential to fund and grow promising new companies.

Some research suggests that corporations with more female board members perform better, though the direction of causality is disputed. I doubt females are innately more talented board members, so the causation, if real, could be the result of female ‘outsiders’ generating better management than a clique of natural friends. Shareholders don’t share the benefits of board members enjoying each other’s company, so if they had effective control of  the companies they owned you might expect then to appoint a diverse ‘team of rivals’ to the board to closely scrutinise one another’s ideas.  My impression is that precisely the opposite is the norm.

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  • CMK

    I’m not sure how large the groups of VCs in this study were (it seems to be pairs), so take this with a grain of salt. 

    There is research suggesting that poor group decision making is caused by affinity with the “group” rather than the sum of affinities toward the individuals within the group.

    More recent research has also suggested that affinity is not the problem per se. Groups with critical norms tended to make better decisions than groups with consensus norms.
    I can’t recall the paper, but iirc the strength of group norms amplified this effect. So critical norms > no norms/entirely personal > consensus norms.

    I think that in both cases personal affinity is still a problem because personal affinities can create emergent group norms of consensus seeking. 

    I suspect that one reason women on boards improves performance is that introducing an outsider with contrary opinions destigmatises dissent. It will be interesting to see if women on boards continue to support high performance once their presence is normalised and less disruptive.

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  • Anita Woolley and Thomas Malone did some work on group intelligence and initially found that more women makes for smarter groups (whereas average and max individual intelligence did not).

    They later found that emotional intelligence accounted for most of this effect – women tend to have more emotional intelligence.

    It wouldn’t be the least bit surprising that smarter boards make better investment managers. That boards with more women seem to perform better would suggest it’s true.

    Institutional investors that can surmise a group’s emotional intelligence could have a critical advantage.

    • Daniel

      > […] initially found that more women makes for smarter groups

      Can it be that the mechanism behind the effect is simply increased competition among group members (of the same sex)?

      > They later found that emotional intelligence accounted for most of this effect – women tend to have more emotional intelligence.

      How can someone prove such a thing?

  • John Maxwell IV

    Affinity-based pairs could perform worse because people who tend to form such pairs aren’t that smart. Figure at a typical university the football players and cheerleaders are the ones with the highest level of school spirit, and (stereotypically) are the least intelligent. I tend to be a bit surprised when I meet someone who is really sharp and also has strong tribal affiliations.

    I’m surprised to see you speculating on why institutions haven’t responded to these findings given that they haven’t been published yet.

    With regard to female board members, there’s the obvious argument that since fewer females are on boards, those females that are on boards tend to be those who are highly qualified. A baseball team that’s willing to hire the best players regardless of race will tend to perform better than a baseball team that sticks to one race, even given racial equality.

  • Anjjbbb

    Selection bias. Those without the right background may find it so hard to attract good strangers to work with AND trust that affinity may be the only realistic option. Think of the family firm throughout history. Family members were rarely optimal employees but made sense in worlds of weak institutions, capital markets, and contracts. It’s better now but younger or less experienced startups still have smaller networks and less access to capital markets.

  • Andreas Moser

    I have had so many businesses, I have no friends left. 🙁

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  • Elmer Rich

    The inclusion of different kinds of brains appears optimal based on research we’ve seen,  Gender and IQ differences seems to help.  Also, clear independence of opinion helps.  More heads are just better, more information flows, regardless of IQ.

    U of Chicago did a great study, which they were embarassed about and did not publicize, that people actually make no difference in PE and VC success — it’s all about whether there is a growth market or not. 

    Peopla re actually irrelevant but are cheapest and easiest to study and it fit pop ideologies.  Ho hum.

  • I don’t think about that “Good friends can make bad business
    partners”. We are four friends and running a successful partnership business
    from few years ago.

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