RFS Advance Access published online on June 20, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn065
Financial Contracting with Optimistic Entrepreneurs
Stern School of Business, New York University
HEC School of Management, and CEPR
Address correspondence to Augustin Landier, Leonard N. Stern School of Business, Tisch Hall, 40 West 4th Street, Room 9-09, New York, NY 10012; telephone (212) 998-0101; fax (212) 995-4233; e-mail: alandier{at}stern.nyu.edu.
JEL Classification: G32, D86
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Abstract |
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Optimistic beliefs are a source of nonpecuniary benefits for entrepreneurs that can explain the "Private Equity Puzzle." This paper looks at the effects of entrepreneurial optimism on financial contracting. When the contract space is restricted to debt, we show the existence of a separating equilibrium in which optimists self-select into short-term debt and realists into long-term debt. Long-term debt is optimal for a realist entrepreneur as it smooths payoffs across states of nature. Short-term debt is optimal for optimists for two reasons: (i) "bridging the gap in beliefs" by letting the entrepreneur take a bet on his project’s success, and (ii) letting the investor impose adaptation decisions in bad states.
We test our theory on a large data set of French entrepreneurs. First, in agreement with the psychology literature, we find that biases in beliefs may be (partly) explained by individual characteristics and tend to persist over time. Second, as predicted by our model, we find that short-term debt is robustly correlated with "optimistic" expectation errors, even controlling for firm risk and other potential determinants of short-term leverage.
This paper owes much to the constructive remarks of the referee and the editor. This paper also benefited from insightful discussions with Nicholas Barberis, Marianne Bertrand, Gilles Chemla, Bengt Holmstrom, Steve Kaplan, Ulrike Malmendier, Sendhil Mullainathan, Bernard Salanié, Per Strö mberg, Tano Santos, Antoinette Schoar, Enrico Perotti, Raghuram Rajan, Jeremy Stein, Luigi Zingales, as well as numerous seminar participants.