Persistent Blessings of Luck

Lin William Cong (叢林) Yizhou Xiao, Yizhou Xiao - Apr 05, 2017

Persistent fund performance in venture capital is often interpreted as evidence of differential abilities among managers. We present a dynamic model of venture investment with endogenous fund heterogeneity and deal flows that produces performance persistence without innate skill difference. Investors work with multiple funds and use tiered contracts to manage moral hazard dynamically. Recently successful funds receive continuation contracts that encourage greater innovation, and subsequently finance innovative projects through assortative matching. Initial luck, therefore, exerts an enduring impact on performance by altering managers' future investment opportunities. The model generates implications broadly consistent with empirical findings, such as that persistently outperforming funds encourage greater innovation and attract better entrepreneurs even with worse terms. The model further predicts ``incumbent bias'' in investing in funds, mean-reversion of long-term performance, backloading across contracts, and amplification of innate skill differences.
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private equity venture capital innovation delegated investment performance persistence manager skills dynamic contracts deal flow