Optimal Debt with Unobservable Investments

Abstract

We study financial contracting when both an entrepreneur's investment and the resulting revenue are unobservable to an outside investor. The optimal contract must induce the entrepreneur both to choose a particular investment and to repay the investor; what complicates the problem is that once the contract is signed, the entrepreneur's incentives to invest may differ from his ex-ante incentives. We show that a debt contract is always optimal; repayment is induced by a liquidation threat that increases with the extent of default. We further show that when the entrepreneur's decision concerns the scale of his project, a contract that minimizes liquidation losses is optimal. When the entrepreneur's decision concerns his managerial effort or the riskiness of a project, however, it may be optimal to write a contract with a greater threat of liquidation, in order to induce the entrepreneur to exert more effort or to choose a less risky project.

Keywords: financial contracting, security design, debt, bankruptcy, agency problems, moral hazard, risk-shifting, asset substitution

JEL Classification: D82, G32, G33