Ebook Debt Covenants and Distressed Equity Issuance: Optimal Financing in the Presence of Monitoring
Monitoring is an important feature of many corporate finance theories, and the recent empirical literature on debt covenants has shown that monitoring is a vital feature of debt. As a firm experiences losses, it triggers covenants, and management finds itself increasingly restricted in what corporate policies it can use. Covenants can alleviate agency problems but they are potentially costly to the firm exactly because they restrict the set of management choices. Despite this, the role of monitoring has remained relatively unexamined in dynamic settings, including the dynamic theory of security design. The primary obstacle has been the lack of a parsimonious monitoring model.
Our paper makes three contributions. First, we present a parsimonious dynamic principal agent model with monitoring, and we characterize the optimal contract. Second, we show that this contract can be implemented with debt and equity, where debt covenants implment monitoring choices and equity issuance implements changes in performance sensitivity allowed by monitoring. In doing so, we can explain patterns in both the use of debt covenants and equity issuance, and we make new testable predictions. Third, we show that the optimal equity issuance policy arises in a game with strategic actions by equity holders and management. After we present the model in the main text and describe its properties, we will discuss our empirical predictions in the conclusion (Section 7).
We begin with a dynamic agency problem similar to DeMarzo and Sannikov (2oo6) in which the project manager with limited liability can imperfectly divert cash flows for his own consumption. To induce the manager to report cash flows accurately, the principal can use standard performance based incentives, where low performance leads to termination of the project but high performance leads to additional consumption for the agent.
The manager adds value to the project, so termination of the project (default) is costly to the principal because he retains the now less valuable assets. We extend this setting by allowing the principal access to a stochastic monitoring technology that can detect diversion by the manager. This second technology represents an average profitability vs. monitoring trade off: the principal can impose constraints that make diversion more difficult (less efficient) but only at the cost of reducing the overall profitability of the project. Using pay for performance incentives results in a higher average project profitability, but they also increase the likelihood of costly termination because the manager is receiving a higher share of the projects gains and losses. The optimal contract efficiently trades off these two ways of providing incentives to the manager.
We derive an optimal contract that maximizes the total surplus from the project. In our continuous time setting, the contract takes a tractable form. The managers expected payoff from now until the termination of the contract (continuation utility) acts as a state variable that determines the nearness to default and the efficient trade off between the two incentive technologies. When the project nears default, the principal becomes effectively more averse to volatility in the managers continuation utility, and so the principal switches to the use of monitoring and away from performance based promises. When the managers continuation utility becomes large enough, the principal pays the manager out of the collection of promises.
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