The presence of established institutional factors in a country is more important than interpersonal trust, finds Sofia Joha

Johan, Sofia

LSE Research Online

10/23/2015As venture capitalists cross borders, they look forinstitutional trustblogs.lse.ac.uk /businessreview/2015/10/23/as-venture-capitalists-cross-borders-they-look-for-institutional-trust/Venture capitalists (VCs) are increasingly investing across jurisdictions, with the vast majority of thesecross-border investments being carried out in a syndicate of two or more VCs. This paradigm shift is of interest togovernments seeking to further develop local immature venture capital markets by attracting both foreign funds andexpertise. Researchers, such as my co-authors Daniel Hain, Daojuan Wang and I, also have an interest indeciphering this changing paradigm and understanding the determinants of cross-border venture capitalinvestments.Local bias has long been considered inherent in financial intermediary activity, especially so for venture capital.Investment in innovative activities involves considerable uncertainty and is characterized by at least two factors. Atthe outset, there is asymmetric information: one party usually has access to better information than the other; andduring the investment process there may be agency problems, when one party is supposed to act on behalf ofanother but conflicts of interest get in the way. Therefore, frequent and open interaction between investor andinvestee within close proximity appears necessary for these investments to succeed. A new, growing body ofliterature, however, suggests a paradigm shift towards a more globally distributed venture capital investment pattern.In our research we examine worldwide venture capital investment flows from 2000-2012 and consider the effects ofgeographical, cultural, and institutional proximity as well as institutional and interpersonal (relational) trust.Geographical proximity and local expertise or knowledge is used by VCs to identify innovative ventures and togather the information required to mitigate their significant financial risk. The physical distance between the VC andthe innovative start-up firm may determine the frequency and openness of their interactions.Prior research finds that differences in legalsystems increase information asymmetries,the cost (legal and contractual) and the riskof investment. More dissimilar andinefficient legal systems impede the abilityof a VC to finance firms and, thus, hamperthe rate of investment. In addition to legaldifferences, we also consider culturaldistance as it is associated with divergingvalues, business ethics, and codes ofconduct. Countries with higher culturaldistance show higher mistrust, anddiscourage risk sharing among potentialinvestors. That tends to represent a majorobstacle for cross-border investments.Institutional trust is present prior to the interaction among parties and refers to the trust in the institutionalenvironment, which includes factors related to the legal framework and its enforceability as well as soft factors, suchas a society’s attitude towards behaving fairly and honestly.In contrast, relational trust unfolds gradually through repeated interactions between parties over time. Bothinstitutional and relational trust are very important in cross-border venture capital deals, but they differ in theirinfluence, depending on the participant composition (foreign only vs. foreign and domestic VCs) of the investmentsand the institutional setup of the destination country (developed vs. emerging economy).1/3We believe that while institutional trust is not attached to a particular relationship, it serves to ease the way inestablishing one, as it mitigates the effects of lack of proximity in cross-border investments. It is pretty much a beliefin the system over anything else. As the relationship is established and relational trust is built, the perceiveduncertainty of the investments gradually declines while a mutual understanding develops, and both parties movetowards a more symmetric information base. Thus, even in the absence of relational trust, we expect countries withhigh institutional trust to hold higher venture capital inflows and syndication activities, despite potential social andgeographical distance.In brief, we find that the higher the geographical and cultural distance, the lower the likelihood of cross-borderinvestment. However, venture capital flow does appear to move from high-growth countries to low-growth countries;therefore, it appears that VCs are willing to take on the higher risk of investment in emerging economies. Ourfindings suggest that high-market capitalisation and low corruption levels in the destination country encourage VCsto overcome local bias and consider an investment there.Our findings also suggest that VCs mitigate the investment risk with social exchange among a syndicate comprisingat least one local VC to overcome lack of proximity. What is interesting is that while relational trust helps overcomehigh geographical, cultural, and institutional distance, institutional trust has a more positive impact on cross-borderventure capital flows from developed to emerging economies. This may be because VCs may prefer to rely on theirfamiliarity with established institutional factors in making investment decisions and do not necessarily view relationaltrust as a substitute for institutional trust.Sophisticated foreign VCs, for example, may believe they are sufficiently capable of assessing the viability of aninnovative firm, and are not reliant on the information gathered after having social exchanges with less sophisticatedlocal VCs, though such information may still mitigate investment risk. Another explanation for institutional trusthaving more of an impact on cross-border venture capital flow from developed to emerging markets is that VCs fromthe developed economies would prefer not to dilute their reputational capital by investing with less reputable VCsfrom emerging economies.Governments hoping to attract both foreign venture capital investment and arguable more sophisticated value addedexpertise from foreign VCs should be building institutional trust as it provides the foundation for building up a criticalmass of initial trust to enter a relationship involving proximity.♣♣♣Notes:The post gives the views of the author, and not the position of LSE Business Review or the London School ofEconomics.Featured image credit: Marta Sánchez (IV SeedRocket Investors’ Day) CC-BY-2.0 Inside photo: GotCredit CC-BY-2.0 Sofia Johan, LL.B (Liverpool), LL.M. in International Economic Law (Warwick), Ph.D. in Law(Tilburg), is the Extramural Research Fellow at the Tilburg Law and Economics Centre(TILEC) in The Netherlands and also with the Schulich School of Business, York University.Her research is primarily focused on law and finance, sovereign wealth funds, marketsurveillance, and alternative investments including but not limited to hedge funds, venturecapital, private equity, real estate investment trusts and IPOs. Her work has appeared inmajor journals and has been presented at leading international conferences.  She has co-authored the books titled Venture Capital and Private Equity Contracting  and Hedge FundStructure, Regulation and Performance Around the World. Prior to her Ph.D., she was legalcounsel for a derivatives clearing house and the head legal counsel at the largest2/3government owned venture capital fund in Malaysia. She has also consulted for a variety of governmental andprivate organizations.Copyright © 2015 London School of Economics3/3

As venture capitalists cross borders, they look for institutional trust

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