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Too Big to Cheat: Efficiency and Investment in Partnerships

Many economic activities are organized as partnerships. These are ventures formed with capital contributions by partnership members that in exchange obtain a share of ownership. The design of the partnership rules dictates how much of the profits are distributed among the members and how much are reinvested. In this paper, we study the optimal design of partnerships under the assumption that one of the members (the founder) privately observes shocks to his liquidity needs. When the ownership share of the founder is large enough, private information is immaterial and the ownership structure remains constant over time. The founder has no incentives to misreport because a fraction of the increase in his payouts after reporting high liquidity needs is financed by disinvesting in the partnership. When the founder''''s ownership share is not big enough, the ownership structure of the partnership must vary over time to prevent misreporting. In the long run, only two possible outcomes have positive probability: Either (i) the ownership shares of the founder converge to zero (i.e., “immiserization," as in other models of private information), or (ii) the founder''''s share of the partnership becomes too big to cheat (i.e., his incentives to misreport vanish) and thus both partners own a constant positive share of the partnership forever.

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