Working Paper No. 96-17 Public versus Private Debt: Confidentiality, Control, and Product Markets

We thank Greg Udell, Patricia Wilson, and participants at the 1995 FMA meetings for helpful comments and discussions. We are responsible for any mistakes that remain. The views in this paper are not necessarily those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Abstract We examine a firm's choice between public and private debt in a model where the firm's financing source affects its product market behavior. Two effects are examined. When firms' risk-taking decisions are strategic substitutes, debt financing leads to excessively risky product market strategies (as in Brander and Lewis' (1986) Cournot oligopoly with debt). Lender control through restrictive covenants-which is characteristic of private debt-can commit the firm to reduce aggressiveness in product markets and increase expected profits. This is the monitoring effect. On the other hand, private debt reduces the amount of public information about a firm that becomes available to its competitors. This is the confidentiality effect. When firms' risk-taking decisions are strategic substitutes, firms prefer to precommit to communicate idiosyncratic private information about costs or demand. By choosing public debt, a firm is able to precommit to communicate private information. The choice between public and private debt depends on the relative weights of the monitoring and confidentiality effects.