Contingent Control Rights and Managerial Incentives: The Design of Long-term Debt

Enterprises, small or large, rely heavily on long-term financing arrangements to fund their operations. However, it has proved difficult for financial theory to justify the use of long-term contracts when the manager has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as a court, to verify or prove any managerial wrongdoing. Why would investors enter into financial contracts that extend beyond the life of the firm's existing physical assets when such contracts rely on the manager to make repeated investments during the life of the contract? How can investors induce the manager to make these investments when such investments cannot be contracted upon? In this paper we show that with the appropriate design of the control rights longer-term debt contracts can become sustainable. In particular, investors are willing to hold long-term debt if they are granted (1) the right to dismiss the manager and to take over the company as a going concern upon default; or (2) the right to dismiss the manager and to extend the maturity of the debt in default. Interestingly, it is the threat of dismissal that induces management to comply with the contract but it is the investors' ability to extend the maturity of the debt in default that makes this threat credible. Empirical evidence reported by Gilson (1990, 1993), Gilson, John and Lang (1990), Franks and Torous (1993, 1994), Franks, Nyborg and Torous (1996), Franks and Sussman (1999) supports our view that creditors' right to dismiss manager and to take equity or to extend the maturity of the debt in default plays a key role in enforcing the repayment of debt. Once we established that long-term debt is sustainable, the natural question to ask is whether investors would be indifferent between long-term debt and outside equity or whether they would prefer one over the other. Despite the strong similarity of the control rights and the maturity of debt and equity, investors will not be indifferent between the two securities in our model. If a project can raise long-term debt it can also raise outside equity but the reverse is not true: there are projects that cannot issue debt but may still obtain outside equity financing. This is so because of the nature of the control rights. Since debtholders have contingent control rights, they cannot exercise control unless default has occurred. Hence, the manager can devise more profitable default strategies by planning his default ahead of time and milking the assets prior to default. Since contingent control rights allow the manager more opportunities for wealth transfer from investors off the equilibrium path than unconditional rights, long-term debt contracts must offer the manager substantially higher incentive payments in equilibrium than equity. Thus, a project aiming to secure longer-term debt financing must show evidence of higher expected profitability than one seeking equity financing

The Defeasance of Control Rights

We analyze one frequently used clause in public bonds called covenant defeasance. Covenant defeasance allows the bond issuer to remove all of the bond's covenants by placing the remaining outstanding payments with a trustee in an escrow account to be paid out on schedule. Bond covenants are predominantly noncontingent, action-limiting covenants. By giving the issuer an option to remove covenants, noncontingent control rights can be made state-contingent even when no interim signals are available. We provide a theoretical justi cation for covenant defeasance and show empirically that such a clause allows for the inclusion of more covenants in public bond issues. In line with the model's prediction, our empirical analysis documents a 13-25 basis points premium for defeasible bonds. This premium amounts to an annual saving of about $1m per year, or$11m over the lifetime of an average bond.Bonds; Covenants; Defeasance; Renegotiation

Venture Capital Contracting and Syndication: An Experiment in Computational Corporate Finance

This paper develops a model to study how entrepreneurs and venture-capital investors deal with moral hazard, effort provision, asymmetric information and hold-up problems. We explore several financing scenarios, including first-best, monopolistic, syndicated and fully competitive financing. We solve numerically for the entrepreneur's effort, the terms of financing, the venture capitalist's investment decision and NPV. We find significant value losses due to holdup problems and under-provision of effort that can outweigh the benefits of staged financing and investment. We show that a commitment to later-stage syndicate financing increases effort and NPV and preserves the option value of staged investment. This commitment benefits initial venture capital investors as well as the entrepreneur.

Capital Structure Decisions in Small and Large Firms: A Life-cycle Theory of Financing

This paper focuses on the dynamic capital structure of firms: Why do firms use very different financial contracts in different stages of their life-cycles? In a model of optimal financial contracting, we investigate whether firms' subsequent financing decisions are affected by the outcome of their previous financing decisions. We find that the initial and subsequent financing decisions of the same firm may lead to different security choices. The firms' financing decisions will differ in two respect. First, there will be equilibrium contracts that investors would reject for some startup firm, but would accept for an otherwise identical ongoing ¯rm (i.e. even when the two firms have identical projects). Secondly, even the set of the equilibrium financial contracts differs in different stages of the firm's lifecycle: some contracts which are never sustainable as an initial contract but become sustainable as a subsequent contract. The reason is the stage-dependency of the control rights of subsequent claimholders: in addition to their own rights, holders of subsequent security issues may also rely on the firm's existing investors to enforce their claims. Whether or not they can do so, depends on the priority structure of the claims

The Optimality of Debt versus Outside Equity

This paper presents a theory of outside equity based on the control rights and the maturity design of equity. We show that outside equity is a tacit agreement between investors and management supported by equityholders’ right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity. Furthermore, as a tacit agreement outside equity is sustainable despite management’s potential for manipulating or diverting the cash flows and regardless of how costly it is for equityholders to establish a case against managerial wrongdoing. We establish that the only outside equity hat investors are willing to hold in equilibrium is outside equity with unlimited life, the very outside equity that corporations issues. Consistent with empirical evidence, this model predicts that debt-equity ratios will be higher in industries where cash flow variability is low relative to industries where cash flow variability is high. Furthermore, our theory implies that investors practice maturity- matching: they match the maturity of the optimal debt contract with the life of the physical assets and the maturity of the equity contract with the life of the company’s real options

Contingent Control Rights and Managerial Incentives: The Design of Long-term Debt

Enterprises, small or large, rely heavily on long-term financing arrangements to fund their operations. However, it has proved difficult for financial theory to justify the use of long-term contracts when the manager has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as a court, to verify or prove any managerial wrongdoing. Why would investors enter into financial contracts that extend beyond the life of the firm's existing physical assets when such contracts rely on the manager to make repeated investments during the life of the contract? How can investors induce the manager to make these investments when such investments cannot be contracted upon? In this paper we show that with the appropriate design of the control rights longer-term debt contracts can become sustainable. In particular, investors are willing to hold long-term debt if they are granted (1) the right to dismiss the manager and to take over the company as a going concern upon default; or (2) the right to dismiss the manager and to extend the maturity of the debt in default. Interestingly, it is the threat of dismissal that induces management to comply with the contract but it is the investors' ability to extend the maturity of the debt in default that makes this threat credible. Empirical evidence reported by Gilson (1990, 1993), Gilson, John and Lang (1990), Franks and Torous (1993, 1994), Franks, Nyborg and Torous (1996), Franks and Sussman (1999) supports our view that creditors' right to dismiss manager and to take equity or to extend the maturity of the debt in default plays a key role in enforcing the repayment of debt. Once we established that long-term debt is sustainable, the natural question to ask is whether investors would be indifferent between long-term debt and outside equity or whether they would prefer one over the other. Despite the strong similarity of the control rights and the maturity of debt and equity, investors will not be indifferent between the two securities in our model. If a project can raise long-term debt it can also raise outside equity but the reverse is not true: there are projects that cannot issue debt but may still obtain outside equity financing. This is so because of the nature of the control rights. Since debtholders have contingent control rights, they cannot exercise control unless default has occurred. Hence, the manager can devise more profitable default strategies by planning his default ahead of time and milking the assets prior to default. Since contingent control rights allow the manager more opportunities for wealth transfer from investors off the equilibrium path than unconditional rights, long-term debt contracts must offer the manager substantially higher incentive payments in equilibrium than equity. Thus, a project aiming to secure longer-term debt financing must show evidence of higher expected profitability than one seeking equity financing

Control Rights and Maturity: The Design of Debt, Equity, and Convertible Securities

This paper investigates the design of the control rights and the maturity of securities when management has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as court, to verify or prove any managerial wrongdoing. By endogenizing claim structures, control rights and maturity, I derive a diverse set of optimal contracts. Debt with a maturity shorter than the life of the assets is sustainable when investors have the contingent right to liquidate the firm's assets. Long-term debt can be sustained by investors' right to dismiss management and take over the firm as a going-concern in the event of a default. Investors are willing to hold indefinite life equity if they are granted either the unconditional right to liquidate firm's assets or the unconditional right to dismiss management. Finally, convertible debt can be sustained by investors' right to dismiss management and take over the firm in the event of default by the holder's option to convert their debt contract to an equity contract prior to its expiration date. Consistent with empirical evidence, this model predicts that small entrepreneurial firms use short term bank loans, convertible debt, or outside equity at their initial financing stage; as they show evidence of higher profitability, they can secure longer-term financing

The Dynamics of the Management-Shareholder Conflict

This paper investigates the distribution of equity ownership between entrenched corporate insiders and dispersed outsiders when management has the ability to divert or manipulate the cash flows and when it is costly for equity holders to verify or prove any managerial wrongdoing for a third party such as a court. Management chooses the distribution of equity ownership so as to maximize private benefits against the risk of potential control challenges. When shareholders are long term oriented, then outside shares trade at a premium over their value to management, and management is inclined to sell of its equity stake to dispersed outsiders. When shareholders are short-term oriented, then outside share trade at a discount below their value to management, and disciplinary pressure can be substantially reduced via strategic share purchases

Control Rights and Maturity: The Design of Debt, Equity, and Convertible Securities

This paper investigates the design of the control rights and the maturity of securities when management has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as court, to verify or prove any managerial wrongdoing. By endogenizing claim structures, control rights and maturity, I derive a diverse set of optimal contracts. Debt with a maturity shorter than the life of the assets is sustainable when investors have the contingent right to liquidate the firm's assets. Long-term debt can be sustained by investors' right to dismiss management and take over the firm as a going-concern in the event of a default. Investors are willing to hold indefinite life equity if they are granted either the unconditional right to liquidate firm's assets or the unconditional right to dismiss management. Finally, convertible debt can be sustained by investors' right to dismiss management and take over the firm in the event of default by the holder's option to convert their debt contract to an equity contract prior to its expiration date. Consistent with empirical evidence, this model predicts that small entrepreneurial firms use short term bank loans, convertible debt, or outside equity at their initial financing stage; as they show evidence of higher profitability, they can secure longer-term financing

Privatization with Political Constraints: Auctions versus Private Negotiations

This paper investigates the design of privatization mechanisms in emerging market economies characterized by political constraints that limit the set of viable privatization mechanisms. Our objective is to explain the striking diversity of privatization mechanisms observed in practice and the frequent use of an apparently suboptimal privatization mechanism: private negotiations. We develop a simple model wherein privatization is to be carried out by a government agent who plays favorites among bidders and is potentially disciplined by forthcoming elections. We find that it is the degree of political constraints that determines which mechanism is more successful in raising funds. If the political environment is such that the privatization agent himself aims at raising the fair value for the company, then privatization auctions and private negotiations are equally successful in raising public revenues. If, however, political constraints distort the agent’s incentives, then one mechanism outperforms the other. In particular, if the distortion is moderate, then private negotiations can raise more value for a successful enterprise than privatization auctions. In this case the agent may play favorites among the bidders, but to the extent he cares about the price, he will use his bargaining power to negotiate his target price. If, however, the distortion is severe so that the agent lacks sufficient motivation to raise a fair price for the company, then privatization auctions will outperform private egotiations. Even though the agent may play favorites among the bidders, he would not put pressure on the bidders to raise the price during negotiations. In an auction, in contrast, the presence of other bidders, regardless how informed they are, induces competition and places a lower bound on the equilibrium winning bid. We also show that information disclosure laws may have negative welfare implications: they may help the privatization agent to collude with some of the bidders to the disadvantage of non-colluding bidders. Our theory provides further regulatory implications for privatization procedures in emerging market economies