Management Pay-off in Corporate Restructuring and the Optimal Composition of Corporate Debt

In this paper, we build up a signaling model that links management pay-off in corporate restructuring (widely known as absolute priority violations) and optimal composition of a firm’s debt. We show that in the event of corporate reorganization and the renegotiation of debt claims, the management receives a pay-off that consists of two elements. (a) A signaling component that sends a message to outside financiers about the quality of the reorganized firm. (b) Incentive components that induce the management to exert a higher level of effort resulting in a larger firm value. The signaling component of management compensation reduces the interest issued on fresh loans needed for refinancing old obligations. Faced with a liquidity crisis, the lending bank will prefer to reveal the quality of profitable projects to “armslength” financiers in order to reduce the costs of refinancing of outstanding junior debt. We show that a renegotiated contract (one in which the manager’s payoff is appropriately high and increasing in the firm value) can serve as a credible signal of project quality of a firm. As for the impact of expost renegotiations on the ex-ante choice financial structure, we show that the signaling component is fully priced (ex-ante) in the financing costs of the entrepreneur and does not affect the optimal composition of debt. On the other hand, the incentive component enhances the value of the firm and thus prompts the entrepreneur either to issue public debt (along with a senior private debt) or to resort to multiple lenders —a large bank coupled with smaller banks. Hence, it is not only the level but also the composition of debt that exert impact on firm value. Our result holds true when even we allow the bank to issue protective covenants that restrict the amount of the junior debt that a firm can issue. Finally, despite renegotiations, we show that the choice of optimal financial structure results in inefficient liquidation of assets due to endogenous debt-overhang effects.