Abstract

This study suggests a theoretical complement to thus far proposed explanations of disproportionate returns in the venture capital industry. Departing from a focus on firm-specific resources, we develop a model and simulate a process of hierarchical market allocation, in which the most promising ventures are allocated to venture capital firms (VCFs) in the order of a generally shared criterion, such as reputation, status, or expected value of VCF’s contribution to venture. The second part of the study tests proposed relationships from the simulation on a sample of 227 US early stage VC funds. The findings suggest that the mechanism of hierarchical market allocation is a significant driver of systemic differences in VCFs’ performance. Importantly, this effect is not specific to characteristics of any individual VCF, but to the VCF’s position in the hierarchy. Both simulation and empirical findings show that performance of the VCF is curvilinearly related to the position in hierarchy: the higher up the VCF moves in the hierarchy, the higher the marginal effect on performance.

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