This paper presents the theory that managers can use the liquidity of securities as a choice variable to screen for deep-pocket investors, those that have a low likelihood of facing a liquidity shock. We assume an information asymmetry about the quality of the manager between the existing investors and the market. The manager then faces a lemons problem when he has to raise funds for a subsequent fund from outside investors, because the outsiders cannot determine whether the manager is of poor quality or the existing investors were hit by a liquidity shock. Thus, liquid investors can reduce the manager's cost of capital in future fundraising. We test the assumptions and predictions of our model in the context of the private equity industry. Consistent with the theory, we find that transfer restrictions on investors are less common in later funds organized by the same private equity firm, where information problems are presumably less severe. Also, partnerships whose investment focus is in industries with longer investment cycles display more transfer constraints. Finally, we present evidence consistent with the assumptions of our model, including the high degree of continuity in the investors of successive funds and the ability of sophisticated investors to anticipate funds that will have poor subsequent performance.

The paper builds a tractable model of patent pools, agreements among patent owners to license sets of their patents. It provides a necessary and sufficient condition for patent pools to enhance welfare and shows that requiring pool members to be able to independently license patents matters if and only if the pool is otherwise welfare reducing. The paper allows patents to differ in importance, asymmetric blocking patterns, and licensors to also be licensees. We undertake some initial exploration of the impact of pools on innovation. The analysis has broader applicability than pools, being relevant to a number of co-marketing arrangements.