From the perspective of “law and economics,” corporations are seen as “nexus of contracts.” This is a view that a corporation is made up of many long term contracts. And this nexus of contracts theory applies not only to corporation but to other firms as well. If that is the case, how would limited partnerships be interpreted under the nexus of contracts theory?
There are many things in partnerships that can be argued in the same manner as corporations. When seeing from the principal agency model (which is in a core of nexus of contracts theory), shareholders are principals and directors are agents for a corporation. Whereas, in a limited partnership, limited partners are principals and the general partner is the agent. The general partner, as an agent, will act to maximize the benefit of the principals (the limited partners). In that case, what will be the difference between partnerships and corporations, seeing from this principal agency model? I would like to raise two points.
The first point is that incentives are more aligned between the principals and agents in case of a partnership. The general partner receives certain percentage of the limited partnership’s profit (distribution) as carried interest, so it is very clear that the general partner will make more money if it can bring more profit to the limited partners. On the other hand, directors’ remuneration is often a fixed amount. Even though a stock option can be issued to directors to directly link their incentive to the wealth of shareholders, gains earned by stock options are relatively smaller and it is not so easy to realize the gains earned by stock options. Also, a share price is influenced by many factors and it is difficult for directors to control by their sole efforts (as compared to a profit). And we are all aware that there is an increasing pressure against directors to consider the benefits of stakeholders other than the shareholders. Thus, principal agency model in limited partnerships has much simpler and straightforward incentive alignment.
The second point is that the general partner of a partnership fund has much more discretion in terms of business operation as compared to a director of a corporation. The limited partners do not have the same level of voting rights as shareholders have at shareholders’ meeting. Limited partners’ power to dismiss the general partner is very limited in most cases. Thus, the general partner can concentrate on maximizing long term benefit of its principals, as compared to directors who faces the risk of being dismissed by shareholders’ resolution.
Well, the second point raises a question that whether limited partners can monitor and control its agent (the general partner) effectively as expected by principal agency theory. However, the general partner has sufficient incentive to achieve good performance for the limited partners, because if the performance of the fund is poor, the general partner will not be able to raise its subsequent funds and will be required to exit from the investment fund industry in a few years.
To summarize, partnership funds are more loyal to original concept of the principal agency theory. Thus, investors may have become aware that investments in partnerships funds have lower agency cost and thus better return as compared to other vehicles such as corporations. I believe that the above is one of the factors that have contributed to the increasing use of partnerships over the years.
(Of course I do not deny that tax structuring is very important factor in choosing partnerships as investment vehicles, but it is sometimes meaningful to see things from a different angle.)