Short-term termination without deterring long-term investment: A theory of debt and buyouts

Allowing early termination minimizes investor losses if the manager is unskilled. However, the possibility of termination deters a skilled manager from undertaking long-term projects that risk interim turbulence. This paper introduces a novel role of debt that allows it to overcome this tension. Leverage concentrates equityholdersstakes, creating incentives for them to \u85nd out whether short-term losses result from low ability or a temporary downturn in a pro\u85table project. If the \u85rm is fundamentally sound, it is not liquidated upon poor performance. Debt therefore allows termination without deterring investment. Unlike models of managerial discipline based on total payout, here dividends are not a substitute for debt as they only achieve termination without incentivizing monitoring. Debt can also signal managerial quality, and managers have ongoing incentives to maintain leverage even after initial funds have been raised. Dynamic consistency obtains as the manager bene ts from monitoring by a concentrated investor. In traditional thoeries, monitoring constrains the manager; here it frees him to take long-term projects