Contracting in Delegated Portfolio Management: The Case of Alternative Assets

Abstract

This study explores optimal portfolio management contracts in the context of ‘opaque’ portfolios invested in illiquid or privately held assets. We identify shortcomings of linear contracts in this context and demonstrate that the second-best optimal contract features a convex component. The importance of the convex component is an increasing function of the portfolio’s opacity. Furthermore, the principal’s utility loss from restricting the weight of the convex component to zero is increasing in the portfolio’s opacity. These results help provide a rationale for the form of contracts observed in the case of alternative investments including hedge funds and private equity funds.

Keywords: Delegated Portfolio Management, Incentive Contracts, Hedge Funds, Alternative Investments, Moral Hazard

JEL Classification: G20, G10