Wharton's Exequiel (Zeke) Hernandez discusses his research on how immigrants facilitate cross-border VC investments.

Venture capitalists face more risk and uncertainty when they invest in companies that are far away compared to startups in their own region or country. Yet, more cross-border VC investment is happening than ever before. New research from Wharton management professor Exequiel (Zeke) Hernandez and Sarath Balachandran, assistant professor of strategy and entrepreneurship at the London Business School, looks at why that is happening. In a paper titled, “Mi Casa Es Tu Casa: Immigrant Entrepreneurs as Pathways to Foreign Venture Capital Investments,” the two authors examine the role immigrants play in facilitating these investments. Hernandez recently spoke with Knowledge at Wharton about their research. (Listen to the podcast at the top of this page.)

An edited transcript of the conversation follows.

Knowledge at Wharton: In your paper, you note that cross-border investments by VC firms have risen to record levels over the last decade, which is both an important and puzzling trend. Why is that?

Exequiel (Zeke) Hernandez: It’s important because the globalization of capital to fund startups allows both investors and entrepreneurs to find each other better than before. And it reflects that the sources of entrepreneurial ideas and talent — and also capital — are more globalized than before. Even a few years ago, most of the high-growth startups came from just a few countries in the world, like the United States or the United Kingdom or Israel more recently, but not really reflecting a broad variety of source countries. Now we’re seeing a change and [entrepreneurial activity around the world is] growing very fast. That’s why it’s important.

The reason it’s puzzling is because the venture capital industry is famously very localized. There have been quite a few studies before mine that have shown that venture capital investment is very unlikely to happen more than about 40 to 60 miles from the headquarters of the VC firm. Silicon Valley investors invest in the Valley, Boston investors in Boston, etc. I’ve talked to a lot of VCs who confirm this.

Why does this happen? Because it’s really hard to get information about startups and to monitor their performance. If you think about investing in a publicly held company, you can find their financial statements; you know they exist. But how do you even know that a startup exists? Proximity allows you, as an investor, to find out what new startups are out there, to meet the founders and develop a relationship with them before you invest. After you invest, proximity is really important to monitor performance of the startup, to meet, to provide advice when things come up, etc.

The puzzle is that international venture capital investment violates this proximity rule. You invest in a startup abroad: Obviously, you’re very far away, but you have other risks beyond geographic separation. You take on cultural differences, legal differences, and other institutional factors that come in just because countries differ from one another. That’s why observing this is both important, but it’s also puzzling to explain.

Knowledge at Wharton: What was the main question you set out to answer with this research?

“Broadly, we wanted to know why VC firms would take on the risks of investing in startups from other countries and, importantly, where they invest.”

Hernandez: Broadly, we wanted to know why VC firms would take on the risks of investing in startups from other countries and, importantly, where they invest. As we looked at the data, we noticed that as we compared firms, there was a lot of variation in where they invested. Some invested in Israel, Canada, China, India. How do we explain the destination of their investments? That was the broad thing we were trying to understand.

We had a very specific hypothesis: One mechanism that explained this was that immigrant entrepreneurs play a really crucial role in facilitating cross-border venture capital investment. The more a venture capital firm — in this case, in the U.S. — invests in startups that have immigrant founders, the more that firm will later invest in startups located in the country where the immigrant founders are from. To give a general example, if I’m a venture capital firm in Silicon Valley, and I end up investing in U.S. startups that have Indian entrepreneurs as founders, then I’m more likely in the future to invest in Indian startups that are located in India.

Knowledge at Wharton: Your study focuses specifically on the role that immigrant entrepreneurs play in this scenario. How do they facilitate these investments?

Hernandez: The mechanism is pretty straightforward. An immigrant entrepreneur has knowledge about their home country and connections in that country. If I’m a venture capitalist and invest in a startup that an entrepreneur from India or China or Israel has founded, then over time, just because I interact with that individual, I become exposed to the knowledge and connections of that person.

In fact, stepping back a little bit from immigrant entrepreneurs, we know from previous research that venture capitalists source new deals in part from the founders they already know. It’s not that shocking to think that a venture capitalist will also source deals from immigrant entrepreneurs. The difference is that those entrepreneurs will know about business opportunities not just in the U.S. or in the same country where the venture capitalist is located, but also in their homeland. It’s a way to extend that network. That’s basically the mechanism.

Knowledge at Wharton: What did you find in this study? What were your specific results?

Hernandez: In our study, we had data on the investments of U.S.-based venture capital firms in Indian startups. What we found is that the more a U.S. venture capitalist invested in startups in the U.S. that were founded by Indian entrepreneurs, the more they later invested in startups in India, [or] the greater the count of investments [in India].

But what’s really important is that we found that this effect only happened if the Indian entrepreneurs in the U.S. were first-generation immigrants, meaning they had come directly from India. There was no effect for second- or later-generation Indians, for the ethnic Indians who didn’t live or spend time in India, who didn’t grow up there.

We also found some very specific results that are interesting. For example, we found that if a venture capitalist is exposed to Indians from a certain region of India, say West India, they will make more investments in West India than in other parts of India. Or if they are exposed to Southern Indians, then they will make more investments in South India than in West India or other parts. So, it seems to be that the exposure is very specific to the region, that the knowledge and connections of these immigrants are very specific to where they spent time in India growing up.

The other result we found is that if you make an investment in India because you’re exposed to Indian entrepreneurs in the U.S., you’re less likely to co-invest with a local Indian venture capitalist. You kind of go it alone, probably because you’re willing to take on a little bit more risk. Perhaps the Indians gave you information [and make it so that] you don’t feel it’s as risky to go it alone.

Knowledge at Wharton: India was the context for this study. Why did you choose that particular country?

Hernandez: It wasn’t necessarily because we had a predilection for India. The main reason is that India offers a very good and convenient empirical context to answer the questions we had. Unlike immigration from a lot of European nations, Indian immigration into the U.S. is relatively recent (in the last 30 years or so). That means that we have a large group of Indians that are either first generation or second generation, but we don’t have a long tail of history there. That avoids some confounding effects from immigrants being here and being more embedded into the culture of the United States.

“The more a venture capital firm invests in startups that have immigrant founders, the more that firm will later invest in startups located in the country where the immigrant founders are from.”

Also, Indian immigrants have a substantial rate of entrepreneurship in the U.S., especially high-tech entrepreneurship. That’s important because we needed enough observations of entrepreneurs in sectors that would receive venture capital funding.

There is another particularity of India that is really interesting to me. I mentioned that we knew [what regions] the Indians were from — West India or South India. It turns out that one way you know that is from last names. If your last name is Balachandran, like my co-author, his last name is from South India. But a last name like Nerkar or Patel is from West India. This comes from linguistic and other historical differences that are pretty persistent. The names allow us to know the origins of these individuals. If we try to do this with other nationalities — take my last name, Hernandez: That doesn’t represent one country. That could be dozens of countries. India was convenient for all those reasons.

Knowledge at Wharton: Unlike previous studies in this area, you looked at firms’ interactions with individual immigrants as opposed to the broader immigrant population. Why is that important?

Hernandez: It’s important because there are previous papers that have looked at how immigrants affect the foreign investments of companies in general. I’m not talking about venture capital, but just direct investment. Think of a multinational firm setting up a subsidiary somewhere. I’ve done some of that work. Others have done some of that work. One of the things that all those previous papers have in common is that they looked at exposure to … the population of immigrants from a certain country. Let’s stay with Indians as our example. If I’m in a place like New Jersey or California that has a lot of Indian immigrants, then that might stimulate investment in India. But that exposure at the population level doesn’t really explain why two firms headquartered in the same location and exposed to the same number of Indian immigrants at the population level might behave differently. We observe one firm investing in India and another firm not investing.

We need a setting where we can observe a firm interacting with individual Indians. Venture capital was really great in that sense because we can observe this. It’s that exposure at the individual level that allows me to know if you were, to use a medical term, infected with the knowledge and connections in a way that’s going to influence you later.

“Perhaps the broadest implication [of our study] is that immigration plays a really important role in the diffusion and the allocation of capital across countries.”

Knowledge at Wharton:  You mentioned earlier that this impact on venture capital investment happens with first-generation immigrant entrepreneurs, but not with later-generation immigrants. Can you explain more about why that’s so?

Hernandez:  The reason that’s a key finding is just because it helps validate that mechanism I mentioned earlier of knowledge and connections, and it’s really quite straight-forward. A first-generation immigrant has firsthand knowledge and connections, has spent time and has had meaningful business and personal experience in India, and a second or later generation immigrant doesn’t have that. So we can distinguish between the effect of the first generation versus others and find that the effect is primarily driven by the first generation. It tells us that this is really probably about knowledge, connections, experience — as opposed to some other ethnic preference or something that would be an alternative explanation for why we see this result.

Knowledge at Wharton: You also looked at the role that immigrants play at the VC firms. Can you explain that?

Hernandez: This is a little more convoluted. We also wanted to see what happens if the VC firm itself has immigrants in its management team. If I’m a venture capital firm, and I have partners who are Indian, does that make a difference? You could expect that it might because I might be more receptive, more attuned to opportunities in India just because I know something about the homeland. We found that in general that’s true, but there’s a twist here. Remember how for the Indian entrepreneurs we found that it’s the first generation that has the effect? For the partners of the venture capital firms, it’s … the opposite. It’s the second-generation partners who are extra receptive to the information provided by the first-generation immigrant entrepreneurs. The first-generation partners don’t seem to be extra receptive. They’re receptive, but there’s not a bump. There’s not an extra effect of being a first-generation partner.

We kind of scratched our heads at this for a while. We don’t know for sure, but a speculation that we have is that if you’re a second-generation Indian, you are primed to be interested in the homeland, but you don’t have the knowhow on your own to make investments. What the immigrant entrepreneurs are bringing kind of activates your interest and is complementary to your interest in India. If you’re already a first-generation partner in the firm, you have your own connections and knowledge. Maybe what these immigrant entrepreneurs are bringing is more redundant. I can’t be sure about that, but it’s an explanation that seems to fit the data.

Knowledge at Wharton: What implications does your study have for immigration policy?

Hernandez: I think that perhaps the broadest implication is that immigration plays a really important role in the diffusion and the allocation of capital across countries. To put it differently, migration is a leading indicator of where firms are going to invest capital many years later. And the reason that matters is because if you’re a country or a city or a jurisdiction that wants to increase capital investment — I think this is a concern of most mayors and governors and presidents — then one of the best things you can do is have immigrants.

“If you’re a country or a city or a jurisdiction that wants to increase capital investment … then one of the best things you can do is have immigrants.”

It takes time for this to happen, so it’s not an investment with an immediate payoff. But it matters because in policy discussions, when we talk about how immigrants affect the economy, most of the debate circles around questions of jobs and labor. How do immigrants affect jobs and wages of local workers? Do they create more jobs? We don’t usually talk about capital. But if we think about the economy, it doesn’t just grow because of labor issues. It grows because there’s also capital that’s productively invested. Immigrants play a role in that huge part of the economy that is increasing the stock of capital. That’s a very broad implication. Of course, this study by itself doesn’t make that point, but it’s one more nugget of evidence on this issue of capital.

There’s another implication that has to do with the issue of “brain drain.” I think it’s a term that is understood, but for those who might not have heard it before, there has long been a concern that when a country sends out immigrants, it loses a lot of talent. The brains get drained from the country, and then the country won’t grow and develop. I’m not going to speak to that. There’s a big literature that’s beyond this conversation. But what this study is adding is that it seems to be that, in the long run, one of the gains that sending countries get is more capital. In this case, it’s in the form of venture capital that helps startups from that country grow and scale and provide jobs. It could be that immigration can be a form of long-term investment in that the immigrants that go to the receiving country then facilitate capital coming back into the country that sent them. Again, this study by itself doesn’t put the nail in the coffin on whether that happens, but it suggests that we also need to think about that.

Knowledge at Wharton: What would be good to explore as a follow-up to this study?

Hernandez: In this study, we’ve just looked at whether these immigrant entrepreneurs facilitate more venture capital investment. We haven’t looked at the performance of those investments. I think it would be an obvious next step to look at whether these venture capitalists get greater returns when they invest because of exposure to immigrants. Are there differences in the kinds of startups that receive investment through this immigration mechanism or not? That would be interesting, too. We’re also aware that we have a sample in this case just of Indian entrepreneurs and Indian startups, for the reasons I explained earlier. But we should also see if this holds for other nationalities. For the U.S., the biggest destinations for foreign venture capital besides India are China, Israel, Canada and the U.K., so it would be interesting to see if there are differences in how immigrants from those countries affect investment.