The second part of the research looked at geographic diversification and the performance of funds investing globally, versus those specialized in North America, Asia, Europe, or the rest of the world. The results showed that global funds outperform North American funds – historically, the number one geography for VC – with 11.5% versus 10.2 % in terms of median IRRs. Asian funds realize 16.2% in the median, but the superiority of Asian funds vanishes when looking at more complex measures such as the Adjusted Sharpe Ratio, which measures on a risk-adjusted basis how much additional return an investment is returning compared to a risk-free investment.
A drawback of the analysis and even the notion of specialization is a lack of common understanding in the profession of what specialization means. For instance, high-tech could mean that a startup is building software for an AI product, engineering parts for drones, or licensing the use of patented materials. A VC that invests in all three of these functions is already diversified in a certain sense. Do they need to invest in antibiotics or an Alzheimer’s cure to be considered diversified? Furthermore, can a VC that invests across Europe be called a geographic specialist? Deciding a fund’s investment thesis, and how it constructs its portfolio, requires a clear definition of these terms as well as discipline in applying them.
The study provides evidence in favor of diversification rather than specialization. But why?
An intuitive reason might be the high failure rates. Good startups are rare and few, such that VCs moderate their returns by specializing. Specialization is a proactive self-limitation of the investment universe. A generalist hypothesis is thus that you cannot proactively forgo promising projects from the right industry but the wrong geography or vice versa.
Another reason may be that entrepreneurs may possess part of the specialist knowledge themselves. Entrepreneurs are not all young and inexperienced. Having a track record in their industry themselves, they know what they are doing. For them, a generalist VC that has experience in transferring their product into a different industry may be exactly the complement they need. This leads to a second generalists’ hypothesis: the characteristics of a successful VC are more transferable between industries and geographies than a specialist might think.
What this means for VCs, entrepreneurs, and limited partners
Historically, many stakeholders in the profession have favored specialization. Many VCs have branded themselves as industry specialists and invested a lot to build a specialist reputation, and some have been successful. Expanding the boundaries of a specialist fund to provide a certain measure of diversification not only involves a dramatic change in the investment model but also a big move in the fund’s positioning and branding in the market.
