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

Abstract

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.