03 / 2006 Real options in partnerships

We study partnership contracts under uncertainty but with clauses that admit downstream flexibility. The focus is on effects of flexibility on the synergy set, the core, of the contract. In a partnership context the value of flexibility is captured by the partners who own the right to exercise. On one side, there are cooperative options, which are exercised jointly and in the interest of maximizing the total contract value, on the other side, there are non-cooperative options, which are exercised unilaterally, or by coalitions, in the interest of the option holders’ payoffs. We provide a modelling framework that captures the effects of optionality on partnership synergies. We study these effects under a complete markets assumption, based on standard contingent claims analysis, as well as under heterogenous risk-aversion, using a dynamic programming model. The models shows the effect of several strategies on the synergy set and the bargaining position of the partners. It also shows that non-cooperative options, if agreed prior to the negotiation, are powerful bargaining tools but that they can also destroy the partners’ incentive to participate in the contract. Finally, the model illustrates how risk sharing provides larger synergies for partners with heterogeneous risk attitudes.