A Unified Theory of Delegated Capital Management

Alternative funds differ sharply from mutual funds: institutional investors dominate, fees are performance-based and investor-specific, access is rationed, and some investors earn positive alpha. We show that these differences arise endogenously in competitive capital markets when managerial skill is uncertain. With liquid, transparent assets, investors optimally learn from performance, capital adjusts through flows, investors earn zero alpha, and the mutual fund contract is optimal. With illiquid, opaque assets, costly ex ante due diligence becomes efficient, with institutions as information producers. Delegation creates a free-rider problem, requiring preferential terms for informed investors. The standard alternative-asset contract, featuring management fees, carried interest, preferential terms, and capped fundraising, implements the first best. Finally, delegation is necessary. Bilateral contracting avoids free riding but is inefficient because informed capital must both reveal information and determine fund size. Delegation separates these roles, allowing informed capital to reveal information while uninformed capital achieves efficient scale.