Leveraged Buy Out: Dynamic Agency Model with Write-Off Option

Abstract

We present a dynamic agency model in which the LBO fund may write the entrepreneur's project off at the end of the starting stage to invest in a competitive project. The two partners provide unobservable efforts in both stages to enhance the productivity of the acquired company. We show that under restrictive conditions, the debt-equity contracts induce the entrepreneur and the LBO fund to provide the first best efforts under restrictive conditions in the two stages. Moreover, the write-off threat boosts the incentives of the entrepreneur and the LBO fund such that they provide high efforts. If the compensation cost is exogenous, the sharing rule of this cost depends on the quality of the competitive project. The entrepreneur and the bank share the amount of compensation if it is not very profitable. Otherwise, it is pledged to the entrepreneur. If the compensation's amount is endogenous, in order to induce the entrepreneur to provide high effort, the optimal financial contracts must give her the entire compensation's revenue.