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  5. Corporate Finance: Contracts and Incentives
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Corporate Finance: Contracts and Incentives

Paper Session

Saturday, Jan. 6, 2024 8:00 AM - 10:00 AM (CST)

Marriott Rivercenter, Grand Ballroom Salon C
Hosted By: American Finance Association
  • Chair: Adriano Rampini, Duke University

The Optimality of Debt

Pierre Chaigneau
,
Queen's University
Alex Edmans
,
London Business School
Daniel Gottlieb
,
London School of Economics

Abstract

Standard theories of debt consider a risk-neutral manager and a single contractible performance measure ("output"). It seems that debt may no longer be optimal if the manager is risk-averse and thus dislikes being the residual claimant, or if additional performance signals are available. This paper shows that debt remains the optimal contract under additional signals -- they only affect the contractual debt repayment, but not the form of the contract. While debt may remain optimal under risk aversion, this may not be the case even if risk aversion is low, and even if there is no trade-off between incentives and risk sharing.

Household Debt Overhang and Human Capital Investment

Gustavo Manso
,
University of California-Berkeley
Alejandro Rivera
,
University of Texas-Dallas
Hui Wang
,
University of Texas-Dallas
Han Xia
,
University of Texas-Dallas

Abstract

Unlike labor income, human capital is inseparable from individuals and does not completely accrue to creditors, even at default. As a consequence, human capital investment should be more resilient to “debt overhang” than labor supply. We develop a dynamic model displaying this important difference. We find that while both labor supply and human capital investment are hump-shaped in leverage, human capital investment tails off less aggressively as leverage builds up. This is especially the case when human capital depreciation rates are lower. Importantly, because skills acquisition is only valuable when households expect to supply labor in the future, the anticipated greater reduction in labor supply due to debt overhang back-propagates into a reduction in skills acquisition ex ante. Using longitudinal data, we provide empirical support for the model.

Monitoring with Small Stakes: Evidence from Leveraged Loans

Sheila Jiang
,
University of Florida
Shohini Kundu
,
University of California-Los Angeles
Douglas Xu
,
University of Florida

Abstract

The growing participation of institutional investors in the risky segment of corporate lending, which requires effective creditor monitoring poses a challenge to the conventional wisdom that banks’ retention of sufficiently large stakes in their originations is key to the provision of adequate monitoring incentives. We propose a new mechanism that provides an explanation behind the monitoring with small stakes puzzle and rationalizes the design of split control contracts in the leveraged loan market. We conceptualize two sources of incentive provision for creditors to conduct costly monitoring: skin in the game and rent extraction from renegotiation. As an alternative to skin in the game, the rent extraction-based mechanism plays a critical role in the provision of monitoring incentives and facilitating the participation of institutional investors in leveraged lending. We use the passage of a tax policy as a natural experiment that implies an exogenous reduction in renegotiation frictions to empirically identify the key channel of our theoretical framework. We find that a less frictional renegotiation environment leads to greater improvements in the performance of existing loans associated with the split control structure, and impacts the contractual features of newly issued loans that are arranged as split control deals relative to non-split control deals. Our analysis and findings provide important policy implications regarding the increasing participation of non-monitoring institutional investors in lending markets that require intensive creditors monitoring.

Discussant(s)
Ernst-Ludwig von Thadden
,
University of Mannheim
Constantine Yannelis
,
University of Chicago
Bo Becker
,
Stockholm School of Economics
JEL Classifications
  • G3 - Corporate Finance and Governance