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

56 Pages Posted: 22 Feb 2017 Last revised: 28 May 2020

See all articles by Lin William Cong

Lin William Cong

Cornell University - Samuel Curtis Johnson Graduate School of Management

Yizhou Xiao

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

Date Written: May 6, 2020

Abstract

Persistent fund 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 innate skill difference and predicts mean reversion in long-term performance. Investors work with multiple funds and use contingent payments and tiered contracts to induce proper project nurturing style and managerial effort dynamically. Recently successful funds receive continuation contracts that tolerate investment failure and encourage greater innovation, and subsequently finance innovative entrepreneurs through assortative matching. Initial luck thus exerts an enduring impact on performance by altering managers' future investment opportunities. The model generates implications consistent with recent empirical findings and the economic mechanisms are robust to, among others, lack of commitment, 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 (May 6, 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/

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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