Dynamic Financial Contracting with Persistent Private Information

Abstract

This paper studies a dynamic agency model in which the agent privately observes the firm's cash flows that are subject to persistent shocks. Persistent private information alleviates the agency problem. Because bad firm performance distorts investors' forecast downward, it's optimal to lower future investment, leading to smaller future information rents. The compensation is therefore less than what the agent can divert and is convex in performance. We show that promising agent utilities contingent on performance today and tomorrow is effective in providing incentive and formulating the problem recursively. The optimal contract can be implemented by equity, stock options, credit line, and long-term debt. In contrast to the iid case, our findings are more in line with the empirical evidence, viz, (i) the agent is compensated via equity and stock options; (ii) firm credit line limits and coupon payments are contingent on compliance with a cash flow covenant; (iii) the firm (possibly) experiences longer time of being financially constrained; (iv) investment is efficient in the constrained firm, and is varying with cash flow in the unconstrained firm.