Are Two Investors Better Than One?

Abstract

The paper compares the optimal financial contracts of a firm which has private information over its expost revenues when the finance can be provided by a single or by two groups investors. Costly monitoring can be carried out only by one group of investors. When they are the only investors we use a financial contract with non-contractible monitoring, in which the probabilities of cheating by the entrepreneur/firm and monitoring by investors are mutual best responses. The contract is written by the entrepreneur knowing that this equilibrium will subsequently occur. With a second group of investors who have no monitoring rights, cheating and monitoring probabilities are chosen in a similar way. The non monitoring investors learn the results of any monitoring for free. A main result is that without commitment there is a negative correlation between repayments to the two investor groups: The contract uses the non-monitoring group to smooth out the repayments of the entrepreneur optimally. This reduces his incentive to make false reports and mitigates the investor's incentive to monitor. A second result is that the two investor scenario is Pareto superior to the single investor model. A third result is that the possible extent of this smoothing depends on whether the investors have limited liability; it is found that in some circumstances investors should make repayments to the firm rather than receive them. A further result is that, by restricting to offers coming from the informed party, the three party contract is collusion-proof. Last we show that under limited liability the share of finance provided by the two investors is strictly positive.