The Disciplinary Role of Debt and Equity Contracts: Theory and Tests

Abstract

This article studies how financial contracts commit investors to disciplinary actions after poor managerial performance. Two questions are addressed both theoretically and empirically: What disciplinary action should investors choose to motivate their managers? And what is the optimal capital structure, debt structure and allocation of control rights that implements the chosen disciplinary action? The paper shows that investors should choose the least costly disciplinary action. When the least costly disciplinary action is managerial replacement, control rights should be allocated at the outset to equity holders, and capital structure should consist of equity and long-term debt. If the least costly disciplinary action is liquidation or stopping projects then short-term debt is necessary and, at the outset, control can be allocated to the manager. The predictions of the model are tested on a sample of leveraged buyout transactions in the U.S. between 1986 and 1989.