Determinants of the Usefulness of Inside Debt in Debt Contract Design

Abstract

Evidence shows that managers’ debt-like compensation (i.e., inside debt) aligns their incentives with lenders’, reducing the agency cost of debt. We examine how changes in the contracting environment affect the use of inside debt in debt contracting. We find evidence of reduced reliance on inside debt for debt contracting when borrowers have credit constraints, consistent with a shift in bargaining power to lenders, and when firms experience financial distress, consistent with increased agency costs when bankruptcy is more probable. We detect reduced reliance on inside debt for debt contracting during the financial crisis and during shocks to industry demand, two plausibly exogenous shocks to firms’ contracting environments. In total, the results suggest that the role of inside debt changes predictably with the contracting environment.