Too Big to Cheat: Efficiency and Investment in Partnerships

Abstract

Many economic activities are organized as partnerships. These ventures are formed with capital contributions by partnership members who obtain a share of ownership in exchange. The design of the partnership dictates how much of the profits is distributed among the mem- bers and how much is reinvested. In this paper, we study the optimal design of partnerships under the assumption that partners privately observe shocks to their liquidity needs. When the ownership share of a partner is large enough, his incentives to misreport vanish. This occurs because a fraction of the increase in his payouts after reporting high liquidity needs is financed by disinvesting in the partnership. When his ownership share is not big enough, the ownership structure of the partnership must vary over time to prevent misreporting. The limiting distri- bution of shares depends on the initial ownership structure. Under certain conditions, if the partnership starts with approximately equally distributed shares, both partners are too big to cheat and the ownership structure remains unchanged forever. Instead, if the initial ownership structure is such that one of the partners is too big to cheat but the other is not, the share of the initially larger partner ends up either reaching 100% (i.e., sole proprietorship forever) or decreasing to the point at which both partners are too big to cheat (i.e., shares are approximately equally distributed forever).