The Investment Style Drift Puzzle and Risk-Taking in Venture Capital

Abstract

Limited partners allocate capital into venture capital funds with the expectation of a risk-return profile matching the fund’s investment style in terms of startup investment stage, location, and industry. This paper draws a connection between style drifts in these three dimensions and the connected risk-taking attitude of the general partner. By analyzing a sample of 31,521 investments concerning the motivation for style drifts, this paper seeks to answer whether style drifts are deliberate risk shifts or happen out of competitive pressure. The results suggest that venture capitalists increase risk when they have strong past performance and public markets are bullish to make the most of the balance of compensation and employment incentives. This balancing most likely constitutes an agency conflict between limited partners and general partners. Further, results show that riskier style drifts have a negative impact on investment performance even after controlling for performance persistence and endogeneity. Finally, the findings show that aggregate style drift has a negative effect on a fund’s performance measured as its exit rate.

Keywords: investment style, style drifts, agency conflict, risk, venture capital, entrepreneurial finance

JEL Classification: G11, G24