Diversification, Risk, and Returns in Venture Capital

We explore an alternative, finance theory-based explanation for the documented positive relationship between fund diversification (or lack of fund specialization) and performance in venture capital (VC). Our proposed “Risk Hypothesis” posits that the expected negative impact of diversification on fund risk induces fund managers to endogenously select riskier investments, which in turn leads to higher performance of more diversified funds. While other channels may also be at play, we provide results that support this hypothesis for an international sample of VC funds. However, this effect is weakened when expertise is limited. The study offers implications of how VC fund managers' investment decisions are influenced by strategic portfolio considerations, which in turn affect which innovative ventures receive funding.