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  1. 1. KNOWLEDGE, INSTITUTIONS, AND THE INTERNATIONALIZATION OF U.S. VENTURE CAPITAL FIRMS Isin Guler Boston University Mauro F. Guillén The Wharton School University of Pennsylvania Very First Draft with Preliminary Results Comments Welcome Please Do Not Circulate without Permission October 2004 Version Funding from the Mack Center for Technological Innovation at the Wharton School is greatly appreciated. Adrian Tschoegl provided excellent comments and suggestions.
  2. 2. 2 KNOWLEDGE, INSTITUTIONS, AND THE INTERNATIONALIZATION OF U.S. VENTURE CAPITAL FIRMS ABSTRACT This study examines the country-level factors that affect U.S. venture capital firms’ decisions to invest in foreign ventures. Foreign venture capital investment is driven by a combination of factors different than those accounting for either foreign direct or portfolio investment: the availability of innovative opportunities, the ability to commercialize these opportunities, and the extent to which the institutional infrastructure of each country enables the appropriation of returns. We report preliminary results using a sample of 350 U.S. venture capital firms potentially investing in 140 countries during the 1990-1999 period. Countries with more opportunities, as measured by the level of scientific knowledge, and those with better commercialization institutions, as measured by capital market development, are more likely to attract U.S. venture capital investments. We find no effect for institutions guaranteeing the appropriability of returns.
  3. 3. 3 1. Introduction Venture capital firms have traditionally raised and invested money within the borders of their home country. Many a venture capitalist would even take pride in investing in ventures located within a couple hours’ drive from their offices so as to be able to monitor them closely (Sorenson and Stuart, 2001). In the last ten years, however, cross-border venture capital investment has started to rise. This paper investigates the choice of international venture capital investment location, a question of increasing relevance as the world economy shifts toward knowledge-intensive activities. The venture capital industry has played an important role in spurring innovation and entrepreneurship in the United States. In recent years, U.S. venture capital firms started to look abroad for investment opportunities in other countries. This trend is important not only in providing new opportunities for venture capital firms, but also in contributing to the development of local economies through entrepreneurship and innovation. There is a large body of theoretical and empirical research on the destination of foreign direct investment (FDI), i.e. when a firm decides to set up operations abroad by managerially controlling a foreign asset (Caves, 1996). This literature highlights that FDI location decisions are driven by country-specific as well as firm-specific factors (Dunning, 1998). There also is a well-established literature on the drivers of international portfolio investment, focusing on interest rates, taxation, legal barriers, and risk (Dornbusch and Fischer, 1994). However, there are no studies specifically focusing on the investment choices of venture capital firms, choices that are different from those faced by either multinational firms or portfolio investors. Unlike FDI, venture capital investments are not aimed at securing managerial control of the venture. Compared to portfolio investments, they are far less liquid. Typically, venture capital firms
  4. 4. 4 identify and invest in relatively high-risk and low-liquidity ventures, provide them with a variety of financial and technical resources, monitor their progress without directly managing them, and seek to realize gains from their investments relatively quickly through initial public offerings (IPOs), acquisitions, stock buybacks or liquidations. We argue that the decision of U.S. venture capital firms to invest in companies located in foreign countries is driven by the availability of innovative and entrepreneurial opportunities, the ability to commercialize these opportunities, and the extent to which the institutional infrastructure of each country enables the appropriation of returns. 2. Foreign Investments and Location Choice The international investment decisions of venture capital firms have not yet been addressed theoretically or empirically. Location choice by multinational firms, however, has been the subject of a large number of theoretical and empirical studies on foreign direct investment or FDI (Caves, 1996). This voluminous literature suggests that firms choose to invest in countries where location-specific benefits outweigh transaction costs (Dunning, 1998). The benefits have to do with the possibility of improving efficiency, accessing markets or acquiring strategic assets such as brands or technology. The costs of foreign expansion have to do with several variables. First, the level of political hazards and corruption in the host country, which research has shown to be related to the level of foreign direct investment (Wei, 2000; Henisz and Delios, 2001). Government policies that affect business conditions (regulation, taxes) or trade also affect the level of foreign direct investment. Second, the similarity between the home and the host countries in terms of business environment reduces transaction and coordination costs, thus helping firms overcome the “liability of foreignness” (Zaheer, 1995), and inducing FDI.
  5. 5. 5 Empirical findings show higher FDI activity between countries of similar size (Markusen, et al., 1996), language, and culture (Kogut and Singh, 1988; Agarwal and Ramaswami, 1992; Barkema, et al., 1996), and prior network linkages. Third, the presence of other multinationals in the host country attracts new investments because it not only reduces perceived uncertainty for investing firms (Martin, et al., 1998; Henisz and Delios, 2001), but also provides agglomeration benefits (Caves, 1996). In order to minimize the impact of these costs, the foreign direct investing firm seeks managerial control. In sum, foreign direct investment occurs because of market imperfections and is all about the control of resources (Hymer, 1960/1976: 25; Kindleberger, 1969). At first blush, it may be tempting to classify venture capital investments as a special case of FDI, and generalize the findings from this literature to venture capital. However, a closer look at the motives for foreign direct investment activity reveals a crucial difference between FDI and venture capital investments. FDI is typically motivated by a search for natural, human, or knowledge-based resources, new markets for existing products, or ways and means of improving efficiency (Dunning, 1998). By contrast, venture capital investments are not motivated by any one of these. Venture capital firms make capital investments in “opportunities” that typically entail high risk, and a potential of high returns. These opportunities are not single resources or means of production, but individual companies that compile a unique “bundle of resources” (Penrose, 1959). Although venture capital firms undertake ownership in these companies for monitoring purposes, they do not internalize the companies with the intention of managing them (Gompers and Lerner, 2000). Therefore, while the literature on foreign entry location choice sheds some light on the factors that might affect venture capital investments, the question of location choice in international venture capital remains a distinct and interesting one.
  6. 6. 6 Venture capital investment also bears some similarity to international portfolio investment. The literature on international capital movements contends that the determinants of capital flows are changes in interest rates as well as taxes, regulations, political risk, and information asymmetries (Brennan and Cao, 1997). Thus, capital moves from better to less well endowed countries, looking for a higher marginal productivity. At first sight, venture capital movements seem to follow a similar pattern of arbitrage. However, the resemblance is also limited, since there are fundamental differences between foreign venture capital investments and international portfolio investments. The most important has to do with the irreversibility of venture capital investments for longer periods of time. Since venture capital firms invest with longer time horizons, and typically exit investments through IPOs or acquisitions, they face much lower liquidity and higher risk compared to the typical portfolio investor. The question of location choice in venture capital investments, then, still remains a distinct one. In sum, venture capital investments bear resemblances to foreign portfolio investments and to FDI; yet they exhibit distinct features that distinguish them from both portfolio and direct investments. Therefore, a study of international venture capital investment is a worthwhile and interesting question that has not been previously addressed in the literature on foreign investment. Before developing our theoretical approach, we summarize the venture capital industry’s modus operandi. 3. The Venture Capital Industry in the U.S. and around the World The venture capital industry has been one of the major driving forces behind innovative activity and growth of high-technology industries in the U.S. economy. In 2002 over half of the venture capital investments were technology-related (Global Private Equity 2002). Although
  7. 7. 7 venture capital outlays represented only 3 percent of total corporate investment between 1983 and 1992, they resulted in 8 percent of all U.S. industrial innovations (Kortum and Lerner, 2000). As a result, venture capital has been a significant driver of the U.S. economy through spurring entrepreneurial activity. Venture capital invested during the period 1970-2000 created 7.6 million jobs and over $1.3 trillion in revenue. In 2000, venture capital-backed companies represented 5.9 percent of total U.S. jobs and 13.1 percent of GDP.1 Venture capital firms2 act as intermediaries between investors in search of investment opportunities and entrepreneurs in need of capital. The majority of U.S. venture capital firms are structured as limited partnerships, whereby limited partners provide the capital to be invested and general partners provide expertise in selection and management of investment opportunities. Typically, limited partners include institutional investors and wealthy individuals. Among institutional investors, corporate and public pension funds comprise the largest investor group, followed by endowments and foundations, bank holding companies, insurance companies, investment banks, non-financial corporations, and foreign investors (Fenn, et al., 1997). Venture capital firms vary substantially in size. A typical venture capital firm has anywhere between two and over thirty general partners. The amount of capital can range from 10 million to several billion dollars (Fenn, et al., 1997). Venture capital firms go through a “cycle” of activities that involve selection, management, and liquidation of investments in portfolio companies over a period of 5-7 years (Gompers and Lerner, 2000; Guler, 2003). First, venture capitalists need to generate a steady flow of investment proposals from which to select. Second, they select companies for investment 1 Oct. 22, 2001. ‘Three Decades of Venture Capital Investment Yields 7.6 million Jobs and $1.3 Trillion in Revenue.’ URL: 2 In the discussion pertinent to the venture capital industry we use the term “firm” solely to refer to venture capital firms and “company” to refer to portfolio companies (entrepreneurial ventures).
  8. 8. 8 through a rigorous process of screening. The average venture capital firm invests in only one per cent of the proposals that it receives (Fenn, et al., 1997). Venture capital firms typically invest in their portfolio companies in exchange for equity. Although they do not directly assume full ownership or management of the companies, they monitor them during the life of the investment through advisory functions, board memberships, and the provision of financial and non-financial resources. Finally, they manage the exit process, after which the proceeds are returned to the limited partners. Venture capitalists may exit investments in several ways, including initial public offerings (IPOs), acquisitions, liquidations, or stock buybacks (Gompers and Lerner, 2000). The returns from the investments accrue to the limited partners after liquidation. The success of the U.S. venture capital industry in financing innovation and contributing to growth has encouraged venture capital activity in other countries. Although private equity and venture capital investment around the world are comparatively smaller, many countries report large growth rates. For instance, during 2001 private equity investments grew by 72 percent in India, and 38 percent in Israel (Global Private Equity 2002). The early experiments with venture capital in countries like Germany and Japan failed in spite of government or corporate backing (Kenney, et al., 2002; Becker and Hellmann, 2003). Later developments gave rise to venture capital activity that differed in structure and operation from their U.S. counterparts, always in response to unique institutional demands (Bottazzi, et al., 2004). Some of the factors that have been argued to affect the growth of venture capital activity include appropriate structures to protect investor returns (Becker and Hellmann, 2003), the level of economic development, the availability of exit options (Kenney, et al., 2002) as well as the quality of the national system of innovation and levels of entrepreneurship (Kenney, et al., 2002; Becker and Hellmann, 2003). A small number of studies has examined the growth of the domestic venture capital industry in a
  9. 9. 9 number of countries, and linked it to the institutional environment of the country. A comparative study of German and U.S. venture capital markets suggests that the existence and strength of the stock market is a key determinant of venture capital financing (Black and Gilson, 1998). A cross- country study of venture capital investing in 21 countries finds support for the importance of IPOs and government policies (Jeng and Wells, 2000).3 Entrepreneurial ventures in other countries also present U.S. venture capital firms with new pools of investment opportunities, and potentially high returns. At the same time, U.S. venture capital investments can benefit local economies by supporting entrepreneurial and innovative activity. Moreover, entry of U.S. venture capital firms into other countries creates opportunities for the diffusion of practices to local firms (Kenney, et al., 2002). While U.S. venture capitalists may be less subject to some institutional idiosyncrasies of the portfolio company’s country (e.g. they do not need to raise funds in the host country), they are still subject to many institutional constraints in their operations and in their ability to repatriate returns. 4. The Institutional Environment and the Internationalization of Venture Capital The main argument of this paper is that the institutional environment of each country affects the levels of expected returns for U.S. venture capital firms, and in turn, their propensity to invest in those countries. In particular, three broad sets of factors can affect U.S. venture capital firms’ propensity to invest in a given country. The first relates to knowledge of the availability of investment opportunities, the second to local conditions conducive to commercialization, and the third has to do with the extent to which the institutional infrastructure of the country facilitates the appropriation of returns from the investment. 3 Other studies have focused on differences in decision making (Manigart, et al., 2000) or on the willingness to invest abroad (Hall and Tu, 2003).
  10. 10. 10 Entrepreneurial Opportunities The likelihood of venture capitalists’ investing in a foreign country is a function of entrepreneurial opportunities available for investment. As explained above, venture capital firms constantly seek investment opportunities that can potentially yield high returns. In countries where innovative and entrepreneurial activity is already vibrant, venture capital firms have a higher likelihood of finding lucrative opportunities. Countries differ significantly in the intensity of their innovative activity, even with the increasing possibility of accessing knowledge at a global level (Kogut and Zander, 1993; Furman, et al., 2002). The number and innovativeness of entrepreneurial ideas in a country, in turn, is a function of the level of scientific and technical knowledge, for two reasons. First, the rate at which new ideas are produced in an economy increases with the number of idea workers and the stock of ideas already available (Romer, 1990; Furman, et al., 2002). The availability of a highly trained labor pool, and the extent of resources available for R&D increases the likelihood of innovations in a country. Moreover, the production of new and innovative ideas is facilitated by the availability of other ideas that researchers can build on. Therefore, the presence of innovative clusters, as well as research institutions such as universities, facilitates the level of innovation (Furman, et al., 2002). Indeed, the U.S. venture capital industry has historically developed and operated in clusters comprising entrepreneurial ventures and research universities (Florida and Kenney, 1988; Kenney, et al., 2002; Stuart and Sorenson, 2003). Similarly, anecdotal evidence suggests that venture capital industries in countries such as Israel and the United Kingdom benefited from the existence and quality of higher education institutions (Kenney, et al., 2002). We therefore predict:
  11. 11. 11 Hypothesis 1 (H1). The probability of foreign venture capital investment in a given country increases with the level of scientific knowledge in that country. Commercialization Even when the level of scientific knowledge in a country is high, venture capital firms may be reluctant to invest because their ability to commercialize these investments is hindered by the lack of an appropriate infrastructure. The national innovative capacity of a country is defined as a combination of capabilities to produce and commercialize technologies (Furman, et al., 2002). While the existence of innovative ideas is necessary for a venture capital firm to find attractive investment opportunities in a country, it may not be sufficient to convert these ideas into profitable investments. The ability to extract returns from these ideas requires complementary assets, as well as stable or growing demand conditions. While some complementary assets are firm-specific (e.g. capabilities in marketing), some rely on the physical infrastructure available in the country. For instance, many high-technology industries—e.g. Internet-based services, or wireless telecommunications—critically rely on the physical infrastructure, including energy, transportation and other services. Availability and quality of the infrastructure enables entrepreneurial ventures to provide higher quality services to a wider market, decreasing costs of providing services and increasing potential profitability. Since venture capital firms typically invest in ventures that operate in high-technology industries, countries with better physical infrastructure will be better able to attract U.S. venture capital. Therefore, we formulate
  12. 12. 12 Hypothesis 2 (H2): The probability of foreign venture capital investment in a given country increases with the availability of a physical infrastructure in that country. A second aspect of the ability to extract commercial benefits out of innovative ideas is the availability and size of stock markets. Unlike foreign direct investors, who tend to have a long-term interest in exercising managerial control over the invested company, venture capital firms typically exit investments through public offerings. The existence of developed stock markets signals greater prospects for such successful exits, and provides incentives for venture capital investors (Black and Gilson, 1998; Leachman, et al., 2002). Moreover, the availability of exit options through well-developed stock markets helps venture capital firms to capitalize on earlier investments within a shorter time and to recycle capital towards new opportunities. Well developed stock markets also provide a means to show performance and profitability to potential investors (Black and Gilson, 1998). Thus, we expect that Hypothesis 3 (H3): The probability of foreign venture capital investment in a given country increases with the size of the stock market in that country. Appropriability The attractiveness of a county for venture capital investment is likely to be affected by appropriability conditions. Venture capital firms are more likely to invest in countries where their returns are protected by stable local institutions (Henisz and Delios, 2001). We examine two factors that might affect appropriability, and in turn, the probability of venture capital investment. First, venture capital investments are likely to increase with the existence of stable or
  13. 13. 13 growing demand conditions. In countries where economic conditions are volatile, demand for a product or service can shrink abruptly, leaving investors exposed to large risks on sunk investments. This is referred to as economic uncertainty. Since firms seek to avoid uncertainty in decision making (Cyert and March, 1963), venture capital firms are likely to bypass investments in countries where political or economic conditions jeopardize future returns. Hence, Hypothesis 4 (H4): The probability of foreign venture capital investment in a given country decreases with economic uncertainty in that country. Second, political uncertainty in a country might affect conditions of appropriability and deter investment. Political uncertainty refers to unforeseeable changes in future policies and regulations. Uncertainty about future regulations, tax rates, or government policies can discourage capital investment. Research on foreign direct investment shows that firms tend to avoid countries where political uncertainty is high (Henisz and Delios, 2001). In particular, if policymakers have unilateral power to change the policy regime in a country, the likelihood of an unanticipated future change is higher, and likewise the policy uncertainty. Countries where policy changes are not constrained by multiple political institutions present a higher political hazard (Henisz and Delios, 2001). Thus, we predict that Hypothesis 5 (H5): The probability of foreign venture capital investment in a given country decreases with the level of political uncertainty in that country. It is important to note that the five predictors of foreign venture capital investment considered in this paper affect foreign direct and portfolio investment decisions to varying degrees. A country’s technological and scientific knowledge stock is only relevant for a small proportion of foreign direct investment decisions—those having to do with strategic assets— while it tends not to be a consideration in the cases of the much more frequent efficiency or
  14. 14. 14 market-seeking direct investments (Dunning, 1998). Similarly, international portfolio investors do not look for opportunities exclusively in the technology area, while venture capital investors overwhelmingly do. The physical infrastructure is certainly important to foreign direct investors, though not to portfolio ones. By contrast, the size of local stock markets is much more important to the portfolio than to the direct investor. Economic and political uncertainty affect direct investors seeking market access to a greater extent than those seeking efficiency or strategic assets. Both types of uncertainty are relevant to the portfolio investor. Thus, while the five predictors are pertinent to foreign venture capital investments, their relevance to direct or portfolio investments varies from case to case, reflecting the fact that venture capital investing shares some features of direct and portfolio investing, while exhibiting key peculiarities. 5. Data and Methods In order to test our hypotheses we examine the international investment decisions by U.S. venture capital firms between 1990 and 1999. The U.S. venture capital industry grew significantly during this period, in terms of both capital available for investment and the number and amount of actual investment. Involvement of U.S. venture capital firms in foreign markets also rose as a result of increases in the amount of available capital and the search for new, innovative opportunities. We compiled the venture capital investment data from the VentureXpert database provided by Venture Economics,4 which collects information through an annual survey of over 1000 private equity partnerships in the U.S. This database has been used extensively in venture 4 The data from Venture Economics’ VentureXpert database includes “standard U.S. venture investing” in portfolio companies, as long as the company is domiciled in the U.S., at least one of the investors is a venture capital firm, venture investment is a primary investment, and it entails an equity transaction.
  15. 15. 15 capital research (Barry, et al., 1990; Sahlman, 1990; Megginson and Weiss, 1991; Gompers and Lerner, 2000; Shane and Stuart, 2001). The country-level data on economic, political, and demographic characteristics of potential investment locations were compiled from the World Bank’s World Development Indicators, and World Telecommunications Indicators. Data on the level of scientific knowledge were compiled from the NBER patent database and the ISI scientific citations index. We used data compiled by Beck, Demirguc-Kunt, and Levine (2001) for the size of capital markets, and Henisz’s political hazards index to measure the level of political uncertainty (Henisz and Delios, 2001). We included in our database for analysis venture capital investments undertaken by 350 U.S. venture capital firms (VCFs) over a period of ten years (1990-1999). Taken together, these firms made 336 investments in foreign countries. After casewise deletion of missing data, the sample includes 244,999 unique combinations of VCF-country-years. Dependent Variable. The dependent variable is a non-negative integer count of venture capital investments in each country. The usual approach in estimating models with such dependent variables is to assume that the error structure follows a Poisson distribution (Cameron and Trivedi, 1998). However, the dependent variable exhibits a large number of zero counts since the dataset includes all possible VCF-country-year combinations. In such cases, where overdispersion may occur as a result of excess zeros, a zero-inflated Poisson (ZIP) model can be used. The ZIP model assumes that the process generating the excess zeros is qualitatively different from the process that generates the non-zeros (Greene, 1997; Tu, 2002). We therefore estimated the number of investments by venture capital firm i in country j during year t with zero-inflated Poisson models, nested within a logit model estimating the likelihood of zero investments for the venture capital firm-country pair during year t. In estimating the probability
  16. 16. 16 of zero investments, we used two predictor variables as well as a year control. The first variable is the number of other U.S. venture capital firms that have invested in the focal country as of the previous year. This measure accounts for venture capital firms following one another in location choices under high uncertainty (DiMaggio and Powell, 1983; Sahlman and Stevenson, 1985; Henisz and Delios, 2001). The second variable is the prior international investment experience of the venture capital firm, which accounts for firm heterogeneity concerning the pursuit of foreign opportunities. Prior international investment experience indicates a greater propensity to go abroad, and can provide firms with operational capabilities and decision rules that help manage idiosyncratic institutional environments (Henisz, 2003). The results of the first-stage logit analysis show that both variables significantly reduce the probability of zero investments, confirming earlier empirical studies (e.g. Henisz and Delios, 2001). We conducted a Vuong test in order to compare the estimates of the ZIP and non-nested Poisson models. The test statistic is significantly larger than zero (8.33, p < 0.001), confirming that at least some of the unobserved heterogeneity is due to an excess zero count. Multiple observations for the same country may create correlations between the error structure and the independent variables. To partially account for this we estimate all models with the Huber-White-sandwich estimator of variance yielding robust standard errors. Independent Variables. We use two separate measures to approximate the availability of innovative opportunities in country j. The first is the number of patents granted by the U.S. Patent Office to establishments in country j and year t. Numbers of patents have traditionally been used as a measure of innovative output. Since venture capital firms typically invest in high technology companies, patenting is a relevant measure of opportunities for commercially viable ideas in a country (Furman, et al., 2002). These data were compiled from the NBER patent
  17. 17. 17 database (Hall, et al., 2001). We used the number of patents in the U.S. patent system, since this represents a standardized process of registering innovations, as opposed to possible differences in national systems. We normalized the number of patents by the GDP of each country, and took the logarithm of the measure in order to make it normally distributed. The second measure of the availability of scientific knowledge is the number of scientific publications by residents of a country. The number of articles published in academic, technical, and trade journals is an indicator of knowledge exchange and exposure among members of a community (Guler, et al., 2002). This measure was compiled annually from Science Citation Index (SCI), and normalized by the GDP of each country. We measure the role that the physical infrastructure plays in enhancing the ability to commercialize technology with the number of telephone mainlines per 1000 people. The telecommunications infrastructure is very important not only to the diffusion of many high- technology innovations, such as internet-enabled services, but also to the smooth operation of all kinds of businesses, especially knowledge-intensive ones. The data were compiled from the International Telecommunication Union’s World Telecommunications Indicators database. The second factor we hypothesized as affecting the ability to commercialize technology was the size of capital markets in the country. We use the measure of capital market size compiled by Beck et al. (Beck, et al., 2001), calculated as the value of listed domestic shares on domestic exchanges, normalized by the GDP of each country. We test the ability to appropriate returns with the real conditional variation in the GDP growth rate as a measure of economic uncertainty (Serven, 1998), and with the index of political constraints (Henisz and Delios 2001). The latter measure captures the lack of constraints on policymakers to unilaterally change the policy regime (Henisz, 2000). Accordingly, a higher
  18. 18. 18 number of independent government branches that have veto power over a policy change in a country reduces the political hazard. This indicator is rescaled to range from 0 (minimal hazards) to 1 (extreme hazards). Control Variables. We include controls for the size of the economy (GDP in constant 1995 U.S. dollars), and for time. 6. (Preliminary) Results Table 1 presents the descriptive statistics. The number of investments for each venture capital firm-country-year varies between 0 and 15. The correlations between the explanatory variables and the dependent variable are in the expected direction. Results of the zero-inflated Poisson analysis are presented in Table 2. The first model is the baseline with control variables only. The first stage is the logit model estimating the likelihood of zero investments by VCF i in country j during year t. Other VC investments in country j significantly reduce the likelihood of zero investments, consistent with the literature on international expansion. Similarly, the VCF’s prior international experience significantly reduces the likelihood of zero investments. The second stage shows the effects of the hypothesized variables. We obtain support for the prediction that the availability of investment opportunities increases venture capital investment that is robust to the indicator used (patents or scientific publications) and to the inclusion or exclusion of other variables (hypothesis 1). We obtain partial support for the prediction that the availability of a commercialization infrastructure increases venture capital investment in that the physical infrastructure (telephone lines) does not exert a significant effect (hypothesis 2) while the size of capital markets does (hypothesis 3). This finding confirms the
  19. 19. 19 importance of IPOs as the main exit strategy being sought by VCFs. We fail to find evidence to the effect that appropriability regime increases foreign venture capital investment: neither economic uncertainty nor political uncertainty. Thus, our preliminary results confirm two of our five predictions, and lend support to both the availability of opportunities and the possibilities of commercialization as drivers of foreign venture capital investment. 7. Discussion and Conclusion The most robust finding of this study is that foreign venture capital investment is driven by the availability of innovative ideas. This is consistent with the idea that intensity of innovation is location-dependent, and is affected by the local institutions and agglomeration that exists in a particular country (Kogut and Zander, 1993; Furman, et al., 2002). It is important to note, however, that while U.S. venture capital firms seek out local innovative opportunities to invest and support with a view to making a profit, in so doing they contribute to the development of an institutional infrastructure for further innovation and growth. Although we did not find a significant effect for the presence of a well-developed physical infrastructure, we confirmed the importance of capital markets to the attraction of foreign venture capital investment. This combination of results may be due to the fact that venture capital firms look for opportunities that can attract demand in international markets, as opposed to local markets only. As such, weaknesses in the physical infrastructure do not discourage investment in innovative ideas, as long as they have potential beyond the specific country. In contrast, the size of the capital markets significantly affects the likelihood of venture capital investment, suggesting that venture capital firms seek opportunities with discernible exit options. This is consistent with prior research showing that venture capital funding in domestic
  20. 20. 20 industries is highly related with the strength of the IPO market (Black and Gilson, 1998; Jeng and Wells, 2000). Although countries like Israel host opportunities that are commercialized in other countries through IPOs, this seems to be the exception rather than the rule (Megginson, et al., 2004). Future extensions of this study can examine how the availability of exit opportunities in foreign markets affects the likelihood of venture capital investment, and the relationship between venture capital investment and the size of the capital market. The ability to appropriate returns from the investment was not related with the likelihood of venture capital investment. The results showed that neither economic uncertainty, in terms of variation in GDP growth levels, nor the level of political uncertainty in the country had a significant effect on the likelihood of venture capital investment. This contrasts with studies finding that political uncertainty is a significant determinant of foreign direct investments, and infrastructure investment decisions (Henisz, 2000; Henisz and Delios, 2001). This result could be due to the different nature of venture capital investments. While foreign direct investment requires a significant commitment on the part of the foreign multinational over a presumed long period of time, venture capital investments are typically smaller in scale, involve limited ownership, and have a definite timeline. Since venture capital firms keep a portfolio of uncertain investments, and look to exit investments within 5 to 7 years, they may have more limited exposure to political hazards than multinational corporations. Moreover, venture capital firms look for opportunities that promise potential for high returns, but cannot secure funding elsewhere. Therefore venture capital firms may be more willing to take risks that other investors may not. They may be more tolerant toward economic and political uncertainty in a particular country in choosing locations to invest.
  21. 21. 21 This study represents a first attempt at understanding the factors that might affect patterns of U.S. venture capital investments in other countries. As such, it suffers from certain limitations which we hope to address in further research. First, we would like to test the robustness of our results with other alternative measures that may more specifically address our theoretical arguments. For instance, the number of patents awarded in the U.S. is a measure of the innovative output of a country, but it does not allow us to understand what drives the level of innovative output. Other alternative measures such as the level of R&D investments, and the number of scientists and engineers in a country, may allow us to examine what countries might do to increase innovative opportunity and attract foreign risk capital. Second, we would like to examine some of the more specific relationships between our variables. For instance, our results suggested that the likelihood of venture capital investment was higher in countries where the capital markets are larger. However, we did not examine whether the strength of the capital markets or the level of scientific knowledge can compensate for other institutional shortcomings such as higher levels of economic uncertainty. Another interesting question is whether there are alternative mechanisms for commercialization of opportunities (such as the level of high-technology exports) that can explain the likelihood of venture capital investment in countries where the physical infrastructure is insufficient, and the economic growth is volatile. A closer look at the relationships between variables can yield a more precise understanding of necessary and sufficient conditions determining the likelihood of U.S. venture capital firms to invest in other locations. Despite these limitations, we believe that this study provides an understanding of the country-level factors that affect international venture capital investment decisions. Venture capital has been a significant driver of innovation and growth in the U.S. economy. The ability of
  22. 22. 22 countries to attract foreign capital can also spur economic growth, and contribute to local economies. At the same time, venture capital investment is sufficiently different from foreign direct investment to warrant specific attention to its determinants. This study hopes to provide an initial attempt in understanding the growth of venture capital in a global context.
  23. 23. 23 Table 1. Descriptive Statistics (N=244,999) Variable Mean Std. Dev. Min Max 1 2 3 4 5 6 7 8 9 10 1 Number of 0.002 0.084 0 15 1 investments 2 Sci. knowledge -4.200 6.230 -16.118 2.270 0.021 1.000 – patents (log) 3 Sci. knowledge - 0.025 0.023 0.000 0.139 0.015 0.230 1.000 publications 4 Physical 24.329 21.594 0.190 72.150 0.031 0.558 0.311 1.000 infrastructure 5 Capital market -7.441 1.646 -19.570 -3.470 0.023 0.344 0.059 0.408 1.000 size 6 Economic 0.355 0.426 0.000 2.804 -0.010 0.051 -0.059 -0.144 0.048 1.000 uncertainty 7 Political 0.558 0.291 0.000 0.890 0.017 0.415 0.146 0.595 -0.025 0.297 1.000 uncertainty 8 GDP (*10-8) 3.672 1.054 0.914 8292 0.016 0.264 0.005 0.348 -0.099 0.204 0.212 1.000 9 Year 1994.874 2.747 1990 1999 0.018 -0.006 0.182 0.077 -0.155 0.088 0.113 -0.026 1.000 10 Prior VC 1.687 6.539 0 65 0.064 0.201 0.098 0.310 -0.100 0.189 0.166 0.281 0.232 1.00 investments in country j 11 VC’s prior 0.503 3.901 0 87 0.140 0.001 0.021 0.010 -0.020 0.009 0.011 -0.003 0.112 0.03 international experience
  24. 24. 24 Table 2. Results of Zero-Inflated Poisson Models Stage 2: Poisson (1) (2) (3) (4) (5) (6) (7) (8) (9) model predicting the count of entries Patents (log) 0.437** 0.445** 0.350** 0.370** 0.368** 0.370** (0.114) (0.122) (0.083) (0.085) (0.085) (0.086) Scientific publications 16.188** -1.26 11.414* (5.065) (5.241) (5.356) Physical infrastructure 0.009 0.002 0.002 0.002 0.021 (0.009) (0.011) (0.011) (0.012) (0.013) Capital market size 0.547* 0.574* 0.574* 0.649* (0.261) (0.251) (0.251) (0.274) Economic uncertainty -0.026 -0.026 -0.023 (0.045) (0.045) (0.048) Political uncertainty -0.079 0.479 (0.473) (0.454) GDP 0.034** 0.029** 0.049** 0.027** 0.029** 0.032** 0.032** 0.032** 0.046** (0.008) (0.008) (0.010) (0.010) (0.009) (0.008) (0.008) (0.007) (0.009) Year 0.172* 0.103 0.146 0.104 0.102 0.082 0.078 0.078 0.078 (0.078) (0.066) (0.078) (0.068) (0.064) (0.062) (0.062) (0.062) (0.062) Constant -344.4* -206.9 -292.3 -209.1 -204.6 -164.3 -157.4 -156.8 -159.3 (155.8) (131.7) (154.7) (135.4) (128.6) (124.8) (123.3) (123.5) (123.5) Log likelihood -2500.6 -2396.7 -2479.2 -2396.6 -2394.9 -2383.5 -2383.2 -2383.2 -2415.7 Wald chi-square 27.99 25.81 38.63 28.05 66.15 90.46 109.11 160.66 150 Stage 1: Logit model predicting zero counts Other VC investments -0.055** -0.037** -0.051** -0.037** -0.036** -0.035** -0.035** -0.034** -0.038** in the same country (0.004) (0.005) (0.004) (0.005) (0.005) (0.005) (0.005) (0.005) (0.005) VC firm’s int’l 0.077** -0.085** -0.079** -0.085** -0.085** -0.086** -0.086** -0.086** -0.085** Experience (0.007) (0.013) (0.008) (0.013) (0.013) (0.014) (0.014) (0.014) (0.013) Year 0.122 0.054 0.120 0.054 0.056) 0.047 0.045 0.045 0.075 (0.057) (0.053) (0.032) (0.053) (0.053) (0.052) (0.052) (0.052) (0.050) Constant -236.21 -103.60 -234.12 -101.63 -106.8 -87.76 -85.84 -85.48 -144.33 Observations 244999 244999 244999 244999 244999 244999 244999 244999 244999 Robust standard errors reported in parentheses + p<0.1, *p<0.05, **p<0.01
  25. 25. 25 REFERENCES Global Private Equity. 2002.