March 27, 2013

It's Not Who You Know

Entrepreneurs who launch new ventures away from industry hubs find that knowledge is portable.

It is a classic tale of entrepreneurship: a computer whiz spends a few years working at a large corporation in Silicon Valley, then leaves to launch a startup. But what happens if she locates her firm in Kansas City, 1,500-odd miles away? She will forfeit the perks of working in a high-tech zone, access to clients, inside knowledge, and a community rich in expertise. Should she have stayed in Santa Clara?

Working in an industry hub confers special benefits, known as agglomeration effects. These benefits typically involve sharing both of physical assets and of people. Just as shipping companies share materials and infrastructure in a port, banks in a financial center like New York or London “share” a rich supply of employees who have inside knowledge and industry expertise and can jump easily between firms. Although this phenomenon is well established, little is known about whether a former employee retains these benefits after leaving the industry hub. New research by Professor Evan Rawley, working with Rui J. P. de Figueiredo Jr. of University of California at Berkeley and Philipp Meyer-Doyle of INSEAD, examines how these benefits can be appropriated by an entrepreneur who leaves a firm to start a new venture, no matter where that venture is located, a phenomena they call inherited agglomeration effects.

The importance of an entrepreneur’s prior employment is often overlooked, Rawley says. “When people talk about startups, especially high-tech startups, they often think of two guys in a garage, coming up with new ideas,” he says. “When in fact that’s very unusual. Most entrepreneurial ventures are started by people who have deep knowledge of the industry.”

The researchers focused on hedge funds started by entrepreneurs who had trained in large banks in financial centers. Surprisingly, they found that agglomeration effects are portable. “You would think that staying in the financial center would help, because you would remain close to the industry, to other people,” says Rawley. “But we found that in the context of hedge funds inherited agglomeration effects are derived not from social capital but from knowledge, which for portfolio managers includes trading strategies, and operational knowledge.” In fact, where fund managers spend their early careers (in a financial hub, or not) is at least as important as where they choose to locate their new venture, the study showed.

That might seem counterintuitive in an industry that values connections. But the benefits of staying within in the hub are offset by the effects of greater competition, Rawley explains. “If you’re coming from a New York bank and starting up a new hedge fund, even if you are well connected in New York, you’re competing with people who are also well connected,” he says. “There are a lot of hedge funds chasing dollars in New York, but very few in Missouri.”

In their research, Rawley and his coauthors studied data on hedge fund performance and interviewed portfolio managers of more than thirty funds. Many of these managers said that their prior experience at banks was what enabled them to be successful. But when pressed, most couldn’t give specifics. “It was interesting that so many of them were unable put a finger on it,” Rawley says. “All they could say is that they’d had the chance to learn about the financial services industry.” By studying the managers’ bios and obtaining information about their prior employment experience, the researchers were able to create a clearer picture of how these managers had benefitted from working in a hub.

For entrepreneurs looking to go farther afield when they strike out on their own, these findings are encouraging, though Rawley cautions that the results generalize best to service industries. “The modern economy is about human capital — knowledge — and, in hedge funds, knowledge is the crux of the business, but in other industries workers may be tied to physical infrastructure that will limit the magnitude of any inherited agglomeration effects,” Rawley notes. However, the portability of expertise is not limited to the hedge fund industry; in any sector where human capital is critical, departing employees can take their most valuable asset with them. “Ideas aren’t tied to a physical space,” Rawley says. “Knowledge is easy to move around.”

Evan Rawley is associate professor of management at Columbia Business School.

Read the Research

Rui de Figueiredo, Jr., Phillip Meyer-Doyle, Evan Rawley

"Inherited Agglomeration Effects in Hedge Fund Spawns"

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