Parameterizing ‘Return Effort’ and ‘Return Effort Cost’ Within Venture Capital Markets

Abstract

Typically, studies of efforts of economic agents do not distinguish between efforts that directly generate returns (`return effort') and efforts that facilitate demonstration of return effort, that is, `return effort cost'. This study provides formal theoretical evidence that a distinguishing of return effort from return effort cost produces rational explanations for two seemingly contradictory effects, namely, that venture capitalists (VCs) simultaneously are characterized by each of `too much effort' or `too little effort'. In stated respect, the formal theoretical model demonstrates that whereas VCs' portfolio returns are strictly convex in return effort, simultaneously, they are, in relation to return effort cost, strictly concave. In aggregate then, portfolio returns are, in relation to effort, characterized by strict concavity. In presence of rationality of ubiquity of a `too much money chasing deals' phenomenon, VCs overinvest, yet simultaneously, arrive at portfolio returns that are lower than first-best; hence arrival at inference of `too much effort'. This is a unilateral `level effect' that induces a second-best performance-effort curve, which resides just below the unattainable first-best curve. Cross-sectionally, with VCs located on the second-best curve, return effort is shown to be confluent with `richness' of VCs' investment opportunity sets. The model explicitly rules out increase of effort with riskiness of projects, establishes effort increases with richness of investment opportunity sets. Under the erroneous assumption that optimal effort is conditioned on project-specific risk, as opposed to the continuum of investment opportunity set risk, VCs appear to exert `too little effort'. Given, however, that `too little effort' is ubiquitous, every optimal realization for effort is characterized by `too little effort'. Study findings provide evidence for importance of adoption of equilibrium approaches to modeling of efforts of economic agents within different markets.