Abstract
We analyse an incentive contracting model of partnership formation between heterogeneous investors and entrepreneurs. Partnerships are subject to double‐sided moral hazard problems in entrepreneurial action and monitoring by investors. Greater monitoring ability implies stronger incentives to monitor. On the other hand, low‐collateral borrowers have lower inside equity participation. Hence the incentive problem is best mitigated by assigning low‐collateralized entrepreneurs to high‐ability investors following a negative assortative matching pattern. Moreover, negative assortative matching implies that the equilibrium loan rate is in general non‐monotonic in borrower collateral. Finally, our model sheds light on how changes in the inequality of collateral distribution affect the cost of external borrowing.
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