Co-investment in VC: What are the impact on returns and relationships?
With a little help from my friends: Is co-investing with other VC funds good for returns?
As investors, we seek to gain knowledge of how things work by understanding unconscious biases and developing heuristics that contribute to the quality of decision-making. Among a wide range of possibilities, finding what is our point of view of things taking into account both factors (biases and heuristics) is what makes the investor profession unique and, ultimately, worth paying for. In this following article, I propose a reflection on what may well be one of the biggest Achilles' heels to our day-to-day activities.
The venture capital industry has been known for its closeness and friendship among funds, which drastically contrasts with the dynamics of other private investment classes, such as private equity. Part of the success of VC funds, especially early ones, lies in the ability to graduate their portfolio (see value investing in VC). Meaning that companies that raised a seed round will come to raise series A, B and so on. Consequently, companies with higher graduation rates are at better odds of an exit. Inevitably close ties with other funds happen for a few reasons, but it stems mainly for deal flow sharing and co-investment opportunities.
However, does a deep relationship with other funds correlate with better returns? This article is an attempt to explore the co-investment conventional wisdom and how Brazil’s reality is looking in the recent boom cycle.
If humans are social creatures, VCs are humans on steroids. We have seen this in the recent momentum investing behavior primarily driven by the herd mentality and FOMO coming down to the cracks. Recent examples range from funds changing their focus and positioning (a couple times) to cases like FTX .
A 2019 paper titled “Getting Tired of Your Friends: The Dynamics of Venture Capital Relationships” by Oxford’s Saïd Business School has shown some conclusions that are contrary to what the status quo of the industry would say. It focuses on the impact of returns and relationships between VC funds that co-invest with frequency over the long run. Below is a summary of the three most relevant points in the authors’ own words.
- Deeper relationships lead to lower exit performance over the near term, and a retrenchment from relationships over the medium term (driven by the impact on returns);
- Negative effect of prior relationships on current co-investment behavior stems from hot market relationships, whereas past co-investments made in cold markets have an opposite positive impact;
- Relationship effects are more negative for VC firms with less central network positions, and for deals made in “hot” investment markets.
As Chamath Palihapitiya from Social Capital put it on the All-In Podcast (53:08) on the topic:
“When things go down, the highly correlated are the ones that go down the most as they typically get the most traffic meaning that they have the most investors and during up markets they have the propensity of having the highest prices”.
In an attempt to see how this could look like for some of Brazil’s leading VC firms I dug into Pitchbook’s public data to get a picture of the portfolio’s overlap scenario in the region aggregated from 2020 and 2022. The percentages represent how many out of the 236 deals the firms invested with each other (portfolio size not considered to avoid distortions) i.e: Fund C and Fund D co-invested in 10 deals out of the 236 total (4.2%) done in the period.
To put in perspective on a relative basis, the image below compares Astella’s co-investment number, and how many deals other funds co-invested. Meaning for one co-investment done by Astella how many deals other funds did.
Having a higher overlap doesn't always mean it will have lower performance due to factors like funds having different strategies, such as lead vs. follow, or different entry point (stage) impacts. However, it may tell us a thing or two about the timing that it has happened and what the future may hold.