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

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  • Lin William Cong
  • Yizhou Xiao

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.

Suggested Citation

  • Lin William Cong & Yizhou Xiao, 2022. "Persistent Blessings of Luck: Theory and an Application to Venture Capital," The Review of Financial Studies, Society for Financial Studies, vol. 35(3), pages 1183-1221.
    • Handle: RePEc:oup:rfinst:v:35:y:2022:i:3:p:1183-1221.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhab049
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    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • L26 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Entrepreneurship
    • O31 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Innovation and Invention: Processes and Incentives
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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