Loan Commitments and the Debt Overhang Problem

The debt overhang problem is shown to arise in the context of an entrepreneurial project that requires a sequence of investments financed by an outside lender. The entrepreneur, not internalizing losses accruing to the lender which financed the initial investments, may inefficiently cancel the project and instead pursue an outside opportunity. It is shown that loan commitments (contracts that allow the entrepreneur to borrow a variable amount at a set interest rate in return for a fixed fee) are the optimal financial contracts in this setting, strictly dominating standard debt. The existence of the fixed fee allows loan commitments to set a relatively low interest rate, improving the entrepreneur's incentives to continue the project. The paper specifies the optimal contract fully, derives robust comparative statics properties (using an extension of Milgrom and Roberts (1994)), and extends the results to more realistic settings (e.g., allowing the market risk-free rate to be stochastic).