Investment Allocation and Performance in Venture Capital Scott Hsu, Vikram Nanda, Qinghai Wang Discussant: René-Ojas Woltering, Ecole hôtelière de Lausanne (EHL) 2nd Private markets conference, Lausanne July 6, 2018

What`s the Paper about? Research Question: Research Design Do venture capital firms strategically allocate their best investment opportunities to their newest funds? Research Design Derivation of testable predictions from stylized model Empirical analysis: 17,154 portfolio companies (lead investments only) Successful investment: IPO or/and M&A before the end of the fund`s 10y life The power of a (binary) hypothesis test is the probability that the test correctly rejects the null hypotheses. Larger statistical power  probability of type II error (wrongly failing to reject the null) decreases.

Main results of the paper A VC fund`s early investments are more successful than its later investments. Early investments of a newly formed follow-on fund are more successful than concurrent investments in a VC`s existing fund. Strategic allocation of investments leads to performance persistence across successive VC funds. If true value = 1, then hypothesis that it is 0 will be rejected wit ha very high probability (85-91%)

What I like about the paper Contribution Improves understanding of VC fund behavior and incentives. Identifies a potential conflict of interest between the VC and its investors. Identifies a new source of performance persistence. Very well written paper and very comprehensive analysis. Study is particularly important for small sample sizes (larger samples increase statistical power).

Measurement of Investment success Performance measure: % of investments leading to IPOs / M&A until y10 What about the remaining ~70%? not necessarily all write-offs; e.g. Facebook before IPO VC fund returns tend to be driven by positive outliers  Measure of success is rather a proxy for performance Can the authors provide more background on the reliability of their measure? E.g. correlation between no. of IPOs / M&A within 10y and fund returns Why is the analysis restricted to “lead investments”? Lead investments are not necessarily major positions (high conviction picks) How would the results change if non-lead investments were included? More background on the reliability of the measure: Correlation between number of IPOs / M&As within 10 years and fund returns How realistic is the 10y deadline. What do funds do with investments that have not IPOed  secondary market?

Success of early vs late investments Finding: Early investments within a fund are more successful (due to allocation). Alternative hypothesis: “Success” is due to having more time to mature. When the authors control for “time to investment”: the variable “investment sequence number” becomes insignificant “First investment”-dummy and “first-year”-dummy remain significant Possible to control for the age or funding round of the portfolio investments? (Another) alternative explanation: Longer term investment horizon enables better investment decisions (less constraints) Early investments within a fund are more successful (due to active allocation by the managers between funds) Finding is sold a bit more

Success of new vs old fund investments Finding: Early investments in successor funds are more successful than concurrent late investments in preceding funds (due to allocation). Alternative explanation: New funds are dedicated to a new, promising, upcoming theme. The theme of the old fund is meanwhile outworn / overbought / late stage. Authors address industry-switching Authors include “industry-switching”-dummy, but how is it defined? Almost no successor fund invests in completely different industries One quarter of investments in second fund are different from first fund How do the results change if the analysis is restricted to clear non-switchers? E.g: At least 75% of investments belong to the same industry? Again, the authors address this point, but very late

Minor comments R-squareds tend to be very low (1%-3%) Low explanatory power is not addressed Include a measure of industry-wide IPOs/M&A over the same period as a control (similar to market beta) Assumption that new fund performance is particularly important for fund raising How transparent is this information to investors? Why would investors weigh new fund performance more than old fund performance? Flow-performance literature of mutual funds is based on LTM returns In general, are there possible connections to the mutual fund / hedge fund / real estate literature?