Inside Debt

Abstract:     
Existing theories advocate the use of equity-like instruments in executive compensation. However, recent empirical studies have documented the prevalence of debt-like instruments such as pensions. This paper justifies the use of debt as efficient compensation. Inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses and salaries proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also the firm's value in bankruptcy. Contrary to intuition, it is typically inefficient to align the manager with firm value by granting him equal proportions of debt and equity. In most cases, an equity bias is desired to induce effort. However, if effort is productive in increasing liquidation value, or if bankruptcy is likely, a debt bias can improve effort as well as deterring risk shifting. The model generates a number of empirical predictions consistent with recent evidence.

Keywords: Agency costs of debt, asset substitution, risk shifting, corporate governance, executive compensation, liquidation, pensions

JEL Classifications: G32, G34, J33

Working Paper Series