The benefits from geographically or industry-wise specialised VC fund investment strategies are dependent on the VC firm characteristics and context
Specialisation in industries or geographies increases the capabilities and advantages of the investors
to attract, select and add value to start-ups operating in their specialisation domain. However, the
local markets and the characteristics of VC investors that come with the larger fund sizes shape
1. the needs of the fund to increase the investment scope, and 2. the capabilities of the fund to
attract startups through elevated reputation and status that stem from the extensive experience
that investors able to raise large sums of capital typically possess. Therefore, there exists no
’one-size-fits-all’ investment strategy in VC, and the optimal approach in sourcing deals should
be modified to serve the needs and conditions set by the fund size and the context of the local
markets.
In my thesis, I hypothesise and test a three-way interaction between a fund’s industry scope,
geographic scope and fund size, focusing on the U.S. (334 funds) and Europe-based early-stage VC
funds (67 funds), considering the vintages 1999-2015. The proposed mechanism for the interaction
considers the interaction between the industry and geographic scope, which shape the focus of a
fund’s deal-sourcing efforts to the targeted set of industries and geographies, and consequently,
its capability building within these domains, while the fund size brings its unique implications for
deal flow requirements and competitive advantage in securing the best deals from the market. To
even the differences introduced by the massive domestic VC market of the U.S. in the geographic
scope measure, the geographical markets are categorised as states if the country is the U.S., and
otherwise as countries.
The results of the thesis are novel, and relevant for VC firms and limited partners (LPs) investing
in VC funds. For VC firms, the implications of the study introduce considerations for investment
strategies. For LPs, the findings suggest considering the specialisation as an attribute of a fund
when deciding which funds to invest in, from the perspective that the fund is able to 1. generate
enough quality deal flow, and 2. select, attract and match with the best start-ups.
Smaller funds have a trade-off between the industry and the geographic scope, and
that relationship is context-dependent
Smaller funds can benefit from specialisation, but this is subject to the context of a fund’s geographical location.
• Smaller U.S. early-stage VCs: More geographically focused investment strategies are
linked with better fund performance when widening their industry scope. This association
between the fund returns is dynamic by nature: the benefits obtained from widening the
industry scope is greater when the fund is geographically even more focused. The smaller
fund size level is defined as a few tens of millions (USD).
• Smaller European early-stage VCs: Industry specialists attain greater performance from
expanding their geographic reach. This relationship is also dynamic by nature, suggesting
that the more a fund is specialised to any particular industry, the greater the benefits attained
from increasing geographical reach. Smaller fund size level defined as below 20 million (USD).
These differences that depend on the geographical location of a fund can potentially be attributed
to underlying geographical and market differences intrinsic to each area, i.e., a country in Europe or
a state in the U.S. In the U.S., especially in the states that have the most VC investment activity,
local markets may present a feasible number of opportunities for sourcing high-quality deals. Within
these states, the inherent advantages gained from localised networks, brokerage advantage and
local reputation might be more influential in enhancing fund performance than being specialised
in any specific industry. On the contrary, the European markets, where the markets of individual
countries are often characterised by their limited size (compared to the U.S.), compel funds to
expand geographically and seek cross-border investment opportunities beyond domestic markets.
The primary logic behind the relationship between the fund performance and a fund’s industry
and geographic scopes at smaller fund size levels stems primarily from two things.
• Deal Volume & Quality: A smaller fund must encounter an adequate volume of deals
to identify enough high-quality opportunities. To ensure this, some breadth in its sourcing
strategies becomes essential.
• Value-add Potential: The best startups seek more than just capital − they value partnerships
with VCs that bring tangible benefits. A VC, by specialising either geographically
or industry-wise, can tap into deep knowledge and networks specific to that domain. This
expertise not only gives the VC a competitive edge in sourcing deals but also empowers them
in the post-investment value creation phase.
Moreover, focusing either industry-wise or geographically reduces the information asymmetries
between the VC and investment targets, leading to sharper investment choices. Therefore, the
theory posits that smaller funds fare best when they adopt an investment strategy that is focused
on either a specific industry or region while maintaining diversity in the other dimension. As
established in the results, the context-dependency of a fund poses implications to this, as the U.S.
funds benefited more from geographically local strategies whilst European funds exhibited gains
via industry-specialist approaches.
Larger funds benefit from expanding the investment scope driven by the larger fund
size and the capabilities associated with it
Larger funds benefit from expansive investment strategies across various industries and geographies.
The context-dependent considerations for this include the fund size at which the observed impact is economically significant – in the U.S., the fund sizes measurable in multiple hundreds
of millions (USD) showed evidence for the expansive investment strategies impacting fund performance positively, whilst, in Europe, the same effect was observable in funds with a size reaching 200 million (USD). Similarly, as for the smaller funds, the differences in the fund size levels benefiting
from more expansive investment strategies may be attributed to the local market differences − in
the U.S., and especially in the largest VC hubs, a fund may become fairly large whilst still being
able to generate an ample amount of quality deal opportunities from the local context without
having to go beyond the state boundaries.
Concerning larger fund size levels, the proposed theory posits that the performance and strategic
behaviour of larger VC funds are influenced by several high-level factors:
• Larger Deal Flow Needs: Due to a greater pool of committed capital, larger funds require
a more extensive and diverse range of investment opportunities.
• Increased Expertise Levels: Firms capable of raising larger funds typically demonstrate
higher levels of expertise, stemming from their extensive experience in the field. This increases
their value-added potential in the eyes of an entrepreneur, enhancing access to a higher
volume of quality deals.
• Elevated Status and Reputation: The ability to secure substantial capital is often indicative
of a firm’s elevated status and reputation in the market. Affiliation with a high-reputation
VC typically provides certification for a startup validating the company to the market stakeholders,
thus creating indirect value for the company. This improves the access to quality
deal flow, enhancing the capability of a VC to secure the best deals from the market.
The need for a wider investment scope to ensure that the fund sees enough quality deals is critical
for a larger VC. Also, as the larger funds are typically associated with elevated expertise, status,
and reputation, which collectively contribute to a fund’s ability to add value enhancing the
competitive advantage in the deal-sourcing process and value creation post-investment, the larger
funds benefit more from an increase in the deal flow compared to an increase in specialisation. Furthermore, as larger funds typically employ a greater number of venture capitalists, they actually
can have specialised knowledge across a number of industries or geographies, which would be more
challenging for a smaller VC firm. Important to also note that the fund size does not cause higher
expertise levels and elevated statuses and reputations, but rather there exists a link between larger
funds, or more specifically VC firms capable of raising large amounts of capital, and the increased
expertise, status and reputation levels.
Final Thoughts
This pioneering work sheds light on the intricate relationships between investment strategies and
VC fund performance, offering valuable insights and considerations for VC firms and fund of
fund investors (LPs). While the findings contribute to the debate on the specialisation’s effect
on performance, they also open avenues for future research, especially in validating the observed
relationships in different geographical contexts and exploring more detailed fund size levels. Also,
this study calls for future research in validating the results considering the European VCs, given
that those are subject to sample size limitations.
This blog post is part of our Master’s Thesis Competition. The writer, Hannes Väre, received an honorary mention for his thesis.
