Lin William Cong, Yizhou Xiao - April 5, 2017
Performance persistence in the private equity industry, especially in venture funds, is often interpreted as evidence of differential abilities among managers. We present a dynamic model of delegated investments that produces performance persistence and predictability without skill heterogeneity. Risk-tolerant capital and innovative projects exhibit strong complementarity, and endogenously flow to recently successful funds through incentive contracts with continuation value and assortative matching. Initial luck therefore has an enduring impact on fund performance and managerial compensation, and investors benefit from working with multiple funds with tiered contracts that affect dynamic moral hazard. More generally, we demonstrate how luck induces or amplifies fund heterogeneity that in turn leads to differential investment opportunities performance. Consistent with empirical findings, our model predicts that venture funds that persistently outperform encourage greater innovation and attract better entrepreneurial projects using seemingly less favorable contract terms. The model further predicts ``incumbent bias'' in manager hiring and compensation improvement for recently successful managers, and performance persistence in other delegated investments.