Short-Term Termination Without Deterring Long-Term Investment: A Theory of Debt (Not Dividends)

Abstract:     
The option to terminate a manager early minimizes investor losses if he is unskilled. However, it also deters a skilled manager from undertaking long-term projects that risk low earnings. This paper introduces a novel role of debt that allows it to overcome this tension. Leverage concentrates equityholders' stakes, creating incentives for them to learn the cause of low earnings. If they result from investment (poor management), the firm is continued (liquidated). Therefore, unskilled managers are terminated and skilled managers can invest without fear of termination. Unlike models of managerial discipline based on total payout, here dividends are not a substitute for debt. Dividends only achieve termination upon non-payment; debt also leads to concentration, ex post monitoring by the investor and thus ex ante investment by the manager. Debt is dynamically consistent as the manager benefits from monitoring by a concentrated investor. In traditional theories, monitoring constrains the manager; here it frees him to take long-term projects.

Keywords: Termination, liquidation, managerial myopia, long-term investment, ownership concentration, monitoring, corporate governance, leverage, private equity

JEL Classifications: D82, G32, G33

Working Paper Series