The incentive to give incentives: On the relative seniority of debt claims and managerial compensation

We show that the relative seniority of debt and managerial compensation has important implications for the design of remuneration contracts. Whereas the traditional literature assumes that debt is senior to remuneration, there are in reality many cases in which remuneration contracts are de facto senior to debt claims in financially distressed firms and in workouts. We theoretically show that risky debt changes the incentive to provide the manager with performance-related incentives (a “contract substitution” effect). In other words, the relative degree of seniority of managers’ claims and creditors’ claims in case a bankruptcy procedure starts is crucial to determine the optimal incentive contract ex-ante. If managerial compensation is more senior than debt, higher leverage leads to lower power incentive schemes (lower bonuses and option grants) and a higher base salary. In contrast, when compensation is junior, we expect more emphasis on pay-for-performance incentives in highly-levered firms.     

Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed‐form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in‐depth analysis of probabilities of default and the term structure of credit spreads.     

The Determination of the Seniority Structure of Debt: Theory and Evidence

The purposes of this paper are to provide a theory of determining the firm's optimal seniority structure of debt and examine the relation between the firm's seniority structure of debt and its characteristics. Unlike previous studies, we develop a theoretical model which explicitly includes the benefits and costs associated with senior debt financing, corporate taxes, risk-aversion in the capital market, and costs of financial distress. We next show how a value-maximized firm searches for the optimal trade-off among the present values of the tax advantage of debt, loss of tax credits, expected costs of financial distress, costs of senior debt financing, and benefit of limited liability. Numerical analysis results show that the firm's value is not only a strictly concave function of its capital structure (with a unique global maximum), but also a strictly concave function of its mix of senior and junior debts (with a unique global maximum). We then show that a firm's optimal seniority structure of debt (i.e. the market value of senior debt divided by the sum of the market values of senior and junior debts) increases for low levels of asset riskiness and decreases when asset riskiness becomes sufficiently great. Our model also suggests that a firm's optimal seniority structure of debt increases for low levels of growth opportunities and decreases for high levels of growth opportunities. We test the predictions of our model on the relation between the firm's seniority structure of debt and its characteristics by using the data for the firms in COMPUSTAT over the 1972 through 1991 time period. The empirical evidence is consistent with our theoretical predictions.     

Leverage and pricing of debt in LBOs

We show that the structure and pricing of debt in LBOs mostly depend on a single characteristic of the target firm, pre-LBO profitability. We find a positive relationship between pre-LBO profitability and deal leverage that is consistent with a dynamic trade-off theory of capital structure in the presence of adjustment costs. We argue that the wide range of debt tranches used in LBO financing can be folded into two main categories, senior and junior debt, where the pricing of senior and junior debt depends on their relative use and on bankruptcy risk. Our evidence also suggests that senior lenders oversupply cheap credit during hot buyout markets.     

Why is Convertible Debt Subordinated? An Investment‐Based Agency Theory

This paper offers an agency‐based explanation for the junior priority status of convertible bonds. Using a simple economic model, I show that when convertible and straight debt have equal priority, shareholders can prefer value‐decreasing projects, which results in wealth transfers from bondholders to shareholders; and I prove that this problem is solved when convertible debt is subordinated. Empirical evidence supports the theory. I find that firms with greater potential for investment‐based agency conflicts are more likely to issue subordinated convertible debt, and firms with senior convertible debt are more likely to deviate from the optimal investment policy.     

Why is bank debt senior? A theory of asymmetry and claim priority based on influence costs

This theory can explain why bank debt is universally senior,consistent with the presence of conflict (lawyers) and absolutepriority violations in financial distress: Better organizedbanks would more strongly contest priority in financial distressif they were junior. Because 'deterrence' can reduce creditors'total expenses in a priority contest, the ex post stronger lobbyist/litigantshould be senior ex ante. For equivalent reasons, the theorycan advise when public debt should be senior to trade creditand/or implicit contrasts, and can even suggest one rationalefor the absolute priority rule (APR). This article further showsthat Chapter 11 creditor reimbursement procedures can loweroverall costs.     

Monitoring and Structure of Debt Contracts

This paper presents a theory of optimal debt structure when the moral hazard problem is severe. The main idea is that the optimal debt contract delegates monitoring to a single senior lender and that seniority allows the monitoring senior lender to appropriate the full return from his monitoring activities. The theory explains (i) why debt contracts are prioritized, (ii) why short-term debt is senior to long-term debt, and (iii) why financial intermediaries usually hold short-term senior debt whereas long-term junior debt is widely held. Another implication of the theory is that covenant and maturity structures will be set to conform to the seniority structure.     

The impact of junior debt issuance on senior unsecured debt’s risk premiums

Numerous studies have examined the impact of security issuance upon the value of pre-existing debt and equity but the focus has largely been on changes in equity value. We examine changes in senior unsecured debt risk premiums that accompany new junior debt issues. Additionally, we test several hypotheses regarding the potential impacts of junior debt issues. Extant theory suggests senior debt value may be threatened under certain conditions by the issuance of junior debt. Our results indicate that when junior debt replaces bank debt, senior default risk premiums experience abnormal declines. The result is broadly consistent with the elevation of the senior unsecured debt by way of the elimination of a separate and more senior class of debt claimants. In contrast, we also find that larger junior bond issues are associated with abnormal increases in senior risk premiums, broadly consistent with issue size being correlated with negative information about firm cash flows. We find strong evidence of interaction effects. For example, replacement of bank debt results in greater changes in default risk premiums the larger the issue size. We also find lower credit ratings magnify other effects. For example, if the junior debt issued matures before the outstanding senior unsecured bond, senior risk premiums experience abnormal increases for lower rated debt.     

The Impact of Capital Structure Change on Firm Value: Some Estimates

This study develops a model based on current corporate finance theories which explains stock returns associated with the announcement of issuer exchange offers. The major independent variables are changes in leverage multiplied by senior security claims outstanding and changes in debt tax shields. Parameter estimates are statistically significant and consistent in sign and relative magnitude with model predictions. Overall, 55 percent of the variance in stock announcement period returns is explained. The evidence is consistent with tax-based theories of optimal capital structure, a positive debt level information effect, and leverage-induced wealth transfers across security classes.     

Strategic judgment proofing

A liquidity‐constrained entrepreneur raises capital to finance a business activity that may harm bystanders. The entrepreneur raises senior (secured) debt to shield assets from the tort victims in bankruptcy. For a fixed level of borrowing, senior debt creates better incentives for precaution taking than either junior debt or outside equity. The entrepreneur's level of borrowing is, however, socially excessive. Giving tort victims priority over senior debtholders in bankruptcy prevents overleveraging but leads to suboptimal incentives. Lender liability exacerbates the incentive problem even further. A limited seniority rule dominates these alternatives. Shareholder liability, mandatory liability insurance, and punitive damages are also discussed.     

Bankruptcy priority for bank deposits: a contract theoretic explanation

Over the past decade several countries, including the US, haveintroduced or redesigned legislation that confers priority inbankruptcy upon all or some bank deposits. We argue that inthe presence of contracting costs such rules can increase efficiency.We first show in a private information model that a borrowercan reduce overall costs of finance by letting informationallyheterogeneous lenders choose between junior and senior debt.In particular, we find that debt priorities reduce sociallywasteful information gathering by investors. We then argue why,particularly in banking, legal standardization of debt prioritiesmay be superior to bilateral private arrangements.     

Capital Structure as an Optimal Contract Between Employees and Investors

The ex ante optimal contract between investors and employees is derived endogenously and is interpreted in terms of debt, equity, and employees' compensation. Although public equity financing is feasible in this model through verified accounting income, debt is needed to force value-enhancing restructuring before the income realizes. The optimal debt level, however, is lower than that which maximizes the value of the firm when there is nonmonetary restructuring-related cost to employees. The paper explains how stock prices react to exchange offers, how earnings can be diluted by a decrease in leverage, and why employees' claims are generally senior to those of investors. New testable implications about leverage and compensation levels are derived.     

Maturity and exercise price of executive stock options

Using a simple three-period model in which a manager can gather information before making an investment decision, this paper studies optimal contracts with various stock options. In particular, we show how the exercise price of executive stock options is related to a base salary, the size of the option grant, leverage, and the riskiness of a desired investment policy. The optimal exercise price increases in the size of grant and the base salary and decreases in leverage and the riskiness of a desired investment policy. Other things equal, the optimal exercise price of European options with a longer maturity should increase more for an increase in the base salary and the size of grant and decrease more for an increase in leverage than the one with a shorter maturity. The optimal exercise price of American options is determined by the optimal exercise prices of European options with different maturities. Given the fixed exercise price, the size of the option grant does not decrease in the face value of debt.     

A comparative analysis of proxies for an optimal leverage ratio

Previous studies that test the tradeoff theory commonly use one of the following debt ratio measures to proxy for a firm's hypothesized optimal ratio: firm's time-series mean leverage, moving average leverage based on a firm's historical debt ratios, industry median leverage, and predicted leverage ratio based on cross-sectional regressions. We find that these alternative proxies yield results that are significantly different from each other. Further, regression results of models that use the optimum target leverage and the conclusions drawn from the findings are sensitive to the model's proxy. Of the proxies that are commonly used in the literature, the moving average debt measure exhibits characteristics that are most consistent with the theoretical optimal leverage ratio.     

On the Interaction of Real and Financial Decisions of the Firm Under Uncertainty

This study analyzes the interaction between the optimal level of investment and debt financing. For this purpose, a model is structured in which a firm, facing an uncertain price, has to decide on its optimal level of investment and debt. The amount of investment sets a limit on output whose optimal level is determined after price is realized. The debt involved is risky (there exists a possibility of bankruptcy). The analysis proves that investment and its optimal financing have to be simultaneously determined and that a negative relationship exists between operating and financial leverage. We also demonstrate that as the tax rate increases, optimal capacity decreases and optimal leverage increases. An analysis of the impact of changes in the expected price shows that under some conditions, an increase in expected price would lead to an increase in optimal investment (firm size) and a decrease in optimal debt.     

Can the Trade-off Theory Explain Debt Structure?

We examine the optimal mixture and priority structure of bankand market debt using a trade-off model in which banks havethe unique ability to renegotiate outside formal bankruptcy.Flexible bank debt offers a superior trade-off between tax shieldsand bankruptcy costs. Ease of renegotiation limits bank debtcapacity, however. Optimal debt structure hinges upon whichparty has bargaining power in private workouts. Weak firms havehigh bank debt capacity and utilize bank debt exclusively. Strongfirms lever up to their (lower) bank debt capacity, augmentwith market debt, and place the bank senior. Therefore, thetrade-off theory offers an explanation for: (i) why young/smallfirms use bank debt exclusively; (ii) why large/mature firmsemploy mixed debt financing; and (iii) why bank debt is senior.The trade-off theory also generates predictions consistent withinternational evidence. In countries in which the bankruptcyregime entails soft (tough) enforcement of contractual priority,bank debt capacity is low (high), implying greater (less) relianceon market debt.     

A jump-diffusion model for pricing corporate debt securities in a complex capital structure

This paper proposes a jump-diffusion model, in closed form, to price corporate debt securities, senior and junior, with the same maturity and violation of the absolute priority rule. We take the structural approach that the firm's asset value follows a jump-diffusion process in a stochastic interest rate economy. Default occurs only if the firm value at the maturity of the corporate debts is less than the sum of the prespecified face values. Unlike previous models in the structural approach, our model is consistent with the current term structures of credit spreads for both senior and junior debts. In particular, it captures realistic short maturity credit spreads observed in the market. The key idea is to allow the jump intensity to be a time-dependent function. As an application, valuation of credit spread options is presented.     

Top-Management Compensation and Capital Structure

The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device to minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negative relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy ( 1990 ) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization.     

Optimal leverage strategy: Capital structure in real estate investments

This article examines the optimal leverage strategy for real estate investors who are investing in income-producing properties. Within a discounted cash-flow context, the investment objective for the equity investor is to maximize the contribution to net present value of using mortgage financing. Utilizing more debt decreases the required equity investment and increases the size of the tax shelter. On the other hand, as the loan-to-value ratio increases, the interest rate charged by the lender increases, which indicates a higher cost of debt. This article goes beyond the simple conventional wisdom that debt financing should be used when financial leverage is positive by developing an equation that allows one to determine the optimal level of debt financing to use when positive leverage is possible. The optimal loan-to-value ratio is found to be a function of the investor's characteristics. Several hypotheses about the relationships between such an optimal loan-to-value ratio and the investor's characteristics are derived.     

Real options,agency conflicts,and optimal capital structure

We examine the impact of a stockholder–bondholder conflict over the timing of the exercise of an investment option on firm value and corporate financial policy. We find that an equity-maximizing firm exercises the option too early relative to a value-maximizing strategy, and we show how this problem can be characterized as one of overinvestment in risky investment projects. Equityholders’ incentive to overinvest significantly decreases firm value and optimal leverage, and significantly increases the credit spread of risky debt. Numerical solutions illustrate how the agency cost of overinvestment and its effect on corporate financial policy vary with firm and project characteristics.