Abstract
Abstract This article characterizes optimal compensation contracts in principal-agent settings in which the consequences of the agent’s action are only observed over time. The optimal timing of pay trades off the costs of deferred compensation arising from the agent’s relative impatience and potential consumption smoothing needs against the benefit of exploiting additional informative signals. By capturing this information benefit of deferral in terms of the likelihood ratio dynamics, our characterization covers general signal processes in a unified setting. With bilateral risk neutrality and agent limited liability, optimal contracts are high-powered and stipulate at most two payout dates. If the agent is additionally risk-averse, payouts are contingent on performance exceeding a hurdle that is increasing over time. We obtain clear-cut predictions on how the duration of optimal compensation depends on the nature of information arrival as well as agent characteristics and derive implications for the maturity structure of securities in financial contracting settings.
Highlights
In many real-life principal-agent relationships, actions by agents have long-lasting – not immediately observable – effects on outcomes
How does one optimally structure the intertemporal provision of incentives in “only time will tell ” information environments when the agent’s liquidity and consumption smoothing needs make it costly to defer compensation? We allow for abstract, general information systems, and, yet, obtain a tractable and intuitive characterization of optimal contracts, in particular of the optimal duration of pay
Using simple convexification arguments we show that optimal contracts may require two payout dates in order to exploit significant changes in the growth rate of informativeness over time
Summary
In many real-life principal-agent relationships, actions by agents have long-lasting – not immediately observable – effects on outcomes. In a financial contracting context, our model allows us to derive predictions about the optimal maturity structure of an entrepreneur’s financing decisions: We show that insiders optimally receive payouts if and only if the “discounted likelihood ratio” is above a cutoff This implies a rich dynamic payoff structure for insiders’ and outsiders’ claims, resulting from the trade-off between the entrepreneur’s liquidity needs and the increased informativeness associated with new performance signals available to investors.. The first paper in this literature strand by Hopenhayn and Jarque (2010) analyzes optimal contracts in a discrete-time setting with a risk-averse agent While they obtain some characterization once they restrict their setup to i.i.d. binary signals, they do not generate concrete implications for the timing of pay. We provide sufficient conditions on either the information process (Condition 1), limits on transfers (Condition 2) or the utility function (Condition 3) that guarantee existence of a solution to Problem 1
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