Argentum, in cooperation with NHH and SIFR, will arrange the Argentum Conference and Symposium in Stockholm this September. One of the objectives is to highlight the latest in private equity research. Leading up to the conference, we will present an introduction to one of the papers that will be presented each week.

Yael Hochberg (Northwestern University): The Size and Specialization of Direct Investment Portfolios

Co-author: Mark Westerfield.

In economic literature, there has long been a general presumption that specialization enhances productivity and is an important contributor to growth. By focusing on a limited range of activities, it is possible to better exploit comparative advantage or economies of scale. This paper provides an analysis of specialization and growth in venture capital companies.

The paper shows that larger and more experienced venture capital firms tend to be generalists: They invest in a wide range of industries and geographical areas. The authors present a model where size and specialization are substitutes. A factor that increases the returns to venture capital activity induces funding of more projects and generalization, while a factor that decreases the returns induces a smaller portfolio of companies and specialization.

Earlier research show that a small proportion of venture capital investments account for the majority of venture fund returns. Hence, a critical activity for the venture capital firm is to find the right deal and a critical success factor is access to deal flow. Size and specialization are substitutes because a large venture capital fund need the deal flow to find enough high quality projects to fund, and therefore a large venture capital fund must be less specialized. On the other hand, specialization offers two advantages: It improves the payoff of any given project if that project eventually is successful, and it improves the ability to reuse human capital from a failed project.

The model is tested on a dataset consisting of US venture capital funds raised between 1980 and 1999. Size and specialization appear to be substitutes: Larger funds are less specialized, and more specialized funds have smaller portfolio sizes.

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