Optimal Design of Limited Partnership Agreements

TL;DR

This paper analyzes when whole-portfolio versus deal-by-deal contracting is optimal for general partners, showing that asset correlation and GP reputation influence the best payment structure to mitigate moral hazard and adverse selection.

Contribution

It provides a theoretical framework determining the optimal contracting method based on asset correlation and GP reputation, clarifying when each approach is preferable.

Findings

Whole-portfolio contracting is better with high asset correlation or low GP reputation.

Deal-by-deal contracts are optimal with low asset correlation or high GP reputation.

Results explain empirical patterns in investor-VC relationships.

Abstract

General partners (GP) are sometimes paid on a deal-by-deal basis and other times on a whole-portfolio basis. When is one method of payment better than the other? I show that when assets (projects or firms) are highly correlated or when GPs have low reputation, whole-portfolio contracting is superior to deal-by-deal contracting. In this case, by bundling payouts together, whole-portfolio contracting enhances incentives for GPs to exert effort. Therefore, it is better suited to alleviate the moral hazard problem which is stronger than the adverse selection problem in the case of high correlation of assets or low reputation of GPs. In contrast, for low correlation of assets or high reputation of GPs, information asymmetry concerns dominate and deal-by-deal contracts become optimal, as they can efficiently weed out bad projects one by one. These results shed light on recent empirical findings on the relationship between investors and venture capitalists.