Three Tiers and Thresholds: Incentives in Private Market Investing

TL;DR

This paper analyzes optimal incentive contracts in private market investing, showing that simple three-tier or threshold-based payment structures can effectively motivate diligent screening and truthful reporting by agents.

Contribution

It introduces a novel characterization of profit-maximizing contracts that induce information acquisition and truthful recommendations in private equity and venture capital settings.

Findings

Three-tier contracts are sufficient for optimal incentives.

In symmetric environments, the optimal contract simplifies to a threshold rule.

Contracts promote diligent screening while limiting excessive risk.

Abstract

This paper studies optimal contract design in private market investing, focusing on internal decision making in venture capital and private equity firms. A principal relies on an agent who privately exerts costly due diligence effort and then recommends whether to invest. Outcomes are observable ex post even when an opportunity is declined, allowing compensation to reward both successful investments and prudent decisions to pass. We characterize profit maximizing contracts that induce information acquisition and truthful reporting. We show that three tier contracts are sufficient, with payments contingent on the agent's recommendation and the realized return. In symmetric environments satisfying the monotone likelihood ratio property, the optimal contract further simplifies to a threshold contract that pays only when the recommendation is aligned with an extreme realized return. These results provide guidance for performance based compensation that promotes diligent screening while limiting excessive risk taking.