Credit Market Imperfections and Separation of Ownership from Control as a Strategic Decision

This paper considers a simple finance model with asymmetric information and moral hazard and establishes the following results: (i) in the unique equilibrium of our economy, projects are financed using debt contracts with warrants, thus there exist forces that make equilibrium contracts resemble what we observe in practice; (ii) these contracts are often inefficient and in particular the equilibrium is constrained Pareto inefficient because of the competition among financiers; (iii) the internal organization of the firm is closely linked to the credit market. If ownership can be separated from control, the inefficiencies can be avoided. In equilibrium only projects that hire an outside manager and give sufficient "career concerns" to their managers receive funding; (iv) the introduction of a third-party is essential for this result; (v) even when collusion (renegotiation) between the manager and the entrepreneur at the expense of other claim-holders is possible, separation of ownership from control is beneficial. In this case, debt contracts are used to minimize the gain to collusion, managers are paid an "efficiency salary" and the managerial labor market does not clear. This is a much revised version of "Delegation Through Managerial Contracts: Is Hiring a Manager a Good Idea? " Centre For Economic Performance DP No 82. I am grateful to Abhijit Banerjee, Patrick Bolton, David Laibson, John Moore, Fausto Panunzi, Thomas Piketty, Kevin Roberts, David Scharfstein, Andrew Scott, Jeremy Stein, Jean Tirole, David Webb and seminar participants at the LSE, University of Essex and Harvard/MIT Theory Workshop for valuable comments. I am particularly indebted to Ernst Maug for stimulating my interest in this topic and helpful discussion. Naturally all remaining errors are mine. 1) Introduction The internal organization of the firm has experienced radical changes over the past two centuries. Most importantly, many small and medium sized owner-managed firms have been replaced by large firms run by professional managers. Many implications of this separation of ownership from control are now well understood, e.g. Baumol (1959), Marris (1964), Williamson (1964). Although such separation introduces obvious inefficiencies, it also enables much more complex organizational forms to develop and many economic historians view this process as one of the most important foundations of modern industrial growth. In his influential book, The Visible Hand: The Managerial Revolution in American Business, Alfred Chandler writes "The rise of modern business enterprise brought a new definition of the relationship between ownership and management and therefore a new type of capitalism to the American economy" (p. 9). Chandler's emphasis throughout is on how the introduction of management has changed the organizational form and led to more productive production and distribution systems. As suggested by many economists, the separation of ownership and control does not only influence organizational efficiency but also the cost of capital to the corporation. Since the availability of credit and the cost of capital are among the important ingredients of the growth of industrial enterprise, it is important to investigate the interaction between organizational form and financing decisions. Starting with Jensen and Meckling (1976) many studies have shown how the separation of ownership from control can be one of the key determinants of the capital structure of the firm and the implication of this literature is that ceteris paribus separation of ownership from control leads to a higher cost of capital and perhaps even to more severe credit rationing. However, Chandler in a famous article also points out "After 1897, however, outside funds and often outside promoters who were usually Wall Street financiers, played an increasingly significant role in industrial combination and consolidation" (see also Goldsmith (1969)). This is also the time of the emergence of the modern business enterprise with managerial hierarchies separated from ownership, suggesting that there may be a link between the two events. Related to this conjecture, we can note the example of Barclays Bank & Co in the UK which experienced an increase in price-earnings ratio from five to twenty (and hence a comparable reduction in the cost of capital) after separating ownership from management and floating on the stock market in 1902 (see Hannah (1993)). For the US, similar evidence is reported in Navin and Sears (1955) where they document how, at the turn of the century, the dilution of inside ownership