We study the conflict of interests between limited partners (LPs) and a general partner (GP) in a VC fund with a limited life-span. LPs commit money for investment in risky projects, while the GP selects projects and provides unobservable monitoring effort for each project. We assume that midway into the project, the GP privately observes its quality and the estimated time to exit and decides whether to continue investing and monitoring. The limited time horizon of the fund forces the GP to dispose of any unfinished projects when the fund is dissolved. This, combined with the informational advantage of the GP, leads to inefficient decisions during the intermediate investment stages: frequent continuations of bad projects, as well as occasional write-offs of good, but delay-prone, projects.
This paper presents a simple model that identifies the source and extent of this inefficiency. We show that when unfinished projects are fairly priced, bad projects are always continued. At the same time, under a wide range of parameter values good projects with a somewhat longer expected completion time may be discontinued, since the GP optimally decides not to invest monitoring effort in them. We show that the magnitude of the efficiency loss can be in excess of 25% of the first-best surplus, and propose several contractual amendments to alleviate the problem. First, we show that reduction of the GP’s stake in all the unfinished projects can significantly weaken his incentives to prolong bad projects. This in turn may induce the GP to put effort in the delay-prone good projects, since their price increases. An outright termination of all unfinished projects, as practiced by some VC funds, is similar in nature, but leads to suboptimal early write-offs of some good projects. We also show that allocating nonvested cash (but not decision) rights in the unfinished projects to the GP has similar beneficial effects.
