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.

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