Brain Drain or (Venture) Capital Gain?
Immigrant entrepreneurs help venture capital firms find profitable investment opportunities in their homelands. In the process, they turn brain drain into capital gain.
I’m really excited to tell you about the latest version of a paper I’ve been working on with Sarath Balachandran from LBS. This is what we call a “working paper”, meaning that it’s not yet published. So with the caveat that the peer review process might lead to some changes, here we go!
Wait… one more caveat: some of my former students will remember that I shared this paper in one of my classes, but that applies only to a small number of those reading this post and today I’ll share some totally new results that we’ve added to the paper.
OK, no more caveats.
You’ve probably heard the term “brain drain” before: the concern that emigration hurts the sending country because it loses the talent, ideas, and labor of capable people. This concern often comes up in the context of entrepreneurship. Since immigrants have disproportionately high rates of entrepreneurship, does it mean that the sending country loses potential startups when talented people leave?
If you’re in the world of startups and venture capital (VC), you’re probably also familiar with how strongly localized the industry is. Lots of research shows that VCs invest within just a few kilometers (miles) of their headquarters. Why? Because investing in startups is plagued by problems of information and monitoring. Unlike other forms of investment, it’s very hard to find out that startups even exist, evaluate them pre-investment, and support them post-investment. Proximity allows VCs to develop local networks to source deals and to remain close to startups once they invest. So if you’re an entrepreneur and want to raise capital, you’ll most likely get it from a local investor. Which explains the entrepreneurial clusters in places like Silicon Valley, Boston, Tel Aviv, and Shanghai.
In our paper, we take on these two issues by addressing a fascinating puzzle. International VC investment is growing rapidly. For example, in 2019 venture capital flows from the US to China exceeded foreign direct investment. High growth rates of cross-border VC can be seen across many parts of the world. The puzzle is that cross-border VC seems to violate the proximity rule: why would VCs take the risk of putting their money in startups far from their HQ? How do they even find out about those startups in the first place? And how do they evaluate and monitor them given the challenges imposed by cultural, legal, and geographic differences across countries?
We offer a really simple answer to these questions: immigrant entrepreneurs. The more a VC firm invests (in its HQ country) in startups with immigrant founders, the more exposed the VC becomes to the experiences, knowledge, and connections those immigrants have to their homelands. This opens channels of information and networks that allow a VC to find, screen, and monitor deals in the home countries of the immigrant founders to which it is exposed domestically (i.e. in the HQ country of the VC firm). The VCs we interviewed confirmed that they often get referrals from the founders in which they previously invested. One Silicon Valley VC said: “I was in India last week, and met with 7 or 8 companies. Half of them were introductions from our local (US-based) founders and people they are connected to.”
To test this idea, we gathered a unique dataset of all the investments made by the top 100 VC firms in India between 2005 and 2014, and observed their performance until 2019. Here’s what we found:
1. The more Indian immigrant founders to which the VC firm was exposed through its U.S.-based investments, the more subsequent investments the same VC firm made in startups located in India (over a 5-year period). The graph below (left) illustrates that result.
2. The previous result holds only for 1st generation Indian immigrants. If we consider the exposure of VC firms to the descendants of immigrants -- children or grandchildren -- we find no significant effect on subsequent investments in India (graph above, right). Why? Because only the 1st generation immigrants have first-hand knowledge and connections in the homeland. Later generations probably don’t offer sufficiently rich information or valuable connections for VCs to take on the risk of a foreign investment.
3. But we can go even deeper into the data to find out how important it is for U.S.-based VCs to get rich information and meaningful connections in India. The map below shows some of the distinct regions of India -- a massive and diverse country. For venture investors, south vs. west vs. the rest of India are distinct markets with unique startup ecosystems. So what and who you need to know in each region differs. We show that South Indian immigrant founders in the U.S. have a stronger impact on the investments of VC firms from the U.S. in South India than in any other region. We show the same for West Indian immigrant founders. This is one of my favorite findings in the study because it allows us to really understand the role played by immigrants as brokers of local knowledge and connections.
Before moving on to the final two results, it’s important to address a potential concern: that this is a spurious correlation because some confounding (unobserved) variable explains both the exposure VC firms to Indian immigrant founders and the firms’ choice to invest in India. We deal with that issue at length in the paper (link below), and this isn’t the place to lay it all out. But for those who don’t want to read the paper (I get it!), just two points. First, the exposure of VC firms to founders of certain nationalities is somewhat idiosyncratic. It happens in the regular course of business as VCs go about trying to find profitable deals in their local markets. Conversations about investment opportunities in the founders’ homelands come up only after the VC develops a relationship with the founders post-investment. This was confirmed through many conversations with VCs. Second, there could be other indirect confounders that lead both to a high exposure to Indian founders in the U.S. and to investing in Indian startups. For example, Indians are overrepresented in IT, or the VC firm could have Indian partners, or the VC firm is especially internationally-minded. We take steps to account for all of those and other confounders. Like I said, read the paper!
OK, now that I’ve at least claimed that this is unlikely to be a spurious effect, let me tell you about two more results that have to do with the VC firm’s strategy and performance (instead of the attributes of the immigrant founders).
4. Why would firms take on the risk of investing in India (or another foreign market), even if they have good information and connections through immigrant founders? Wouldn’t they prefer to invest locally, all else equal? But not everything else is always equal! A VC firm will prefer to invest domestically until something “pushes” it to consider alternative markets. One push factor we can measure is the saturation of the VC firm’s primary domestic market. The more total capital flows into startups in the primary sectors in which a VC invests, the more competition there is for the good deals. In VC parlance, the “deal flow” becomes less unique, and valuations may rise above what a wise investment warrants. Which should make the VC more interested in considering other opportunities -- including in foreign markets. We find support for that idea. As the figure below shows, the effect of Indian immigrants on subsequent VC investments in India is significantly stronger when domestic VC investment volume is high (solid line) than when it is low (dotted line).
5. OK, this is all fine, but what about the bottom line? Does exposure to immigrant founders help the VC firm make better, more profitable investments in the foreign country? The answer is yes, as measured by the rate at which the startups in which a VC invests have a successful exit: whether they are acquired or have an IPO. Using that indicator, we find that the odds of successful exit for the Indian startups increase by 1.4% for every Indian immigrant to which the firm is exposed in the U.S. before making the investment in India. This might seem small, but keep in mind that the odds of exit are only 4.5% in our data, so that’s a 31% increase in the odds. We also find that exposure to an Indian immigrant in the U.S. after making the investment in India just about doubles the (initially low) odds of successful exit.
The paper contains a few other results, but I think this is sufficient to tell a compelling story. Immigrant entrepreneurs benefit both the sending and the receiving country at different points in time. The receiving country benefits first through the ideas and firms immigrants create. But the sending country also gains in the form of foreign venture capital to power local startups. A crucial caveat is that we can’t estimate the relative magnitude of those gains, so it’s still possible that one country gains more than the other. But at least these results suggest that concerns of brain drain may be overblown if immigrants produce “capital gain” in the form of venture capital. This study to be paired with other work showing that immigrants also help channel foreign direct investment (FDI), another form of capital investment, to their homelands.
The business message is that immigrants can play an important role in the global strategy of VC firms, by helping them identify profitable opportunities in foreign markets. The policy message is that immigrants are leading indicators of cross-border capital flow.
[If you want to read the full article, it will show up here in about 3-4 weeks. Currently you can only find the version without the last two results I described here.]