Persistent Blessings of Luck
44 Pages Posted: 22 Feb 2017 Last revised: 8 Aug 2018
Date Written: August 6, 2018
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 flow that produces performance persistence without innate skill difference. Investors work with multiple funds and use tiered contracts to manage moral hazard dynamically. Recent successful funds receive continuation contracts that 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 broadly consistent with empirical findings, such as short-term performance persistence and long-term mean reversion, outperforming funds' appeal to innovative entrepreneurs even with worse terms, and the link between failure-tolerance and innovation. Initial luck may also amplify the effect of innate skill differences.
Keywords: Private Equity, Venture Capital, Innovation, Delegated Investment, Performance Persistence, Manager Skills, Dynamic Contracts
JEL Classification: G10, L26, O31, G24
Suggested Citation: Suggested Citation