Strategic Network Formation and Performance in the Venture Capital Industry

Abstract

I investigate the network structure of venture capitalists based on co-investments, and the effects of network structure on investment performance. As venture capitalists select their partners, network structure is endogenously determined in equilibrium. Using comprehensive data on venture capital firms in the U.S., I jointly estimate a model of strategic network formation and a performance equation, taking endogeneity of network structure into account. In the estimation of the strategic network formation model, instead of imposing an equilibrium selection rule, I exploit the partial identification approach. My estimation strategy relies only on the necessary conditions of pairwise stability and is computationally feasible. I find that the network of venture capitalists tends to be homophilous in terms of asset size, but anti-homophilous in terms of investment experience and industry expertise. Moreover, I fi nd that not taking the endogeneity into account results in signi ficant overestimates of the effects of the network structure on investment performance. Lastly, I conduct a counterfactual policy experiment in which the government makes direct investment into the market by establishing a venture capital firm. I examine the effects of the additional venture capital fi rm on equilibrium network structure and investment performance.