Should VCs' Principals Specify Minimum Portfolio Returns to be Delivered by Venture Capitalists (VCs)?
28 Pages Posted: 25 Aug 2020
Date Written: July 19, 2020
This study finds specification of minimum portfolio returns to be delivered by VCs in contracts that subsist between VCs and their principals is not a necessary condition for incentivization of optimal portfolio performance. Within populations of VCs who are characterized by risk aversion, formal theoretical predictions show competition only serves for revelation of true ability of VCs, as such, in entirety is self serving. Within said population, efficiency of financial inter-mediation is endogenously induced by structure of investment opportunity set risk. Absent demonstrations of ability by risk seeking VCs, the continuum of investment opportunity set risk that is occupied by said VCs would be lacking in economic viability. We have then that within said continuum, demonstrations of ability on part of risk seeking VCs induce each of viability and efficiency of financial inter-mediation. While there exists some overlap region in interior of the continuum that is occupied by each of risk averse and risk seeking VCs, we arrive at clustering of risk averse or risk seeking VCs to the right, and to the left, respectively of the overlap region. Overlap is feasible, because the overlap region is, for each of risk averse or risk seeking VCs, the 'lowest portfolio return segment', and because VCs' principals assess each of risk averse or risk seeking VCs on basis of First-order Stochastic Dominance and skewness of project returns. In aggregate, the continuum of opportunity set risk consists of a 'native risk-return' segment populated by risk averse VCs, an 'ability-induced risk-return' segment populated by risk seeking VCs, and an overlap region in interior of the continuum. Absent any assumptions to the effect, the formal theoretical model generates heterogeneity of necessity of pay-performance sensitivities within venture capital markets. In presence of heterogeneity of pay-performance sensitivities, and feasibility of negotiation of higher 'carry' by reputable VCs, VCs which achieve superior performance rationally are able to transition to smaller fund sizes. Formal theoretical support for rationality of transitions to smaller fund sizes by superior performers within venture capital markets had hitherto been lacking in literature of finance.
Keywords: Venture Capital, Investment Opportunity Sets, Ability, Skewness, Performance, Risk Aversion, Risk Seeking, Effort, Effort Capacity
JEL Classification: G24, G11, D53
Suggested Citation: Suggested Citation