Persistent Blessings of Luck: Theory and an Application to Venture Capital

54 Pages Posted: 22 Feb 2017 Last revised: 12 Oct 2020

See all articles by Lin William Cong

Lin William Cong

Cornell University - Samuel Curtis Johnson Graduate School of Management; National Bureau of Economic Research (NBER)

Yizhou Xiao

The Chinese University of Hong Kong (CUHK) - CUHK Business School

Date Written: October 9, 2020

Abstract

Persistent performance in venture capital is routinely interpreted as evidence for skill. We present a dynamic model of delegated investment with endogenous fund heterogeneity and deal flow, which generates performance persistence without skill differences and predicts mean reversion in long-term performance. Investors working with multiple funds utilize contingent payments and tiered contracts to induce proper project nurturing and managerial effort. Successful funds receive continuation contracts that tolerate investment failure and encourage innovation, and subsequently finance entrepreneurs through a path-dependent assortative matching favoring incumbents. Recent empirical findings corroborate the model's general implications and the economic mechanisms are robust to, among others, short-term contracting, endogenous bargaining, and double moral hazard issues.

Keywords: Contracting, Deal Flows, Delegated Investment, Entrepreneurial Finance, Managerial Skill, Moral Hazard, Private Equity, Venture Capital

JEL Classification: G10, L26, O31, G24

Suggested Citation

Cong, Lin and Xiao, Yizhou, Persistent Blessings of Luck: Theory and an Application to Venture Capital (October 9, 2020). Available at SSRN: https://ssrn.com/abstract=2920918 or http://dx.doi.org/10.2139/ssrn.2920918

Lin Cong (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States

HOME PAGE: http://www.linwilliamcong.com/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yizhou Xiao

The Chinese University of Hong Kong (CUHK) - CUHK Business School ( email )

Cheng Yu Tung Building
12 Chak Cheung Street
Shatin, N.T.
Hong Kong

HOME PAGE: http://sites.google.com/site/yizhouxiao/

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