The Persistent Effect of Initial Success: Evidence from Venture Capital

Ramana Nanda is the Sarofim-Rock Professor of Business Administration at Harvard Business School; Sampsa Samila is Assistant Professor of Strategic Management at the IESE Business School; and Olav Sorenson is the Frederick Frank ’54 and Mary C. Tanner Professor of Management and Professor of Sociology at Yale University. This post is based on their article, recently published in the Journal of Financial Economics.

One of the distinctive features of private equity as an asset class has been long-term persistence in the relative performance of private equity partnerships. Kaplan and Schoar (2005) for example, find correlations of nearly 0.5 between the returns of one fund and the next within a given private equity firm. Among venture capital (VC) funds, they report even higher levels of persistence, with correlations approaching 0.7. By contrast, persistence has been almost non-existent among asset managers operating in the public equity markets (Ferson, 2010; Wermers, 2011).

The most common interpretation of this persistence has been that private equity fund managers differ in their quality. Some managers, for example, may have a stronger ability to distinguish better investments from worse ones. Or, they may differ in the degrees to which they add value post-investment—for instance, by providing strategic advice to their portfolio companies or by helping them to recruit able executives.

But differences in performance could also stem from better access to deal flow. To gain greater insight into the sources of persistence, we shift the unit of analysis to the individual investment. Specifically, in our paper we examine how the performance of VC firms’ initial investments—in terms of having successful exits, either through IPOs or trade sales—are related to success that VC firms have with their subsequent investments.

Consistent with prior studies at the fund level, we find high levels of performance persistence at the investment level across VC firms. For example, a 10 percentage-point higher IPO rate among a VC firm’s first ten investments—that is, one additional IPO—predicts a more than 1.6 percentage point higher IPO rate for all subsequent investments by that firm, relative to a VC firm with one fewer IPO among its first ten investments. Given that fewer than one in five investments results in an IPO, that amounts to an 8% higher likelihood of a public offering over the baseline.

Year-state-industry-stage intercepts at the investment level absorb roughly half of this gross persistence. In other words, differences in where, when, and how venture capital firms invest account for much of the persistence in performance across VC firms. But even among VC firms investing in the same stages in the same industries in the same states in the same years, a 10 percentage point higher IPO rate among a VC firm’s first ten investments predicts a roughly 4.3% higher IPO rate for the firm’s subsequent investments. Although the performance of VC firms converges with increasing numbers of investments, initial success predicts future success for as many as 50 subsequent investments.

We find that initial success appears to depend in large part on being in the right places at the right times. VC firms, however, do not appear to have any ability to select those attractive segments on a consistent basis. Differences in the selection or nurturing of specific portfolio companies also appear to contribute little to explaining persistence. Overall, our results appear most consistent with performance persistence in venture capital arising from differential access to deal flow for VCs whose initial investments were more successful.

Access to deal flow matters in venture capital because it operates as a two-sided market. Offering the best price or the first bid does not guarantee an investment. Entrepreneurs can often choose among competing investors. Hsu (2004), in fact, found that entrepreneurs accept lower valuations and less attractive terms from more prestigious VC firms when choosing between offers. Prominent VC firms also gain access to a wider and better range of investment opportunities through syndicate partners who want to co-invest with them (Sorenson and Stuart, 2001).

Despite the beliefs about the importance of VC firm quality, entrepreneurs and others have little on which to base their assessments of VC firm quality (Korteweg and Sorensen, 2017). Even ex post they cannot determine whether another VC firm might have generated more value for a particular venture. In such situations, initial differences in success—even due to chance events—could lead others to perceive a venture capitalist as higher quality, allowing that investor to access attractive deals. Even with no unusual ability to select investments or to nurture them to success, this access advantage allows successful VC firms to invest in more promising start-ups, thereby perpetuating their initial success.

The picture that emerges then is one where initial success gives the firms enjoying it preferential access to deals. Both entrepreneurs and other VC firms want to partner with them. Successful VC firms therefore get to see more deals, particularly in later stages, when it becomes easier to predict which companies might have successful outcomes. Even if venture capitalists do not differ in their abilities to identify more promising ventures (but they all have some ability to predict start-up success), this access advantage could perpetuate differences in initial success.

Although this conclusion may seem at odds with the usual interpretation of persistence in the academic literature, it appears consistent with the perspectives offered by many practitioners. Chris Dixon, a prominent partner at Andreessen Horowitz (a16z), for example, notes that:

“The popular view of venture investing is that it is about picking good companies, because that’s what’s important with public equities. But you can’t apply the logic of public equity markets, where by definition anyone can invest in any stock. Success in VC is probably 10% about picking, and 90% about sourcing the right deals and having entrepreneurs choose your firm as a partner.” (Eisenmann and Kind, 2014, p. 8)

The importance of access to deals for performance in venture capital could also help to explain why persistence appears in venture capital but not in most other asset classes, such as mutual funds and hedge funds. For investors primarily purchasing and selling public securities, access depends only on price. When multiple firms perceive an opportunity they therefore compete away the returns associated with it. But, in venture capital, access often depends on more than price. Because entrepreneurs and other investors believe that they might benefit from affiliating with prominent investors, they willingly accept lower prices from them, allowing those investors to earn rents on their reputations.

The complete article is available here.

Trackbacks are closed, but you can post a comment.

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

  • Subscribe or Follow

  • Supported By:

  • Program on Corporate Governance Advisory Board

  • Programs Faculty & Senior Fellows