Specialization versus diversification in venture capital investing

Abstract

PurposeModern portfolio theory demonstrates that a well‐diversified portfolio will minimize unsystematic risk. It may be impractical to achieve a well‐diversified portfolio of venture capital (VC) investments due to market imperfections, leading to the decision to specialize. The purpose of this paper is to determine the implications of choosing a strategy of specialization versus diversification in venture investing.Design/methodology/approachUsing a dataset of US VC funds across a 20‐year time period, this paper verifies that there has been a tendency for venture capitalists to pursue a specialization strategy in both industry and stage of development of portfolio firms. A multivariate two‐limit tobit model is constructed to determine the effects of these decisions on venture success rates.FindingsIt is found that venture capitalists that diversify across portfolio company stage of development have greater success in bringing companies public and exiting their investments via acquisition. Industry specialization has no significant impact on venture fund success rates.Research limitations/implicationsSuccess rates may be less important than returns to investors in VC. Future research should examine the effects of specialization on investor returns.Practical implicationsIt may be beneficial to increase the level of diversification of VC investments across portfolio company stage of development. The lack of diversification across industry has not significantly affected success rates across funds, thus the tendency to specialize in particular industries over the sample period is not necessarily a poor decision.Originality/valuePrior research demonstrates a tendency for specialization in VC investing. This paper examines the implications of adopting this strategy.