By Patrick L Warren
I attended a great session in Paris this year, and I wanted to commend it to everyone's attention. It included three papers looking at how thinking carefully about relational contracts can affect how we understand firms' financing decisions. It changed how I think. I've attached the abstracts and links to the papers, as available. Check it out.
Dan Barron (Northwestern, Kellogg)
Jin Li (Northwestern, Kellogg)
An entrepreneur borrows money from the credit market, then repeatedly motivates her employees to work hard. If output is not contractible, then the entrepreneur faces commitment problems with both creditors and workers. The principal's financial obligations constrain her promises to workers and so determine productivity. In a profit-maximizing equilibrium, output starts low, increases as the principal repays the creditor, and may continue increasing after the debt has been repaid. Productivity eventually converges to a steady state that is independent of the initial loan. We apply this framework to show how internal agency relationships shape investment dynamics, liquidation, and debt forgiveness.
Florian Englmaier, (LMU Munich)
Matthias Fahn, (LMU Munich)
Abstract: The corporate finance literature documents that managers tend to overinvest into physical assets. A number of theoretical contributions have aimed to explain this stylized fact, most of them focussing on a fundamental agency problem between shareholders and managers. The present paper shows that overinvestments are not necessarily the (negative) consequence of agency problems between shareholders and managers, but instead might be a second-best optimal response if the scope of court-enforceable contracts is limited. In such an environment a firm has to rely on relational contracts in order to manage the agency relationship with its workforce. The paper shows that investments into physical productive assets enhance the enforceability of relational contracts and hence investments optimally are "too high".
Capital Structure Choice and the Cost of Enforcing Contracts - Theory and Evidence
Matthias Fahn, (University of Munich)
Valeria Merlo, (University of Tuebingen)
Wamser Georg, (University of Tuebingen)
Abstract: This paper analyzes the interaction between a firm's optimal capital structure and the type of contracts it uses to deal with its suppliers. We first develop a theoretical model where a firm needs an intermediate good from a supplier, and this intermediate good can be of high or low quality. Court-enforceable contracts can be used to enforce high quality, however their use is costly. If these costs are too high, relational contracts - self-enforcing informal arrangements that can be sustained in long-term relationships - are needed. Relational contracts, though, can only be sustained if debt is not too high. The reason is that a firm's commitment in relational contracts is determined by its future profits in the cooperative relationship, and the need to repay debt reduces future profits. We therefore derive the prediction that higher costs of enforcing formal contracts should be associated with firms having less leverage on average. We test this prediction with the help of two datasets, the Microdatabase Directinvestment (MiDi) provided by Deutsche Bundesbank, which gives balance sheet information on the universe of German foreign affiliates including detailed information on external debt, internal debt and equity capital, and the World Bank's Doing Business Database, which contains information on the average costs of enforcing (formal) contracts between a firm and a supplier of an intermediate good. Using a panel data model for fractional response variables, we can show that an increase in the costs of enforcing contracts in a country makes firms use substantially more equity financing.