Short-Term Termination Without Deterring Long-Term Investment: A Theory of Debt and Buyouts

42 Pages Posted: 8 Jun 2006 Last revised: 20 Dec 2013

See all articles by Alex Edmans

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Date Written: February 9, 2011

Abstract

The option to terminate a manager early minimizes investor losses if he is unskilled. However, it also deters a skilled manager from undertaking efficient long-term projects that risk low short-term earnings. This paper demonstrates how risky debt can overcome this tension. Leverage concentrates equityholders' stakes, inducing 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 invest without fear of termination. Unlike models of managerial discipline based on total payout, dividends are not a substitute for debt -- they allow for termination upon non-payment, but at the expense of investment since they do not concentrate ownership and induce monitoring. Debt is dynamically consistent as the manager benefits from monitoring. In traditional theories, monitoring constrains the manager; here it frees him to invest.

Keywords: Termination, liquidation, managerial myopia, ownership concentration, monitoring, leverage, private equity

JEL Classification: D82, G32, G33

Suggested Citation

Edmans, Alex, Short-Term Termination Without Deterring Long-Term Investment: A Theory of Debt and Buyouts (February 9, 2011). Journal of Financial Economics 102(1), 81-101, October 2011. Available at SSRN: https://ssrn.com/abstract=906331

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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