Contractual Terms and Conditions in Private Equity Partnership Agreements

Abstract

Default penalties are commonly observed in private equity funds. These penalties are levied on limited partners that miss out on a capital call. We show that default penalties are part of an optimal contract between limited and general partners. Default penalties help limited partners in screening general partners, and in minimizing distortions in investment levels and fees, caused by information asymmetries between general and limited partners. We also show that an optimal fee structure requires management fees that are proportional to capital under management, and transaction fees that are paid during the life of the fund when investments are made.