Trust, But Verify…in Venture Capital

trust-1418901_1280-pixabay[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring recently published papers at the journal. This editorial features “The Importance of Trust for Investment: Evidence from Venture Capital” by University of Bologna’s Laura Bottazzi, Tilburg’s Marco Da Rin, and Oxford’s Thomas Hellmann, an article in Issue 29(9) for September 2016. It was selected as an Editor’s Choice article on on the Oxford University Press web site for RFS.]

Former President Ronald Reagan’s quote about trust in diplomacy always resonates, but my own personal favorite is that of Ernest Hemingway: “The best way to find out if you can trust somebody is to trust them.” The salience of these quotes comes on the heels of the 2016 report of the Edelman Trust Barometer which, via a survey of 33,000+ respondents in 28 countries, tracks respondents’ trust in institutions, such as business, media, non-governmental organizations and government. Their report features many interesting facts and trends but each year the financial services sector reveals itself to be the least trusted at 51%. Edelman’s report states that “trust is too fragile and today’s financial services climate is too unpredictable for companies to rest on their laurels…the industry needs to continue to be dynamic and double-down on trust-building solutions.” Even more intriguing is that financial services features the largest and fast-accelerating trust “inequality” score, which is the gap in perceptions between what Edelman calls the informed public, who are college-educated and relatively wealthy, with the population at large.

The paper by Bottazzi, Da Rin, and Hellman is very timely in its examination of trust in venture capital, a segment of the financial services that is acutely dependent on it to make deals happen. What the paper does is connect a hand-collected dataset of European venture capital deals with the Eurobarometer measure of bilateral trust among those nations. The trust measure comes from several survey waves in the 1990s and it is based on a question that asks what percentage of citizens in one country trust a lot of people from another country. The paper’s theory predicts that earlier stage investment require more trust, that syndication is more valuable in low trust settings, and higher trust investors use more contingent contracts.

When I asked the authors what they believed were the takeaways they felt were at risk of being overlooked, they emphasized that generalized trust is based on stereotypical generalizations that are deep-rooted in historical patterns and what they really wanted to understand in this research initiative was whether trust among nations has any place in financial transactions by sophisticated professional investors, like venture capitalists (VCs). One might think that they would go beyond historical stereotypes and it turns out that they do not! A second thought they had concerned the relationship between trust and performance. Intuitively one might think that higher trust is associated with higher performance, but the papers finds the opposite. A positive correlation between trust and performance would make sense for ‘personalized trust,’ or the trust between specific individuals that are collaborating in some fashion. However, the analysis here is about what they call ‘generalized trust,’ which measures broader societal perceptions. The way to understand the negative correlation between trust and performance is then to look at the selection process, the willingness of investors in one country to place a bet on entrepreneurs in another country. The key insight is that venture capitalists apply a higher bar before investing in a relatively low trust country.

If generalized trust drives deal selection, as these authors teach us, and if it is true from Edelman’s Trust Barometer report that worldwide trust inequality in financial services is accelerating, I cannot help but wonder how much the future of the industry will be defined by the success of communication and engagement strategies for the general public, including for their employees as key advocates, to emphasize social purpose, and to contain strategies around data privacy and security, as well as financial education. This is relevant not just to the venture capital industry, but to the financial sector at large.

New Editor Appointment

The RFS is pleased to announce the appointment of Wei Jiang as an editor of the Review, beginning January 1, 2017. Wei is Professor of Free and Competitive Enterprise as well as Vice Dean for Curriculum and Instruction at Columbia Business School. She previously served as an Associate Editor for the Review as well as the SFS Cavalcade Conference Chair in 2015. Please join us in welcoming Wei to her new role.

RFS Article Featured in Forbes

A paper published in RFS issue 29(3), “The Fetal Origins Hypothesis in Finance: Prenatal Environment, the Gender Gap, and Investor Behavior,” by Henrik Cronqvist, Alessandro Previtero, Stephan Siegel, and Roderick E. White, was featured in Forbes in a piece titled, “Stunning Discovery: Prebirth Experiences May Influence Our Financial Decisions.” Read the article online here.

Executive Editor Blog: Ownership and Corporate Financial Policy: Separating Causation from Correlation

A new installment of Andrew Karolyi’s Executive Editor blog is now available. This month’s feature, “Ownership and Corporate Financial Policy: Separating Causation from Correlation,” examines “The Effect of Institutional Ownership on Payout Policy: Evidence from Index Thresholds” by Alan Crane, James Weston, and Sébastien Michenaud. Visit the RFS Executive Editor Blog to read the post.

Ownership and Corporate Financial Policy: Separating Causation from Correlation

[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring recently published papers at the journal. This editorial features “The Effect of Institutional Ownership on Payout Policy: Evidence from Index Thresholds” by Rice University’s Alan Crane and James Weston and DePaul University’s Sébastien Michenaud, an article in Issue 29(6) for June 2016. It was selected as an Editor’s Choice article on on the Oxford University Press web site for RFS.]

school-916678_640-pixabay“Correlation is not causation” is a mantra drilled military-school style into every budding financial economist. I do not quite remember my graduate school days standing at a blackboard writing the four words repeatedly over and over, but it surely felt like it in retrospect. Now, I am not saying that every study in our midst is subject to potential criticism about endogeneity, reverse-causality, or omitted-variable problems, but sometimes, just sometimes, it’s worth pausing to recognize one that seems to have come upon a setting in which we have confidence in a robust causal finding.

Such is the case, I think, with the study by Crane, Michenaud, and Weston, which tries to break the pernicious, correlative connection between ownership decisions and corporate policy choices. They show that higher institutional ownership causes firms to pay more dividends. They force them to do so. And it is not a small effect. A one-percentage point increase in institutional ownership causes an 8% increase in dividends, worth about $7 million for the typical firm. The impact is even larger for firms that would be perceived to have higher expected agency costs. The authors follow up the headline findings with an analysis of shareholder proposals and voting patterns that suggest even non-activist, passive institutions play an important role in reducing wasteful spending that managers might otherwise allow.

mark-804936_640-pixabayWhat attracted me and likely others to the paper is the empirical strategy they invoke to break the reverse-correlation problem. They are the first to exploit a pseudo-experimental setting around mechanical definitions of the popular Russell 1000 and 2000 indexes to test their key hypothesis about institutional monitoring driving payout decisions. In a nutshell, the Russell indexes are formed each year (on May 31) on the basis of market capitalization rankings; the largest thousand form the Russell 1000 and the next two thousand, the Russell 2000. At the cutoff between the two, the differences in capitalization are a tiny fraction of the return variation that firms cannot possibly control, so their index assignment on one side or the other of the threshold is as good as random. The weights these stocks enjoy at the top of the Russell 2000 ledger are substantially higher than those at the bottom of the Russell 1000 given the money tracking them, which opens up the possibility for the discontinuity in weights to serve as an instrument for institutional ownership. Voilà! A quasi-natural experiment is had and causal-not-just-correlative findings ensue.

When I contacted the authors to ask them what they think readers may not fully appreciate about their paper’s findings or approach, they mentioned to me that their paper worked hard to unify a number of different econometric approaches to the use of the Russell index thresholds, one of which includes a paper by Ye-Cheng Chang, Harrison Hong, and Inessa Liskovich that the Review published last year (“Regression Discontinuity and the Price Effects of Stock Market Indexing,” January 2015, Volume 28(1)). In a carefully crafted internet appendix available on the Oxford University Press site for Review publications, Crane, Michenaud, and Weston replicate the results of other recent studies and test the sensitivity to methodological differences. They mentioned to me that “subtle biases and small variations in methodology can drive very different results for some outcome variables,” though their dividend result is robust across all approaches.

Diving into this kind of detailed supplementary note may be just the ticket for scholars who want to pursue this particular event involving exogenous variation in institutional ownership. It could be a template for exploring how other pseudo-experimental settings can be exploited to get traction with causal inference. One thing I am 100% certain of is that it is a more useful pursuit than repeating aimlessly a “correlation is not causation” mantra.

Editor’s Choice: July

The Editor’s Choice article for July 2016 (issue 29/7) is “Loan Originations and Defaults in the Mortgage Crisis: The Role of the Middle Classs” by Manuel Adelino, Antoinette Schoar, and Felipe Severino. You can read the article free online here.