4. Adverse Selection
4.2 Interim asymmetric information and outside finance
τ 8
rl−3qg(rh−rl) rh−rl ,1
2
1−τ rl+qg2(rh−rl) qg−qb
(rh−rl)
.
Proof.See Appendix.
4.2 Interim asymmetric information and outside finance
While there is perfect competition for entrepreneurs at t =0, we have assumed that the (inside) investor is the only source of funding at the refinancing stage—that is, projects that are not refinanced by the inside investor cannot obtain refinancing from outside investors. Intuitively, the
market for outside finance may shut down at the refinancing stage owing to a ‘‘lemons problem.’’ The insiders, namely, the entrepreneur and inside investor, know the project’s interim type, but outside investors do not.
If successful projects are pooled with ‘‘lemons’’—that is, projects with interim type ψ=n—then outside investors may be unable to make an offer that can both attract successful projects and allow the investors to break even.
We proceed as follows. First, we show that there is always an equilibrium in which the market for outside finance shuts down at the refinancing stage, validating the assumption in our base model. Second, to the extent that there is also an equilibrium in which outside finance is feasible, we show that our results hold qualitatively. The inside investor is then no longer the only potential provider of capital at the refinancing stage, but she is still the only provider ofinformedcapital, as only she, but no outside investor, knows the project’s interim type. Accordingly, outside finance commands a lemons premium, providing the inside investor (again) with a strong bargaining position: While projects do not compete for scarcecapital at the refinancing stage, they now compete for cheaper(informed) capital.
For a lemons problem to exist at the refinancing stage, type ψ =n projects must have an incentive to seek outside finance. Otherwise, the pool of projects seeking outside finance would consist only of positive NPV projects. In our model thus far, insiders do not strictly benefit from luring outside investors into refinancing a typeψ=nproject. But they do if we change our model as follows: Suppose typeψ=nprojects, instead of having a zero success probability, have a small but positive probabilitypn of generatingR >0. Ifpnis small, refinancing a typeψ=nproject remains a negative NPV investment.25Most importantly, this modification has no effect on our previous results. In particular, the renegotiatons between the entrepreneur and the inside investor remain exactly the same: There is still no refinancing of type ψ=nprojects by the inside investor, and typeψ=nprojects still generate a zero payoff if they are not refinanced.
However, the insiders now strictly benefit from luring outside investors into refinancing a typeψ=nproject: They have nothing to lose, but they may gainR−Dwith probabilitypn.
The market for outside finance att =1 operates as follows. Projects, represented by the insiders, express their willingness to seek outside finance.
Outside investors then compete to provide fundsI2in return for a share D≤Rof the project’s payoff.26Given the modification introduced above, the insiders now strictly prefer to seek outside finance for unsuccessful projects. In contrast, the insiders may have something to lose from seeking
25Precisely, it must hold thatpn< I2/R.
26In a two-payoff model, with one payoff beingR >0and the other payoff being zero, any feasible financial contract must necessarily involve a positive repayment if the payoff isR.
costly outside finance for successful projects. As successful projects are pooled with lemons, outside finance may be available only at unfavorable terms. If these terms are sufficiently unfavorable, the insiders may prefer not to refinance a successful project—thus realizingR0—instead of seeking costly outside finance. Formally, the insiders will seek outside finance for a typeψ∈ {l, h}project if and only if
λψ :=pψ(R−D)−R0 ≥0. (9) The difference
rψ−λψ=pψR−I2−pψ(R−D)=pψD−I2
represents the lemons premium associated with costly outside finance. If there was no asymmetric information vis-`a-vis outsiders, the insiders could always obtain fundsI2 in return for a repaymentF =I2/pψ, realizing an expected payoff of pψ(R−F )=pψR−I2. If there is asymmetric information, however, outside investors will demand a higher repayment D > Fowing to the possibility of financing a lemon.
Our equilibrium concept is that of perfect Bayesian Nash equilibrium in which outside investors rationally anticipate which projects seek outside finance. Given these rational beliefs, outside investors compete themselves down to zero profits. The following result characterizes all (pure-strategy) equilibria under constrained and unconstrained finance.
Proposition 4.Under unconstrained finance, the market for outside finance at the refinancing stage shuts down completely. Likewise, under constrained finance, there is always an equilibrium in which the market for outside finance shuts down. Depending onτ, there may exist two additional equilibria under constrained finance:If τ is sufficiently large, there exists an equilibrium in which all three interim types have access to costly outside finance at the refinancing stage, while if τ lies in some intermediate range, there exists an equilibrium in which only interim types ψ∈ {n, h}have access to costly outside finance.
Proof.See Appendix.
The intuition underlying Proposition 4 is straightforward. Given that any offer that outside investors make also attracts all lemons, outside investors must setD relatively high to break even. Outside finance thus involves a lemons premium, which makes it costly. Under unconstrained finance, the inside investor has sufficient funds to refinance all successful projects. There is thus no need to draw on costly outside finance. This implies that the only projects seeking outside finance are lemons, which in turn implies that the market for outside finance shuts down. Likewise, under constrained finance, there is always an equilibrium in which the
market for outside finance shuts down. Irrespective ofτor other parameter values, if outside investors believe that only lemons seek outside finance, then outside finance becomes infeasible. This validates the assumption in our base model that the only source of funding at the interim stage is the inside investor.
But Proposition 4 also shows that, at least for certain parameter values, there may be additional equilibria under constrained finance in which outside finance is feasible at the refinancing stage.27 Arguably, since outside finance commands a lemons premium, the inside investor will always find it optimal to use up her capital of I2 to refinanceoneof the two projects (unless both are failures, of course). But if outside finance is feasible, then the other project mayalsobe refinanced—depending on the project’s interim type, of course—implying that inside and outside finance may coexist at the refinancing stage.
Given that there may be an equilibrium in which projects that are not refinanced by the inside investor have access to outside finance, it is important to check whether our previous results hold qualitatively if outside finance is costly but feasible. For the sake of brevity, we only consider the equilibrium in Proposition 4 in which all three interim types have access to costly outside finance. It is easy to verify that qualitatively similar results are obtained regarding the other equilibrium in which only typeψ=nand typeψ=hprojects have access to costly outside finance.
The following proposition establishes the analogue of the responsiveness condition (5) for the case in which outside finance is costly but feasible.
Proposition 5.Consider the equilibrium in Proposition 4 in which all three interim types have access to costly outside finance at the refinancing stage.
Given this equilibrium, the responsiveness of the entrepreneur’s expected payoff to his ex ante type is higher under constrained finance than under unconstrained finance if and only if
(rh−λh)−(rl−λl) < rl−λl
3qg . (10)
Proof.See Appendix.
The responsiveness condition is now expressed in terms of the lemon premiumrψ−λψ, as the insiders now bargain over the cost savings from using cheaper informed capital at the refinancing stage. Most importantly, the responsiveness condition retains its basic qualitative structure from Proposition 1. This points to the crucial driver behind the responsiveness
27The conditions for an equilibrium in which all three interim types have access to costly outside finance, and the one in which only interim typesψ∈ {n, h}have access to costly outside finance, are not mutually exclusive. It is easy to find values ofτfor which both equilibria exist (in addition to the equilibrium in which the market for outside finance shuts down, which always exists).
condition: There must be a benefit to being refinanced by the inside investor. This implies that there will be a benefit to being a high interim type, which in turn implies a benefit to exerting high effort. Whether this benefit arises because not being refinanced by the inside investor means not being refinanced at all, as in our base model, or whether it arises because not being refinanced by the inside investor means a lower surplus due to the use of costly outside finance, as above, is irrelevant for our model’s central argument.
5. Conclusions
This article shows that investors financing a portfolio of investment projects may use the depth of their financial pockets to overcome entrepreneurial agency problems. Limiting the amount of capital allows investors to credibly commit to a tournament among portfolio projects for (cheaper) informed capital at the refinancing stage. While this improves the investor’sex postbargaining position, thereby reducing the entrepreneur’s expected payoff, it may, nevertheless, also improve the entrepreneur’s incentives. This is because projects funded by investors with scarce capital must have not only a positive NPV at the refinancing stage, but one that is higher than that of competing portfolio projects. As a consequence, committing to ‘‘shallow’’ pockets may be optimal despite the allocational inefficiency when positive NPV projects are not refinanced.
Committing to shallow pockets (or ‘‘constrained finance’’) may have also benefits in dealing with adverse selection problems. If all investors have deep pockets (‘‘unconstrained finance’’), it may be impossible to separate good from bad entrepreneurs. If investors can choose between constrained and unconstrained finance, however, such separation may be possible. In the separating equilibrium in question, bad entrepreneurs are financed under unconstrained finance, and good ones are financed under constrained finance.
Our model lends itself to several testable implications. A key implication of our model is that, other things equal, projects financed under constrained finance should have lowerex antesuccess probabilities than comparable projects financed under unconstrained finance. The intuition, which lies at the heart of our model, is that for high success probabilities, the allocational inefficiency induced by constrained finance weighs heavily in expected terms, implying that such projects are better financed under unconstrained finance. The same intuition holds for projects with high investment costs, as such projects require a high probability of success to be financially viable. On the other hand, the main benefit of constrained finance in our model is that it may provide stronger effort incentives to entrepreneurs. Hence, another empirical implication is that constrained
finance should be more likely if the efficiency loss from having low entrepreneurial effort is large.
Appendix A:
Proof of Lemma 1. Claim (i) is obvious. As for claim (ii), denote by yi:=(1−si)R0 and zi:=siR0 the investor’s and Ei’s continuation payoffs, respectively, if the project is not refinanced, and by vi:=Rψi−I2 and wi:=vi−(yi+zi)=rψi their combined continuation payoffs and the net surplus, respectively, from refinancing a project with interim typeψi∈ {l, h}.
Given that the proof is standard, we shall be brief. We characterize offers by the continuation payoffXwhich the offer leaves toEi. The investor always offersXI, whileEi
always offersXE. If the investor must respond toEi’s offer, she accepts anyXEsatisfying vi−XE≥δyi+(1−δ)(vi−XI). (A1) The right-hand side in Equation (A1) represents the investor’s payoff from rejectingEi’s offer: With probabilityδ, the negotiations withEibreak down, and the investor receivesyi. If negotiations do not break down, the investor makes her counterofferXI. Similarly, ifEi
must respond to the investor’s offer, he accepts anyXIsatisfying
XI≥δzi+(1−δ)XE. (A2)
As usual, offers along the equilibrium path must make the counterparty indifferent to accepting and rejecting, implying that Equations (A1)–(A2) must hold with equality. Solving Equation (A1) forXEand inserting the result in Equation (A2), we have
XI=δzi+(1−δ)δ(vi−yi)
δ(2−δ) , (A3)
whichEiaccepts immediately.
By L’H ˆopital’s rule,Ei’s equilibrium continuation payoff asδ→0 is
δ→0limXI=vi−yi+zi
2 =zi+wi
2 =siR0+rψi
2 , (A4)
implying that the investor’s equilibrium continuation payoff asδ→0 is
δ→0limvi−XI=vi−zi−wi
2 =yi+wi
2 =(1−si)R0+rψi 2 .
Note that the same equilibrium continuation payoffs would obtain if, instead of solving for XI, we solved forXEand took the limit asδ→0, i.e., limδ→0XI=limδ→0XE. Consequently, instead of letting the investor make the first offer, we could have assumed thatEimakes the first offer; the equilibrium continuation payoffs are identical.
Proof of Lemma 2.Claim (i) is obvious. As for claim (ii), we use the same notation as in the proof of Lemma 1, except that we use subscriptsiandjto distinguish betweenEiandEj. If ψi∈ {l, h},ψj∈ {l, h}, andψi=ψj, we specify that the investor picks the entrepreneur with the higher interim type. Without loss of generality, we assume that this isEi. We confirm below that this strategy on the part of the investor is optimal. Ifψi=ψj, the investor is indifferent. In this case, we specify that the investor randomly picks an entrepreneur (with
equal probability), with whom she then bargains until there is either a breakdown or an agreement.28Again without loss of generality, we assume that this isEi.
Analogous to the proof of Lemma 1, the investor always offersxiI and accepts any counterofferxEi that satisfies
vi−xiE+yj≥δ(yi+vj−XjI)+(1−δ)(yj+vi−xiI). (A5) In Equation (A5),XIjdenotes the investor’s offer toEjif he is the only entrepreneur present, i.e., if the negotiations withEihave broken down. We already know from Lemma 1 what this offer is going to be. In contrast,xiEandxiIdenoteEi’s and the investor’s offers, respectively, if both entrepreneurs are still present. Note the difference to Equation (A1): If the investor acceptsEi’s offer, she realizes, in addition to
vi−xiE
, also her outside option payoffyj
withEj, whose project is not refinanced. By contrast, if the investor rejectsEi’s offer, the negotiations withEibreak down with probabilityδ, in which case she continues withEj. Finally, if the negotiations withEido not break down, the investor makes her counteroffer xIi. As forEi, he always offersxEi and accepts any counterofferxiIsatisfying
xiI≥δzi+(1−δ)xiE. (A6)
Analogous to the proof of Lemma 1, Equations (A5)–(A6) must hold with equality.
Solving Equations (A5) forxiEand inserting the result in Equation (A6), we obtain xiI=δzi+(1−δ)δ(vi−yi+yj−vj+XIj)
δ(2−δ) , (A7)
whichEiaccepts immediately.
Analogous to Equation (A4), we obtain limδ→0XIj=zj+wj/2. Using L’H ˆopital’s rule, we thus have thatEi’s equilibrium continuation payoff asδ→0 is
δ→0limxiI= vi−yi−wj2 +zi
which implies that the investor’s total equilibrium continuation payoff (i.e., including her outside option payoffyjrealized withEj) asδ→0 is
As in the proof of Lemma 1, we could have equally solved forxEi and taken the limit as δ→0; the equilibrium continuation payoffs are identical.
It remains to show that if both entrepreneurs are still present andψi=ψj, the investor does not find it profitable to deviate and make an offer to the entrepreneur with the lower interim type,Ej. Suppose the investor deviates and offersxjItoEjwhile accepting anyxjEthat satisfies vj−xjE+yi≥δ(yj+vi−XiI)+(1−δ)(yj+vi−xiI). (A8)
28One can show that in the limit asδ→0, the same outcome would be obtained if the investor randomizes in every round rather than staying with her first pick. The analysis involves somewhat longer equations, though.
In Equation (A8), if the investor rejectsEj’s offer and the negotiations withEjbreak down, the investor must necessarily switch back toEi. However, the investor also switches back to Eiif the negotiations withEjdid not break down.29As forEj, he offersxjEand accepts any xjIsatisfying
xIj≥δzj+(1−δ)xEj. (A9)
As previously, Equations (A8)–(A9) must hold with equality. Solving (A8) forxjEand inserting the result in Equations (A9) yields
xjI=δzj+(1−δ)(vj+yi−yj−vi+δXIi+(1−δ)xiI). (A10) To confirm that the investor does not find it profitable to deviate, we must show that
vi−xIi+yj≥vj−xjI+yi. (A11) InsertingxIjfrom Equations (A10) into (A11) and rearranging, (A11) becomes
δzj−δ(vj+yi−yj−vi)+(1−δ)δXIi ≥xiIδ(2−δ). (A12) Next, inserting (A7) into (A12), dividing through byδ, and rearranging, (A12) becomes
(1−δ)(XIi−XjI)≥(zi−zj)−δ(vi−yi+yj−vj). (A13) Note that from Equation (A3) we have that
XIi =δzi+(1−δ)δ(vi−yi) δ(2−δ) and
XIj=δzj+(1−δ)δ(vj−yj) δ(2−δ) .
Finally, insertingXIi andXjI into Equation (A13), multiplying through byδ(2−δ), and rearranging, Equation (A13) becomes
δ[(vi−yi−zi)−(vj−yj−zj)]=δ(wi−wj)=δ(rψi−rψj)≥0, which holds by assumption.
Proof of Proposition 1.It remains to derive Equations (1 ) and (3). Consider first the derivation of (1). Under unconstrained finance, the probabilities of having interim typeψ=n,ψ=l, andψ=hare 1−τ,τ (1−qθ i), andτ qθ i, respectively. Multiplying these probabilities with the respective continuation payoffs from Lemma 1 and rearranging yields Equation (1).
Consider next the derivation of (3). Given that the investor picks the entrepreneur with the higher interim type first, and if she is indifferent, she picks each of the two entrepreneurs with equal probability (see proof of Lemma 2), Lemma 2 implies the following expected continuation payoffs att=1 forEk, an arbitrary entrepreneur: zero ifψk=n, skR0 if ψk=l andψj=k=h,skR0+12
rh−12rl
if ψk=hand ψj=k =l, skR0+12rψk ifψk∈ {l, h}andψj=k=n, andskR0+18rψifψk=ψj=k =ψ∈ {l, h}. Multiplying these
29To prove that the investor’s strategy is optimal, it suffices to consider one-stage deviations. See Fudenberg and Tirole (1992), Theorem 4.2.
expected continuation payoffs with the respective joint probabilities for interim types (ψi, ψj)and rearranging yields Equation (3). The respective joint probabilities areτ2qθ iqθ j for(h, h); τ2(1−qθ i)(1−qθ j) for (l, l); (1−τ )2 for(n, n); τ (1−qθ i)(1−τ ) for(l, n);
τ (1−qθ j)(1−τ )for(n, l);τ qθ i(1−τ )for(h, n);τ qθ j(1−τ )for(n, h);τ2qθ i(1−qθ j)for (h, l); andτ2qθ j(1−qθ i)for(l, h).
Proof of Proposition 2.Analogous to the derivation of Equations (1) and (3) in the proof of Proposition 1, we can derive the investor’s expected payoff att=0. Under unconstrained finance, the investor’s expected payoff att=0 is
τ
and under constrained finance, it is τ If Equations (5) and (6) hold, we haveθi=bin the case of unconstrained finance and θi=θj=gin the case of constrained finance. Accordingly, Equations (A14) and (A15) become
as defined in Equations (7) and (8) in the main text.
We next derive the entrepreneur’s expected payoff att=0 if the project is financially viable and investors compete themselves down to zero profits. Setting (A16) and (A17) equal to zero, solving forsi, and inserting the result in Equation (1) (withθi=b)and (3) (withθi=θj=g), respectively, we have thatEi’s equilibrium expected payoff under unconstrained finance is
πEU−I1:=τ
R0+rl+qb(rh−rl)+B
−I1, (A18)
and his equilibrium expected payoff under constrained finance is πEC−I1:=τ have been established, the rest of the proof is trivial. By inspection,πIU andπEU are both linear and strictly increasing inτ. Moreover, both are zero atτ=0, andπEUlies strictly above πIU for allτ >0.30Likewise, it is easily shown thatπICandπEC are both strictly concave,
30Strictly speaking, (A18) and (A19) are meaningful only for values ofτfor which the project is viable, i.e., values for which (A16) and (A17) are non-negative. This rules outτ=0. However, given that all functions in question are strictly increasing and either linear or strictly concave, considering the functions’ behavior atτ=0tells us their behavior relative to each other for larger, admissible values ofτ.
increasing inτ, and zero atτ=0. Note that
where the inequality follows from our assumption thatθ=gis socially optimal. Hence,πEC lies strictly aboveπEUfor smallτ, implying that it crossesπEUexactly once from the left. In Figure 2, this intersection point is denoted byτ. Straightforward calculations show that
τ:=2(qg−qb) (rh−rl)−B
which establishes thatπIC lies strictly aboveπIU for smallτ, implying that it crossesπIU exactly once from the left as depicted in Figure 2. Denote the intersection ofπICandπIUby τ. Straightforward calculations show that
τ:=4(rh−rl) (qg−qb) rl+qg2(rh−rl) >τ .
Associated withτis a critical value ofI1, which is equal to the value ofπIU(or, equivalently, the value ofπIC) atτ=τ .Denote this critical value byI1.From Equation (7), we have that
Proof of Proposition 3. Denote by sC and sU the equilibrium sharing rules offered by constrained and unconstrained investors, respectively. A separating equilibrium in which typeθ=g entrepreneurs prefer constrained finance and typeθ=b entrepreneurs prefer unconstrained finance exists if (i)sCandsU are incentive compatible, (ii) the investors’ and entrepreneurs’ participation constraints hold, and (iii) there exists no other offer that can break the proposed separating equilibrium. We now address each of these three conditions in turn.
Consider incentive compatibility first. In the proposed equilibrium, unconstrained investors attract only typeθ=bentrepreneurs and make zero profits. Setting (A14) with θi=bandsi=sUequal to zero and solving forsU, we obtain
Consider next sC. Incentive compatibility for type θ=b entrepreneurs requires that constrained investors offersCsuch that typeθ=bentrepreneurs weakly prefer unconstrained
31Dividing through by rh−rl
and rearranging, we obtain 2(qg−qb)−q2g< rl
and rearranging, we obtain 2(qg−qb)−q2g< rl