Abstract
I show equity mutual funds invest less in companies with higher CEO inside debt, whereas corporate bond funds invest more in such companies. The effect persists after accounting for endogeneity using first-time mandatory disclosure of inside debt in 2007 as a quasi-natural experiment, and using state-level personal income tax rates as instruments for inside debt. This finding suggests that fund managers pay attention to incentive implications of inside debt when making portfolio decisions. The effect of inside debt on portfolio allocation is stronger in firms with higher likelihood of default and higher idiosyncratic risk, firms suffering from debt overhang, and firms with lower credit ratings. Lastly, equity funds that underweight high-inside debt firms and bond funds that overweight them deliver positive alphas.
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