The Effect of Leverage on Implicit Incentive Contracts

Abstract

In the context of an infinitely-repeated principal-agent problem with hidden information, I examine the effect of long-term debt on implicit (relational) contracts between the firm and employees/suppliers. Implicit contracts rely on the promise of future surplus as an incentive for parties to fulfill obligations. Long-term debt reduces the discounted value of bilateral surplus accruing to the principal and agent, monotonically compressing the set of credible self-enforcing bonus schedules. Moderate (high) leverage results in partial (complete) pooling. With positive debt, the agent's output is always below first-best. In the event of complete pooling, output for all types is below first-best for even the highest cost type.