Information Acquisition and Corporate Debt Illiquidity∗

Models based on asymmetric information predict that debt is least sensitive to private information and cannot explain the illiquidity of corporate debt in secondary markets. We analyze security design with moral hazard and offer a new explanation. First, the optimal compensation contract creates incentives for the manager to engage in risk-shifting, making her interests congruent with those of shareholders. Second, because debtholders are negatively affected by risky investments, they have an incentive to acquire information and discipline the manager. Debtholders’ information acquisition solves the moral hazard problem, but makes debt less liquid than equity. Debt illiquidity covaries with credit risk. ∗Babenko is at the W.P. Carey School of Business, Arizona State University, Tempe AZ 85287, USA, Email: [email protected]; Mao is at the Warwick Business School, University of Warwick, Coventry CV4 7AL, UK, Email: [email protected]. We are grateful for the comments from Sreedhar Bharath, Sudipto Dasgupta, Paolo Fulghieri, John C.F. Kuong, Michael Lemmon, Günter Strobl, Tao Li, Xuewen Liu, Thomas Noe, Anjan Thakor, Yuri Tserlukevich, John Wei, Hongda Zhong, and seminar participants at 2015 Cambridge Corporate Theory Symposium, Arizona State University, HKUST, Tulane University, and the University of Warwick. It is well known that secondary debt markets are often characterized by a lack of liquidity and that debt liquidity tends to dry up when firms are close to default (Edwards, Harris, and Piwowar (2007), and Bao, Pan, and Wang (2011)). Debt illiquidity also appears to be priced in the data as structural models have difficulty explaining the credit spreads for corporate bonds (Huang and Huang (2012)). Yet, from the standpoint of economic theory it is unclear why corporate debt is illiquid. After all, models based on asymmetric information commonly predict that debt should be more liquid than equity because it is less sensitive to private information (see, e.g., Boot and Thakor (1993), Dang, Gorton, and Holmstrom (2011), Hennessy (2012) and Yang (2014)). In this paper, we aim to explain this puzzle by analyzing the incentives of different claim holders to acquire costly information. The central result that emerges is that, in order to create optimal corporate governance, debt claim has to be more information-rich than junior claims; as such, it is subject to a greater degree of adverse selection. To study the information acquisition incentives, we set up the optimal security design problem. The objective of a firm is to maximize firm value by selling a portfolio of external securities and designing the optimal compensation for the firm’s manager. There is double-sided moral hazard associated with the problem. First, the manager’s unobserved effort affects the quality of a risky project in which the manager can later decide to invest. Second, a critical element of the model is that outside investors can acquire costly private information about the quality of the project and block the manager from making investment. The design of managerial compensation and external securities is directed at inducing sufficient information acquisition by outsiders and creating a discipline scheme that motivates high effort from the manager, thereby maximizing the ex ante firm value. We first show that the optimal compensation contract resembles a performancevested call option, which induces excessive risk-taking by the manager. Intuitively, because the manager is protected by limited liability, the optimal contract has to reEmpirical evidence indicates that secondary equity markets are more liquid than debt markets (see, e.g., Edwards, Harris, and Piwowar (2007)).