Firm Size and Compensation Dynamics with Risk Aversion and Persistent Private Information

Résumé

I study a dynamic cash flow diversion model between a risk neutral lender and a risk averse entrepreneur who has persistent private information about the firm’s productivity. In the optimal contract, the firm’s size is always distorted downwards and its distortions inherit the autoregressive properties of the type process. The entrepreneur’s compensation is smoothed and decoupled from the firm size dynamics. These results contrast those of equivalent models with risk neutrality. I use numerical simulations to study a quasi-implementation with simpler contracts, which highlights that this class of models is unable to generate realistic firm size and equity share dynamics simultaneously.

Mots-clés

Firm dynamics; financing constraints; recursive contracts; persistent private information;

Codes JEL

D82: Asymmetric and Private Information • Mechanism Design
G32: Financing Policy • Financial Risk and Risk Management • Capital and Ownership Structure • Value of Firms • Goodwill
L14: Transactional Relationships • Contracts and Reputation • Networks