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FIIT-5: Funding liquidity
A theory of liquidity in private equity
1Stockholm School of Economics, Sweden; 2Duke University
We propose a model of Private Equity (PE) investment that can rationalize several empirical findings about funds and returns. General partners (GPs) pos- sess superior investment skills and raise capital from Limited Partners (LPs) to finance illiquid projects within funds. The optimal fund contract incentivizes GPs to maximize the expected payoff of fund investments by compensating them with a profit share in the fund. LPs on the other hand need to be compensated for the liquidity risk they face relative to liquid investments. The amount of funds that can be raised from LPs is limited by the amount of wealth that GPs can co-invest themselves. For a given amount of GP co-investment, fund size is higher when LPs expect to be more liquid. When PE investments become more attractive, GPs prefer to increase the size of their fund instead of increasing their profit share if their investments opportunities are scalable. LPs with higher expected liquidity will realize higher returns to PE relatively less liquid LPs, reflecting the scarcity of liquid capital. When LPs can trade their fund investments in a sec- ondary market, partnership claims trade at a discount when aggregate liquidity is scarce. The introduction of a secondary market can lead to a segmentation of LPs where less liquid LPs make primary fund commitments, while more liquid LPs focus on secondaries.
Crowdfunding, Initial Coin Offerings, and Consumer Surplus
1Washington University in St Louis, United States of America; 2University of California Berkeley, United States of America
We study the efficiency implications of crowdfunding with an active resale market, as in the case of initial coin offerings. Product market competition prevents a firm from extracting full surplus from consumers. Hence, traditional bank funding based on cashflow leads to underinvestment. Crowdfunding mitigates this problem by letting consumers fund the firm directly. While the resale market gives consumers an option to sell their claims to future consumers, future consumers cannot commit to paying for their surplus; underinvestment persists. Speculative premia in the resale market can remedy the problem, but also can cause overinvestment.
Dealer Funding and Market Liquidity
1Humboldt University of Berlin; 2INSEAD
We consider a model in which dealers need to raise external financing to provide immediacy to their clients, and also exert unobservable effort to improve the chance of closing their positions at a profit. This moral hazard problem affects how and how much external finance dealers can raise. Therefore, it limits intermediation volume, softens competition between dealers, and widens bid-ask spreads. When dealers suffer losses, the problem becomes worse. Effects are stronger for riskier assets. Endogenous correlation and contagion in liquidity arise between otherwise unrelated assets. As the optimal financing arrangement involves debt, regulations that limits the leverage of bank-affiliated dealers can have adverse effects on market liquidity.
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