INFORMATIONAL ASYMMETRIES, FINANCIAL STRUCTURE, AND FINANCIAL INTERMEDIATION

Abstract

Numerous markets are characterized by informational differences between buyers and sellers. In financial markets, informational asymmetries are particularly pronounced. Borrowers typically know their collateral, industriousness, and moral rectitude better than do lenders; entrepreneurs possess "inside" information about their own projects for which they seek financing. Lenders would benefit from knowing the true characteristics of borrowers. But moral hazard hampers the direct transfer of information between market participants. Borrowers cannot be expected to be entirely straightforward about their characteristics, nor entrepreneurs about their projects, since there may be substantial rewards for exaggerating positive qualities. And verification of true characteristics by outside parties may be costly or impossible. Without information transfer, markets may perform poorly. Consider the financing of projects whose quality is highly variable. While entrepreneurs know the quality of their own projects, lenders cannot distinguish among them. Market value, therefore, must reflect average project quality. If the market were to place an average value greater than average cost on projects, the potential supply of low quality projects may be very large, since entrepreneurs could foist these upon an uninformed market (retaining little or no equity) and make a sure profit. But this argues that the average quality is likely to be low, with the consequence that even projects which are known (by the entrepreneur) to merit financing cannot be undertaken because of the high cost of capital resulting from low average project quality. Thus, where substantial information asymmetries exist and where the supply of poor projects is large relative to the supply of good projects, venture capital markets may fail to exist. For projects of good quality to be financed, information transfer must occur. We have argued that moral hazard prevents direct information transfer. Nonetheless, information on project quality may be transferred if the actions of entrepreneurs ("which speak louder than words") can be observed. One such action, observable because of disclosure rules, is the willingness of the person(s) with inside information to invest in the project or firm. This willingness to invest may serve as a signal to the lending market of the true quality of the project; lenders will place a value on the project that reflects the information transferred by the signal. As shown by the seminal work of Akerlof [1970] and Spence [1973], and by the subsequent contributions of Rothschild and Stiglitz [1975] and Riley [1975], [1976], equilibrium in markets with asymmetric information and signalling may have quite different properties from equilibrium either with no information transfer, or with direct and costless information transfer. Signalling equilibria may not exist, may not be sustainable, and may not be economically efficient. In subsequent sections, we develop a simple model of capital structure and financial equilibrium in which entrepreneurs seek financing of projects whose true qualities are known only to them. We show that the entrepreneur's willingness to invest in his own project can serve as a signal of project quality. The resulting equilibrium differs importantly from models which ignore informational asymmetries. The value of the firm increases with the share of the firm held by the entrepreneur. In contrast with Modigliani and Miller [1958], the financial structure of the firm typically will be related to project or firm value even when there are no taxes.1 And firms with riskier returns will have lower debt levels even when there are no bankruptcy costs. Signaling incurs welfare costs by inducing entrepreneurs to take larger equity positions in their own firms than they would if information could be directly transferred; we show, however, that the set of investment projects which are undertaken will coincide with the set which would be undertaken if direct information transfer were possible. Finally, we suggest that financial intermediation, which is difficult to explain in traditional models of financial equilibrium, can be viewed as a natural response to asymmetric information. Consider an investment project which involves a capital outlay K and a future return μ + x ˜ , where µ is the expected end-of-period value of the project and x ˜ is a random variable with zero mean and variance σ 2 . We shall consider an entrepreneur who wants to undertake this investment project and plans to hold a fraction α of the firm's equity, raising the remainder of the equity from other lenders. Throughout our analysis, the firm and the entrepreneur (on personal account) are both assumed to be able to issue debt at the riskless rate.2 The entrepreneur has information that leads him to assign a specific value to µ, but he has no credible way to convey this information directly to other potential shareholders, who have a subjective probability distribution for µ. However, other potential shareholders will respond to a signal by the entrepreneur regarding his evaluation of µ if they know that it is in the self-interest of the entrepreneur to send true signals. The signal which we shall examine is α, the fraction of the equity in the project which is retained by the entrepreneur. This will be taken by other lenders as a (noiseless) signal of the true µ. That is, the market perceives µ to be a function of α. We shall assume that μ(α) is a differentiable function.4 In addition to the possibility of investing in his own project, the entrepreneur can invest in the market portfolio. Define We shall make the "perfect competition" assumption that the project is small relative to the market as a whole; the entrepreneur perceives his decisions with respect to the project to have a negligible effect on the returns and value of his share of the market portfolio. We are not interested in arbitrary functions μ(α); rather, we shall restrict our attention to schedules which have an equilibrium property. More precisely, we define an Condition (5) is a natural notion of equilibrium given competitive capital markets. If the imputed μ(α) were greater than the actual μ of an entrepreneur retaining α, outside investors would on average receive less than the return required for the project's risk, and equity financing would not continue on such terms. If, on the other hand, μ(α) consistently underestimated the entrepreneur's true μ, given α, excess returns would exist for outside investors. Competitive forces would eliminate these excess returns. Thus, for levels of μ for which entrepreneurs undertake their projects, (5) must hold in equilibrium.7 We shall not address the difficult problem of whether an equilibrium schedule μ(α) exists.8 Rather, we shall presume that at least one equilibrium schedule exists, and examine its properties. In the subsequent section, we consider an example in which we can actually compute an equilibrium valuation schedule. Equation (7) can now be used to solve for β as a function of α and μ Substituting this relationship for β into (8) yields a differential equation relating μ and α. Any equilibrium schedule must satisfy this differential equation over the relevant domain. The necessary conditions (8) and (9) will be used to examine properties of equilibrium valuation schedules. But first, we need a definition: An individual's demand for an asset is said to be normal if, in a portfolio choice situation without signaling, the individual will always demand a larger amount of that asset when its price falls. Theorem I.The equilibrium valuation function μ(α) is strictly increasing with α over the relevant domain, if and only if the entrepreneur's demand for equity in his project is normal. Proof 1.See Appendix. I provides a fairly strong characterization of equilibrium schedules: under normal conditions they are monotonically increasing with the fraction of ownership α retained by the entrepreneur. The market reads higher entrepreneurial ownership as a signal of a more favorable project. And the entrepreneur is motivated to choose a higher fraction of ownership in more favorable projects, given the equilibrium valuation function. Theorem II.In equilibrium with signaling by a, entrepreneurs with normal demands will make larger investments in their own projects than would be the case if they could costlessly communicate their true mean. Proof 2.See Appendix. II can be viewed as a welfare result: the "cost" of signaling the true μ to the market through α is the welfare loss resulting from investment in one's own project beyond that which would be optimal if the true μ could be communicated costlessly. Of course, less costly communication may not be possible. And, as argued in the introduction, equilibrium with no communication could result in no projects being undertaken. To examine further aspects of equilibrium valuation schedules and their implications for financial structure, we turn our attention to a specific example. Entrepreneur's expected utility can be expressed in the form The risk adjustment coefficient can be expressed as λ = λ ∗ Cov ( x ˜ , M ˜ ) , where Note that Z will always be nonnegative, and can be interpreted as the specific risk of the project. If the project is independent of the market returns, Cov ( x ˜ , M ˜ ) = 0 and Z is simply the variance of x ˜ . If the market and project returns are perfectly correlated, Z = 0 . In most cases, of course, Z will lie between these extremes. Equilibrium signaling schedules Figure 1 shows some examples of valuation functions satisfying the equilibrium form (15). We will now show that further equilibrium arguments can be used to reduce this family of curves to a single schedule which will be viable in the market. Thus, at α = 0 , schedules such as JJ′ have the property that entrepreneurs with true μ < μ J ( 0 ) could undertake the project, retain zero equity, and be better off than they

Keywords

Affiliated Institutions

• University of California, Berkeley US
• London Business School GB

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