Performance-sharing optimization by risk-constrained equity investors

Abstract

An investment project may be capital constrained when its risk exceeds the risk limit of prospective investors. We propose a new equity-contract in which the project’s performance-sharing across investors respects the individual investor’s risk limit while staying as close as possible to his/her percentage contribution in equity of the project. The proposed arrangement of performance-sharing thus ensures that the investors with constrained risk limits take less share of performance during high-risk episodes, while the less constrained investors are more exposed. The former pay a premium to the latter to compensate for the partial risk transfer. The proposed performance-sharing agreement is expected to be especially useful for risk-constrained equity investors who are restricted in their use of risk-free investments to reduce investment risk.