Featured Article:

by Anna Kovner and Josh Lerner

Should one expect to do well when investing in community development venture capital funds (CDVCs)? In comparing investment patterns and performance outcomes with traditional venture capital (VC) funds and CDVCs, Anna Kovner and Josh Lerner conclude that companies backed by CDVCs are less likely to go public or be acquired than VC-funded ones. This finding remained consistent, even after controlling for the lower success rates in the industries and locations that CDVCs target. In a Q&A, Kovner and Lerner discuss the unique challenges associated with CDVCs, their potential societal benefits, and how their financial performance could be improved.

The following section is a Q&A with Anna Kovner and Josh Lerner

1. What are the biggest challenges facing newly established CDVC firms?

CDVC firms are typically established with a dual mandate for financial and social benefits. One of the critical aspects of the venture capital process is the alignment of incentives so that all parties benefit from the same outcomes at similar times. With the presence of multiple objectives, it can be hard to ensure an optimal alignment of interests in CDVC.

2. What role does geography play in CDVC investments?

We find that investment geographies of CDVCs are strikingly different from traditional venture capital firms, whose investments are highly geographically concentrated. CDVCs seem to shun investing in the San Francisco area (3% vs. 30% for non-CDVC funds) and are more likely to be headquartered outside the ten regions that have historically attracted the most venture capital financing (57% vs. 49% of non-CDVC funds). Non-metropolitan areas, which account for a tiny fraction of non-CDVC fund investments, represent 5% of CDVC funds’ investments. CDVC groups are also substantially more likely to invest locally (52% vs. 32%).

3. From your research, how could CDVC firms have a better financial performance?

The industries which are associated with the highest success rates—Internet and Computers, Communications and Electronics, and Biotech and Health—tend to be ones that the community development funds shy away from. Early-stage and expansion transactions, companies where the first investment is in an earlier round, and those in regions with less venture activity are less likely to be successful, all else equal. Once again, these are ones where CDVCs disproportionately invest. Similarly, less experienced venture capital groups have less successful investments. However, all of these characteristics are precisely those that may benefit the other mission of CDVCs – the development of venture activity in hitherto neglected communities and industries. While it is far easier to measure financial performance, when viewed through a broader lens of all stakeholders, CDVCs may have a positive return to their community.

4. Although CDVC investments have a lower probability of success, what kinds of societal benefits do they provide to the community?

We find that investment geographies of CDVCs are strikingly different from traditional venture capital firms, whose investments are highly geographically concentrated. CDVCs seem to shun investing in the San Francisco area (3% vs. 30% for non-CDVC funds) and are more likely to be headquartered outside the ten regions that have historically attracted the most venture capital financing (57% vs. 49% of non-CDVC funds). Non-metropolitan areas, which account for a tiny fraction of non-CDVC fund investments, represent 5% of CDVC funds’ investments. CDVC groups are also substantially more likely to invest locally (52% vs. 32%).

5. What further research questions do you hope to be answered regarding CDVC investments and their impact?

First, to what extent do CDVC investors make use of the crucial governance tools the venture capitalists employ, such as convertible preferred stock and the right to replace key management? Second, does the growth of these investments in employment and sales mirror those of traditional venture investments? Finally, does the outcome of CDVC investments vary with the characteristics of the CDVCs, or the nature of the funders (e.g., governments vs. foundations)? These and related questions would reward careful research.

Anna Kovner

Josh Lerner