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

Lin Cong and Yizhou Xiao

The Review of Financial Studies, 2022, vol. 35, issue 3, 1183-1221

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 use 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 short-term contracting, endogenous bargaining, and double moral hazard issues.

JEL-codes: G10 G24 L26 O31 (search for similar items in EconPapers)
Date: 2022
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