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Decoding the behavioral biases that influence venture capital funds

Published 5 December 2023 in Finance • 8 min read

Beyond the number crunching, the decisions made by venture capital funds often depend on a complex and intricate mix of human behavior and psychological biases that can significantly influence the outcome of the fund. 

In the late noughties, the rise of the internet made it far more convenient to share physical assets on a larger scale. Termed the “sharing economy” by Harvard Law School Professor Lawrence Lessig in 2008, it led to a proliferation of companies such as Uber and Airbnb, all promising to revolutionize the way people used and shared resources from cars and houses to power tools and surfboards. By 2016, those two startups were valued at $80bn and $30bn respectively, far greater than the market capitalization of global hotel chain Hilton and traditional automakers Volkswagen and GM.

As these platforms became household names, global venture capital (VC) funds rushed to seize a piece of the action; they assumed that the disruptive potential of these platforms was enormous and they didn’t want to miss out on the next “Uber of X.” A BCG analysis of sharing startups found the number of venture-financed sharing companies jumped from 40 in 2007 to 420 in 2016, with the amount of funding growing from $43m to about $23.4bn over the same period.

VC firms’ rush into shared economy startups is a prime example of the herd mentality, just one of several psychological biases that can sway investment decisions. In this case, many VC funds followed the crowd into a trendy sector that was showing signs of success. Yet amid the hype, many firms overlooked the fundamentals. Not every sharing economy startup was headed for success, and many faced regulatory, competitive, or operational challenges. A case in point is WeWork, the shared office firm that was once valued at $47bn and was forced to file for bankruptcy in the US, or the scooter company Bird, once valued at $2.5bn, that delisted from the NYSE after the stock collapsed. 

Post-COVID-19, the frenzy around sharing economy startups cooled, revealing market saturation and intense competition. Many startups failed or were acquired at lower valuations, impacting fund returns. For instance, Turkish delivery company Getir acquired its rival Gorillas for $1.2bn in 2022, at a valuation significantly lower than its previous funding round. 

As Nicolas von der Schulenburg, Managing Director at Portfolio Advisors, which has invested over $7.6bn across more than 650 VC funds since it was started 25 years ago, says: “You need to understand what the herd is doing and come to your own conclusion as a disciplined venture investor as to whether to dip your toe in the water or not.” 

While it’s natural for funds to be drawn to promising trends, following the crowd without critical evaluation can lead to overexposure, increased competition, and potential challenges for the fund’s performance. To avoid falling into the herd mentality trap, it’s important to be aware of some of the psychological biases that can significantly influence the performance of a fund. 

How ego and overconfidence impact check sizes

In venture capital, the size of the investment check (the amount invested in a deal, be it a company or another fund) is not always a purely financial decision; sometimes it also reflects how the fund wants to present itself to the world. Wanting to win a “hot” deal and secure a leading position in a desirable startup often leads to inflated check sizes. If an investor’s ego influences the size of their investment, it can lead to too much focus on control, the risk of overvaluing the company, less diversification in their investment portfolio, and less money available for future investments. 

VC firms’ rush into shared economy startups is a prime example of the herd mentality, just one of several psychological biases that can sway investment decisions

Balancing the desire for influence with a realistic assessment of a startup’s potential and market conditions is essential for sustainable and successful investment strategies. “I see it not only in venture funds investing in startups but also in funds investors [funds of funds]. For instance, in our investment committee, we usually have a slightly higher conviction around one fund manager than another. There’s often the temptation to say we’re going to oversize our commitment to this firm, but experience typically says that you need to remain rigidly disciplined when building a portfolio,” says von der Schulenberg.

How the fear of losing control and risk aversion impact the ownership percentage

Moreover, the decision around how much of a startup to own isn’t purely financial but reflects the fund’s risk appetite and strategic priorities. High ownership percentages, for example, may signal a risk-averse stance, with a desire for greater control and influence over the portfolio company.

Having a larger ownership in a startup gives a VC fund more control and aligns its interests with the founders, fostering collaboration for shared long-term goals. It also enhances the fund’s brand, as it shows they can secure significant stakes in leading companies, says von der Schulenberg.  

However, aiming for high ownership can in theory limit the fund’s portfolio diversification and increase exposure to individual companies’ performance. While General Partners in VC chase the benefits of Power Law, they need to achieve minimal portfolio diversification. It may also restrict the fund’s ability to adapt to market changes or capitalize on new trends. Lastly, a large stake can complicate liquidity events, as finding suitable buyers or achieving satisfactory valuations becomes more complex.

How loss aversion can cause firms to hold onto underperforming companies

Loss aversion is a cognitive bias that means humans experience losses asymmetrically more severely than the equivalent gain. In the context of VC firms, this means leading investors may struggle to part ways with investments that are underperforming. A complicating factor is that VC investments are illiquid, and therefore selling stakes in portfolio companies is not as straightforward as in public equity markets. Even though an outright sale may not be feasible, the reluctance to acknowledge losses may lead to prolonged support for underperforming ventures, potentially tying up valuable resources that could be redirected to more promising opportunities.

The loss aversion bias impacts VC operations in several different ways.

Firstly, loss aversion can influence how operating partners support underperforming companies. They may delay or resist tough decisions to avoid admitting failures and may not suggest necessary changes for the company’s long-term health of the portfolio company. 

Second, loss aversion can impact the allocation of additional funds for companies needing bridge rounds. Investors may hesitate to invest more in struggling companies due to fear of losses, limiting their support during challenging times. Conversely, they might be tempted to do bridge rounds to delay inevitable write-downs or write-offs.

As von der Schulenberg explains: “If you were the one who championed the deal, pushed it through, and thinks it’s going be a success, then you’re probably going to be inclined to reserve more capital for follow-ons than might be necessary.” While these reserves often don’t get used up depending on the market environment, there is a tendency for partners to over-reserve funds for their own deals, he adds.

For limited partners, it's essential to focus on the human aspect when conducting due diligence on a specific VC fund
For limited partners, it's essential to focus on the human aspect when conducting due diligence on a specific VC fund

For limited partners, it’s important to pay attention to how general partners design and implement their valuation policies. Venture capitalists might be reluctant to mark down valuations since they dread the impact on the perceived success of their investments. This can result in inflated valuations that do not accurately reflect the current market conditions or the company’s performance.

How ego leads to recycling exits

Sometimes bias leads general partners to recycle exits. Simply put, this is when a VC fund exits a company and gets a cash distribution which it then reinvests into the fund, either in new or existing portfolio companies, rather than returning it to investors. The main reason why some VC firms recycle is because they want to generate a higher multiple for their investors. If they recycle, they intend to get a higher total value on paid-in (TVPI) even though the drawdown might be lower. “Clearly as a GP you must be confident that with the money that you are reinvesting, you are going to be able to also invest very profitably. I guess this could be where ego comes in, as you say to your LPs that you should in theory be able to find another opportunity that is as successful as the one that you just sold. But in theory, that is why people are VCs, because they are convinced they can find great opportunities and great startups,” von der Schulenberg says.

How over-optimism on exit models influences funds

As a general partner in a VC fund, optimism about profit generation is essential. However, this optimism can be excessive in certain situations. For instance, if a partnership has uneven deal distribution, a partner with fewer deals might be unrealistically optimistic about the exit multiple of their successful deal. This could be due to the pressure to perform well or the risk of being asked to leave the partnership. Ego and peer pressure can also play a role, leading to overambition on the exit side, especially when a partner feels the need to close more deals.

So how can investors manage these potential biases among fund managers?

In the context of VC fund modeling, it’s important to identify and minimize the impact of harmful behavioral biases, while taking advantage of beneficial ones to make well-informed decisions. General Partners should aim for a balanced strategy that blends optimism and flexibility with a realistic evaluation of market situations. This balance is vital for enhancing the fund’s performance over time. 

It’s also essential for limited partners to focus on the human aspect when conducting due diligence on a specific VC fund. Building enduring relationships with general partners enables limited partners to better understand and manage mental biases. Here are some ways you can identify potential biases:

  • Scrutinize the portfolio construction: Take a close look at the way a VC fund constructs its portfolio. If they have put 30% of the fund into just one deal, which would be a lot, it’s a red flag that they have let their ego get in the way of sound investment discipline, says von der Schulenberg.
  • Watch for potential trend followers: It’s important to examine the sectors a fund has invested in over time to understand if their strategy adapts to current trends. Some VC relationships may invest in different sub-sectors of the economy and startup world based on what’s trending. However, if a fund consistently changes its investment focus, it might be too much of a trend follower, points out von der Schulenberg. 

Authors

raphael grieco

Raphaël Grieco

Research Associate at the IMD Venture Asset Management Initiative

Raphaël Grieco has joined IMD as a Research Associate for the Venture Asset Management Initiative, drawing on over 15 years of leadership experience at the intersection of cross-asset Wealth Management and Technology. Raphael specializes in early-stage venture investing, multi-support educational content creation spanning written and audio formats, as well as building entrepreneurial ecosystems focusing on technology (including crypto and web3).

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