The Importance of Trust for Investment

Thomas Hellmann is Professor of Entrepreneurship and Innovation at the University of Oxford. This post is based on an article authored by Professor Hellmann; Laura Bottazzi, Professor of Economics at the University of Bologna; and Marco Da Rin, Associate Professor of Finance at Tilburg University.

In our article, The Importance of Trust for Investment: Evidence from Venture Capital, forthcoming in the Review of Financial Studies, we ask whether trust among nations affects the decision to make an investment across different countries, how trust is related to investment success, and how trust affects deal structures. Following the social capital literature, we define trust as a subjective belief about the likelihood that a potential trading partner will act honestly. Distinguishing between two different types of trust is essential: Generalized trust pertains to the preconceptions that people of one identifiable group have for people from another identifiable group. Personalized trust, on the other hand, concerns an evolving relationship between two specific agents. In this article we focus solely on generalized trust, so that we are concerned with what might be considered cursory beliefs, generalizations about others, or even stereotypes. Moreover, generalized trust does not necessarily pertain to the specific company that an investor deals with, but it may pertain to the company’s countrymen and country’s institutions, which can influence the investment outcome.

A natural null hypothesis is that trust does not matter. Conceptually, one might think that venture capitalists are sophisticated professional investors who should not be swayed by popular trust stereotypes. They might also be able to arbitrage any irrational trust differentials. As an alternative, we develop a simple model that shows how trust can matter in a rational equilibrium model. In our theory a focal investor considers investing in a company. Trust affects the likelihood that investors receive get their returns in case of success.

The model makes three central predictions. First, the probability that investors makes an investment is positively related to their level of trust, where trust is always relative. Second, there is a negative relationship between trust and the success rate of investments. This is because of a selection effect, where higher trust investors are relatively more willing to invest in higher risk companies. Third, the model makes several predictions on how trust should be related to investment stage, syndication, and contingent contracts, as discussed below.

To test the model’s predictions, we use a hand-collected dataset of European venture capital investments made between 1998 and 2001 that contains investors and companies from fifteen European Union countries, Norway, Switzerland, and the United States. One of the advantages of using microeconomic data is that reverse causality can be safely dismissed: trust among nations can affect venture capital investments, but the venture capital industry is clearly too small to influence the trust among nations. Given the inherently subjective nature of trust, it is appropriate to measure it by surveying opinions. We adopt the approach of Guiso, Sapienza, and Zingales (2009), who use the Eurobarometer survey data of bilateral trust between nations. This measure is based on how much citizens of one country say they trust the citizens of each other country (including their own).

The data clearly rejects the null hypothesis of no trust effects. There is a positive effect of trust on investments. The effect is highly significant, both statistically and economically. A-one-percentage point increase in those who have high trust towards another country implies an almost seven-percentage-point increase in the probability that an investment is made.

Our econometric specification considers all potential financing deals between investors and companies in our sample and asks which deals are realized. We use a set of fixed effects, most notably company and investor fixed effects. The Eurobarometer measure of generalized trust varies at the country-dyadic level. Given our fixed effects, it only measures the relative (or dyadic) trust distance between an investor and a company. To isolate the effect of trust and eliminate alternative explanations, we control for a large set of other country-dyadic variables, such as differences in GDP, legal origin, language overlap, common borders, and even the amount of information about foreign countries available in the business press. We also control for several variables that vary at the company-investor-dyadic level, such as their physical distance, or the investor’s propensity to invest in the company’s stage and industry. We provide numerous robustness checks, including alternative ways of measuring trust.

Obtaining data on venture capital returns is fraught with difficulty, so we use the standard approach in the literature of focusing on investment outcome. We consider three measures: (1) IPO, which are relatively few but clearly associated with high returns; (2) Exit, a measure that also includes acquisitions—a more frequent but also noisier measure of success, and (3) Failure, which identifies companies that have gone out of business. Our evidence points to a negative relationship between trust and successful outcomes. We consider a variety of models and find that the coefficients for trust are always negative for IPO and Exit, and always positive for Failure. They are often, but not always, statistically significant.

Our theory suggests that the negative relationship between trust and success is driven by selection effects. We look for evidence of such effects by considering both selection on observable and unobservable characteristics. To test for selection on observables, we construct an index that maps the company information available at the time of investment into predicted outcome probabilities. We find a highly significant negative correlation between trust and these predicted outcome indices. To test for selection on unobservables, we estimate a Heckman selection using a plausible exclusion restriction. Our focus is on the Mills ratio, which estimates correlation among the unobservables. We find mild evidence for such unobservable selection effects.

Our final research question concerns the relationship of trust to deal structures. Our theory generates three main predictions, namely, that early-stage deals require higher trust, syndication becomes more attractive in low-trust deals, and contingent contracts are more likely to be used in high-trust deals. We leverage our hand-collected data to empirically evaluate these predictions and find empirical evidence supporting all three predictions.

The full article is available for download here.

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