Why don't successful venture capitalists eliminate excess demand for
their follow-on funds by aggressively raising their performance fees? We
propose a theory of learning that leads to informational hold-up in the
VC market. Investors in a fund learn whether the VC has skill or was
lucky, whereas potential outside investors only observe returns. This
gives the VC's current investors hold-up power when the VC raises his
next fund: Without their backing, he cannot persuade anyone else to fund
him, since outside investors would interpret the lack of backing as a
sign that his skill is low. This hold-up power diminishes the VC's
ability to increase fees in line with performance. The model provides a
rationale for the persistence in after-fee returns documented by Kaplan
and Schoar (2005) and predicts low expected returns among first-time
funds, persistence in investors from fund to fund, and over-subscription
in follow-on funds raised by successful VCs. Empirical evidence from a
large sample of U.S. VC funds raised between 1980 and 2006 is consistent
with these predictions