Investment Incentives, Bankruptcies and Reverse Convertible Debt
35 Pages Posted: 20 May 2015
Date Written: March 1, 1995
The combination of risky cash flows, leverage and absolute priority rules in bankruptcy create a well known agency problem; shareholders face incentives to take risky, as opposed to value maximizing, investment projects. Recently, it has been argued that deviation from absolute priority rules in bankruptcy or workouts mitigates this problem. Working with the principle of contract theory that ex ante welfare gains can be maximized by pre-commitment (if contracts are resistant to re-negotiation), we consider efficiency gains from pre-commitment to such alternatives to absolute priority. The instrument is an inversion of convertible debt in which the conversion option is held by the owners. This instrument can be designed so that the conversion option is less costly ex post (i.e., after issue of debt) to bondholders than the default put implicitly embedded in non convertible debt. This design not only lessens the ex ante incentive problem but avoids the transaction costs of bankruptcies and workouts. Finally, we show that this form of debt is re-negotiation proof.
Keywords: reverse convertible debt, bankruptcy, pre-commitment
JEL Classification: G32, G33
Suggested Citation: Suggested Citation