Optimal Financial Contracts in Leveraged Buy Out: A Double-Sided Moral Hazard Model

Abstract

We consider a double moral hazard model with three agents: the entrepreneur, the LBO fund and the bank. The entrepreneur and the LBO fund have to exert efforts in order to improve the productivity of their project; efforts are not observable. We show that the bank's payments decrease with the outcome of the project. When the project is not very risky, the entrepreneur and the LBO fund exert first best efforts and they get equal shares of the project's outcome. When it is highly risky, debt gives high powered incentives to the two agents to provide efforts but it still not sufficient to induce them to provide the first best efforts. However, these efforts are more efficient than those that could be provided if the entrepreneur asks the LBO fund for advice and money. Moreover, when the entrepreneur asks for advice from a consultant and for money from a bank, they get equal shares whether the project is very risky or not. When the project is lowly risky, the identity of the advisor (consultant/ LBO fund) is irrelevant. When it is highly risky, the optimal financial structure of capital depends on the impact of their efforts on the performance of the project.