Chinese venture capital (VC) firms suffer from imperfect information and poor legal protections when deciding whether to continue to invest in a company or cut it loose, according to HKUST researcher Yanfeng Zheng and a colleague. Analysing more than a decade’s worth of deals, the authors established that Chinese VCs are more likely to terminate investments if they have substantial funds in similar firms. However, social relationships and network engagement moderate VCs’ decision-making.

VC firms make “equity investments in high-risk and high-return companies” with the promise of significant returns if the gamble pays off, the researchers tell us. In established markets such as the UK and US, VC firms and syndicates (groups of investors that club together) enjoy significant legal protections if companies fail. However, VCs in emerging economies such as China faces substantial challenges. “Information asymmetry is rampant; contracts are weakly enforced, and non-contractual relationships are prevailing,” warn the authors. In China, VCs face more risk and less reward.

Instead of a purely financial choice, say the authors, “VC investments in China are better viewed from social and relational perspectives.” To understand the factors influencing VC decisions, the authors analyzed 12,000 deals completed between 2001 and 2012. They found that when a VC firm has a larger number of investments in a specific industry, it is more likely to terminate investments. “The VC firm is more likely to exercise discretion and be more selective in portfolio companies because it can withhold resources in less promising investments,” say the authors. A deeper understanding of the market enables them to “capture more value from those promising ones,” the authors explain.

In addition to market exposure, the level of “embeddedness” in social networks is a crucial factor influencing termination decisions, note the authors. The more engaged a VC firm is with a group of investors in the same sector (a “deal dependent network”), the less likely it is to terminate investments in similar companies, even if they have significant exposure to the market.

However, the authors also found that VC firms with strong links to investment firms in other markets established a “network access advantage”. This functioned to “enhance the positive effect of similar investments on the likelihood of investment termination.” The more comprehensive the network of connections, the more significant the opportunities to invest in different sectors.

The research highlights the challenges faced by VC investors in emerging economies, specifically a lack of legal protection and information asymmetry. The study provides valuable insights into the previously hidden forces influencing investment decisions in emerging economies. “Our findings provide evidence that, beyond managing its own investment portfolio, a VC firm is likely to consider its deal network embeddedness around a particular setting associated with the jointly invested company,” say the authors.

As well as making a significant contribution to the investment literature, the study highlights how structural changes in a VC portfolio can influence decision-making. VCs with a considerable investment in one sector demonstrate insight and a strategic focus. Still, this should act as a warning sign that termination is more likely for early-stage investments, say the authors.