  General partners (GP) are sometimes paid on a deal-by-deal basis and other
times on a whole-portfolio basis. When is one method of payment better than the
other? I show that when assets (projects or firms) are highly correlated or
when GPs have low reputation, whole-portfolio contracting is superior to
deal-by-deal contracting. In this case, by bundling payouts together,
whole-portfolio contracting enhances incentives for GPs to exert effort.
Therefore, it is better suited to alleviate the moral hazard problem which is
stronger than the adverse selection problem in the case of high correlation of
assets or low reputation of GPs. In contrast, for low correlation of assets or
high reputation of GPs, information asymmetry concerns dominate and
deal-by-deal contracts become optimal, as they can efficiently weed out bad
projects one by one. These results shed light on recent empirical findings on
the relationship between investors and venture capitalists.
