Dynamic Financial Contracting with Persistence

We study a setting in which a principal provides an agent with funds to operate a rm. The agent is liquidity constrained and privately observes the revenue of the rm. In other words, the agent can divert revenue to projects that bene t only him. Time is discrete and in nite, and revenues are subject to stochastic shocks that are persistent over time. As in the iid case studied by Clementi and Hopenhayn (2006), nancing constraints emerge endogenously as part of the optimal contract so that investment is inef cient, rents are backloaded, and the agent doesn’t receive dividend payments until the rm matures. In the optimal contract, the rm matures with probability one, from which point on, investment is always ef cient. However, in contrast to the iid case, persistence implies that investment in a mature rm is not constant, the debt-to-equity ratio of a mature rm is not constant, compensation in a mature rm is via a combination of cash and equity, and, most importantly, the agent is not the residual claimant in a mature rm, predictions which are consistent with empirical evidence. ( ) We thank Adriano Rampini, Philipp Sadowski, and Neil Wallace for helpful comments. Krishna is grateful to the National Science Foundation for nancial support through grant SES-1132193. (Ž) Duke University () Duke University