Managerial Incentives and the Choice between Public and Bank Debt

I propose a simple model with complete and perfect information that analyzes the relation between managerial incentive compensation and the firm’s choice between public and bank debt. My analysis of firm-level data over the period 1992-2005 offers considerable support to the predictions of the model. I find a positive relation between the level of incentive compensation and the preference for bank debt, which is consistent with the prediction that managers whose compensation is tied to firm performance choose bank over public debt as a commitment mechanism to reduce the cost of debt. Further, I find that public lenders price the incentive alignment between manager and shareholders by increasing the cost of debt, while the overall cost of bank loans does not depend on the manager’s incentive compensation. Finally, I find that banks are more likely to include a collateral provision in the debt contract if the manager’s compensation is tied to firm performance. This version: June 2009 JEL classification: G32, G34, J33, D82.