Predators in the Board Room: Relating Private Capital Performance and Predatory Behavior Imogen Rose Smith Investment Fellow, University of California Phillip Auerswald Associate Professor of Public Policy, George Mason University Gitanjali Swamy Research Fellow, Director Special Projects, Private Capital Research Institute, Harvard University DRAFT June 6, 2018 Abstract This paper is a study of the impact sexually predatory behavior has on venture capital and private equity fund performance. We hypothesize that predatory behavior is a poor management practice that leads to poor investment performance. To test our hypothesis, we construct the Predatory Behavior Index, a fund-scale index of predatory behavior. We do this by establishing an order relation between different types of predatory behavior, gathering validated information from legal filings to score the index value, and creating a weighted sum from the scoring to derive the final index value. We explore the extent to which predatory behavior is correlated with unnecessary risk-taking in other spheres of business activity that adversely impacts investment outcomes, including systematically poor investment judgment. We find statistically significant evidence of a positive correlation between predatory behavior and poor investment performance. Predators in the Board Room Rose Smith, Auerswald, and Swamy Table of Contents Introduction ..................................................................................................................................... 4 Background ...........................................................................................................................6 Previous Work .......................................................................................................................8 Private Capital Investment Performance .................................................................................... 8 Women in Private Capital .......................................................................................................... 10 Women as Investors .................................................................................................................... 12 Women’s Corporate Performance………………………………………………………………….13 Impact of Sexual Harassment and Other Predatory Behavior ................................................ 14 Analysis and Experiments ................................................................................................... 16 The Predatory Behavior Index ........................................................................................... 17 The Private Capital Database ............................................................................................. 21 The Experiment ................................................................................................................... 25 Experimental Results .......................................................................................................... 27 Conclusions .......................................................................................................................... 33 Theory of Change and Future Work .................................................................................. 33 References ............................................................................................................................... .............................................................................................................................................. 35 FIGURE 1. UNCONSCIOUS BIAS IN VENTURE CAPITAL 11 FIGURE 2. PREDATORY BEHAVIORS 17 FIGURE 3. DEFINITIONS OF PREDATORY BEHAVIOR A PREDATORY BEHAVIOR INCIDENT MAY CONSIST OF MORE THAN ONE ACT. FOR EXAMPLE, SOMEONE WHO COMMITS DOMESTIC VIOLENCE MAY ALSO COMMIT PHYSICAL ASSAULT OR SEXUAL ASSAULT. THE PB INDEX TAKES INTO ACCOUNT THE SEVERITY OF EACH ACT, AS WELL AS THE NUMBER OF ACTS COMMITTED. 19 FIGURE 4. PCRI DATASET 22 FIGURE 5. SAMPLE SET CHARACTERIZATION 26 FIGURE 6 EXPERIMENTAL STEPS 27 2 Predators in the Board Room Rose Smith, Auerswald, and Swamy FIGURE 7. DVPI VS. PB INDEX 28 FIGURE 8. REGRESSION ANALYSIS DVPI VS. PB INDEX 28 FIGUR 9. TVPI VS. PB INDEX 29 FIGURE 10. REGRESSION ANALYSIS TVPI VS. PB INDEX 29 FIGURE 11. IRR VS. PB INDEX 30 FIGURE 12. REGRESSION ANALYSIS IRR VS. PB INDEX 31 FIGURE 13. REGRESSION ANALYSIS TVPI VS. SEXUAL HARASSMENT INCIDENTS 32 FIGURE 14. SUPERIOR AVERAGE DVPI, TVPI, AND IRR WITHOUT PREDATORY BEHAVIOR 32 3 Predators in the Board Room Rose Smith, Auerswald, and Swamy Introduction A series of recent incidents and events have drawn attention to the prevalence of predatory behavior in the venture capital (VC) industry. In this paper, we explore the connection between predatory behavior and poor long-term investment performance in the venture capital and private equity (VCPE) industry. We define predatory behavior as the abuse of or an attempt to abuse someone in the perpetrator’s sphere of influence. This behavior includes assault, domestic violence, enabling (of predatory behavior), inappropriate conduct, inappropriate sexual relationship, intimidation, sexual assault, sexual discrimination, sexual harassment, and racial harassment. Many women have filed complaints about repetitive, unchecked, and burgeoning sexual harassment in the VC industry at such top firms as Lightspeed Venture Partners, Bain Capital Ventures, Binary Capital, 500 Startups, and Lowercase Capital. In the summer of 2017 alone, more than two dozen women in the tech startup industry disclosed that they had been sexually harassed by investors and mentors. These disclosures were triggered by revelations about Justin Caldbeck, a McKinsey & Co., Bain Ventures, and Lightspeed alum, who allegedly extorted sexual favors in return for funding over more than a decade (Benner, 2017; Farber, 2017; Zeitlin, 2017). Unfortunately, this type of behavior is fairly prevalent in an industry that combines extraordinary power and influence with limited transparency and accountability. However, instead of addressing such behavior by punishing perpetrators or establishing policy to reduce the risk, VC firms have tended to react to complaints by forcing gag orders on the women who speak up, threatening to withhold funding, and/or isolating them from the investment community (Primack, 2017). Meanwhile, the perpetrators have continued to be promoted in the industry with no apparent consequences—or any change in their conduct. A rich body of research exists around women’s performance in the workplace, including executives and those on boards, and as investors. A growing number of studies also focus on the funding of women entrepreneurs. Nevertheless, the topic of women as VCPE investors remains under-examined, and almost no research has been conducted on sexual harassment and 4 Predators in the Board Room Rose Smith, Auerswald, and Swamy discrimination at VCPE firms. The impact such behavior may have on these firms’ performance has also been overlooked. Despite much prior research on investment in VCPE firms, the performance of these companies and its relationship to such factors as bad management practices remains a relatively under- examined area. This blind spot extends to gender-related workplace issues, such as sexual harassment and other predatory practices. This gender-related blind spot may well be due to the relatively few women working in the VCPE ecosystem as funded entrepreneurs or investment professionals. That said, recent events have revealed that a wealth of data is in fact available on predatory practices in the VCPE industry. The fact that revelations about predatory practices can have significant consequences for the firms involved is in itself a reason to pursue a better understanding of the impact such practices have on the firms where they occur. This paper explores the extent to which predatory behavior is correlated with unnecessary risk- taking in other spheres of business activity that adversely affects investment outcomes, including systematically poor investment judgement. We hypothesize that predatory behavior is a poor management practice and that such practice leads to poor investment performance. Core contributions of this paper include the establishment of a methodology to quantify predatory behavior; the creation of an associated index, the Predatory Behavior Index (PB Index); and confirmation of the strong relationship between the PB Index and poor investment performance in private capital (also referred to as venture capital and private equity, or VCPE) firms. The PB Index was created by first establishing an order relation between different types of predatory behavior, then gathering validated information from legal filings to score the index value, and, finally, creating a weighted sum from the scoring to derive the final index value. The PB Index was then used in a regression analysis against the performance of corresponding private capital funds to establish the nature of the relationship between them. We test our hypothesis by setting up a simple experiment that quantifies predatory behavior using the PB Index. We then mathematically correlate the index with the investment performance of the corresponding venture fund, measured by standard private capital industry performance metrics. 5 Predators in the Board Room Rose Smith, Auerswald, and Swamy Our results strongly suggest that predatory behavior is correlated with the poor investment performance of private capital (in particular venture capital) funds.