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Informed lending as a deterrent to predation
Finance Research Letters 7 (2010) 193–201
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Informed lending as a deterrent to predation Robert Marquez Boston University School of Management, Department of Finance, 595 Commonwealth Ave., Boston, MA 02215, United States
a r t i c l e
i n f o
Article history: Received 1 February 2010 Accepted 4 September 2010 Available online 17 September 2010 JEL classification: L12 G2 G3 G32
a b s t r a c t Predatory practices have been rationalized by positing some information problem between entrant firms and their financiers. We argue that an effective way to deter product market predation is to obtain credit from an informed source, who can disentangle a firm’s expected profitability from its realized profits. Bank finance is often seen as a way of obtaining informed financing. We thus offer a rationale for choosing between bank financing and public debt financing based on its implications for competition in the product market. Ó 2010 Elsevier Inc. All rights reserved.
Keywords: Predation Bank financing Competition
1. Introduction There is a broad literature studying the interaction between product markets and capital structure.1 In particular, a number of papers analyze whether product market ”predation” can ever be rational, given that if such behavior occurred in equilibrium, it ought to be fully anticipated and hence actions might be taken either to prevent it or to avoid it. Much of this literature rationalizes predation by positing an information asymmetry, either across firms by assuming that entrants lack some information about the product market or about other competitors,2 or between entrant firms and their financiers.3 However, there is a relatively small literature considering how the type of debt – informed versus uninformed – affects firms’ product market behavior. We argue that one fundamental factor facilitating (and rationalizing) predation is the asymmetry of information that may exist between a new firm and its creditors. An
1 2 3
E-mail address: [email protected] Brander and Lewis (1986) is a classic study on the effect of limited liability and leverage on firms’ product market strategies. See, e.g., Milgrom and Roberts (1982), Fudenberg and Tirole (1986), Saloner (1987), or Benoit (1984). See Bolton and Scharfstein (1990), Poitevin (1989), or Snyder (1996).
1544-6123/$ - see front matter Ó 2010 Elsevier Inc. All rights reserved. doi:10.1016/j.frl.2010.09.001
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effective way of preventing product market predation may therefore be to obtain credit from an informed source. If creditors lack information regarding firms’ prospects, they must base loan renewal decisions on observed profitability. Predation that is aimed at lowering a firm’s perceived returns may then decrease that firm’s probability of obtaining financing in the future. A firm that can obtain financing from an ‘‘insider” who is able to disentangle a firm’s expected profitability from its realized profits would not be subject to this kind of predation: a competitor would have no incentive to prey if it has no hopes of driving the entrant out. However, informed finance comes at a cost, since firms may wind up being informationally locked into their lenders (see Sharpe, 1990; Rajan, 1992 and von Thadden, 2005). Also, information acquisition is costly, and this must be weighed against the benefits of deterring product market predation. Firms may also have incentives to hide from creditors information that might reveal them to be bad credit risks. This leads firms to obtain financing from creditors who rely on noisier signals of quality. Bank finance has often been seen as a form of informed financing that enables the creditor to make efficient project continuation decisions (see, e.g., Von Thadden, 1995). This paper therefore establishes a tradeoff between contracting with a bank in order to prevent predation and contracting in the public debt market in order to prevent informational lock-in but as a result being subject to inefficient expost continuation decisions. Thus, this paper provides a rationale for why firms might choose to obtain a bank loan instead of accessing the public debt market that does not rely on the formation of reputation, as in Diamond (1991). A related work is that by Poitevin (1989), who studies how rival firms may benefit from borrowing from the same source (e.g., the same bank) in order to limit competition, thus benefitting from a form of collusion. In our paper, a similar effect of softening competition arises if all firms borrowed from an informed lender, or had deep pockets. Perotti and von Thadden (2005) study the strategic role of firm transparency on product markets, and how dominant lenders such as banks may discourage transparency as a way of limiting competition. This protects the bank’s claim since it protects weaker firms from more aggressive product market competition. This is similar to our argument that firms financed by an informed lender are less likely to be preyed upon. 2. A simple model of competition and financing An entrepreneur has an investment project to undertake in each of two periods and needs financing in each period. The investment requires a capital inflow of $1. The project can return two different profit levels, pH and pL, with probabilities hi and 1 hi, respectively. These profit levels are contractible. hi can take one of two different values, hG and hB, with hG > hB. There is a prior probability q that an entrepreneur is of type G and 1 q that it is of type B, and this is common knowledge to all parties. Entrepreneurs do not know their own type i but rather learn it in the course of investing. The return on each project is, conditional on type, i.i.d. across the two periods. There are two possible sources of financing: (1) a bank or (2) an arm’s length public debt market. We assume that a creditor from the public debt market is only able to observe what is public information to all parties, which includes the realization of profits each period. In contrast, a bank can, at a cost of c, observe not only realized profits, but also the entrepreneur’s type, hi.4 The market for credit is competitive, both in the public debt market and in the banking market. Entrepreneurs derive some benefits from being in charge. Specifically, the entrepreneur earns a non-pecuniary benefit B in each period in which the investment project is undertaken. B may also represent a portion of cash flows that is not pledgeable to an investor and is always subject to appropriation by the entrepreneur.5 We assume:
4 The usual justification for this is that public debt holders are generally a disperse group, so that if there is any cost to monitoring in order to obtain this information, a free-rider problem will prevent any of them from investing in information acquisition. 5 Similar results are obtained if banks have some monopoly power and therefore earn rents, or if the costs of bank monitoring are sufficiently high and must ultimately be borne by the entrepreneur.
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Assumption 1.
p G hG pH þ ð1 hG ÞpL > 1 > hB pH þ ð1 hB ÞpL p B Assumption 2. Define
h ¼ qhG þ ð1 qÞhB : Then hpH þ ð1 hÞpL > 1 Assumption 1 states that only high quality projects should obtain financing. Assumption 2 states that, ex ante, the expected pledgeable return on any project is positive. We also assume that p B þ B > 1, so that an unconstrained entrepreneur would always undertake the project, even when he knows himself to be of the low type hB. The fact that the private benefit B cannot be pledged to a financier therefore introduces an inefficiency of financing. All parties are risk neutral. Entrepreneurs consume any net profits each period, so that they need to finance the full amount for the following period externally. 6
3. The choice between bank or public debt financing Since creditors in the arm’s length market only observe the realization of profits after each period, after observing either pH or pL these creditors will update the probability they assign to the firm of being good as follows.
qhG : qhG þ ð1 qÞhB qð1 hG Þ Prði ¼ GjpL Þ ¼ : qð1 hG Þ þ ð1 qÞð1 hB Þ
lH Prði ¼ GjpH Þ ¼
ð1Þ
lL
ð2Þ
3.1. Financing in the public debt market An arm’s length creditor can only condition its refinancing decision on the realizations of profits. B > 1, so that refinancing after observing G þ ð1 lH Þp Note that, by Assumption 2, we have that lH p pH is optimal. We further assume that: Assumption 3. period).
lL p G þ ð1 lL Þp B < 1 (termination is optimal after observing low profits in the first
Given that the firms are able to obtain competitive bids from the arm’s length market, creditors will compete until they obtain zero profits in equilibrium. We restrict our analysis to one period contracts and assume that creditors must break even each period.7 Let D1A ðpÞ represent the payment made to the creditor contingent on the realization of profits p in period 1. Limited liability for the firm implies that D1A ðpi Þ 6 pi ; i ¼ H; L. In order for the financier to break even, we require that:
½qhG þ ð1 qÞhB D1A ðpH Þ þ ½qð1 hG Þ þ ð1 qÞð1 hB ÞD1A ðpL Þ P 1:
ð3Þ
Since there are no information asymmetries at the time of contracting, any contract that guarantees creditors an adequate return will be optimal. Therefore, without loss of generality we can let D1A ðpL Þ ¼ pL , and solve for D1A ðpH Þ as:
6 Dewatripont and Maskin (1995) make the same assumption in their comparison of centralized versus decentralized economies. Allowing firms to save each period complicates the algebra but does not qualitatively change the results. 7 A long term contract could stipulate that the firm needs to pay the creditor a premium in period 2 irrespective of whether a loan is taken or not. Since there is no question of moral hazard in project choice or effort decision, we believe the restriction to one period contracts is immaterial.
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D1A ðpH Þ ¼
1 ½qð1 hG Þ þ ð1 qÞð1 hB ÞpL : qhG þ ð1 qÞhB
ð4Þ
We can perform a similar calculation for period two, assuming creditors must break even in period two, that they update their prior probability that the firm is good using Bayes’ rule, and that they only refinance if the profit realization was high. Again, letting D2A ðpÞ represent the profit-contingent payoff in period 2, and letting D2A ðpL Þ ¼ pL , we obtain
D2A ðpH Þ ¼
1 ½lH ð1 hG Þ þ ð1 lH Þð1 hB ÞpL : lH hG þ ð1 lH ÞhB
ð5Þ
3.2. Bank financing Since banks observe a firm’s quality, hi, after granting a loan, they can make their refinancing based on hi. We assume that anyone denied funding or seen leaving their old bank is believed to be of type hB, and consequently will be unable to obtain funding anywhere else. This gives all bargaining power to the bank in period 2, so that the bank is able to extract all the surplus from the firm. This reflects the idea of ”informational capture” established in Sharpe (1990), Rajan (1992), and von Thadden (2004), and these beliefs are consistent with various standard refinements. To see this, define the beliefs by a lender approached for a period 2 loan by an entrepreneur who obtained a loan in period 1 from a different bank as l = Pr(i = Hjswitch). Our assumption is that l = 0. To show that these beliefs are consis B > 1. Then it would be G þ ð1 lÞp tent, suppose to the contrary that beliefs l are such that lp optimal to offer financing to anyone switching, and since the market is competitive it would be at terms reflecting the beliefs l. Since under the proposed equilibrium each good firm staying with its old bank has all its surplus extracted in the second period, both good and bad firms would find it optimal to switch. But given this, it is not a best response for the prior bank to charge a rate that extracts the entire surplus, since it would be strictly better off charging a lower rate only to the firms identified as good. Under such a proposed equilibrium strategy by the old bank, however, only bad firms would switch, implying that the beliefs l described above are inconsistent. Using arguments of this kind, one can show that the only consistent beliefs are l = 0, as posited. We note, however, that though banks extract all the surplus from the firm in period 2, the banking market is nevertheless competitive ex ante, so that in the first period the banks will offer better terms and bid away all the rents.8 Letting DiB ðpÞ represent the payoff the bank receives in period i as a function of the realized profit p, we can set D2B ðpL Þ ¼ pL and D2B ðpH Þ ¼ pH . Thus, the bank’s expected return in the second period will be h GpH + (1 hG)pL 1, since only those firms known to be of high quality will obtain financing. However, this occurs only with probability q. Therefore, we need to find D1B ðpL Þ and D1B ðpL Þ to satisfy:
½qhG þ ð1 qÞhB D1B ðpH Þ þ ½qð1 hG Þ þ ð1 qÞð1 hB ÞD1B ðpL Þ þ q½hG pH þ ð1 hG ÞpL 1 P 1: ð6Þ Again, without loss of generality we can consider a contract that sets D1B ðpL Þ ¼ pL , so that satisfying (6) with equality yields:
D1B ðpH Þ ¼
1 þ q ½qð1 hG Þ þ ð1 qÞð1 hB ÞpL q½hG pH þ ð1 hG ÞpL : qhG þ ð1 qÞhB
ð7Þ
8 We could equally well assume that banks must break even each period, or that they are limited in their second period surplus extraction by the availability of credit to a firm from the arm’s length market when its profit realization is high. This latter assumption would imply that banks need to charge somewhat higher rates in period 1. The extreme surplus extraction assumption is primarily for analytical convenience.
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3.3. The firm’s financing decision The firm will choose the type of financing that gives it the highest expected surplus ex-ante. Recall that with arm’s length financing, refinancing occurs with an ex-ante probability qhG + (1 q)hB, and with bank financing it occurs with probability q. The payoff to the firm when it obtains uninformed finance is
½qhG þ ð1 qÞhB fpH D1A ðpH Þ þ ½lH hG þ ð1 lH ÞhB ½hG D2A ðpH Þ þ Bg þ B:
ð8Þ
We compare this to its payoff when it obtains bank financing:
½qhG þ ð1 qÞhB fpH D1B ðpH Þg þ qB þ B:
ð9Þ
Eqs. (8) and (9) provide a condition for arm’s length financing to be preferred to bank financing:
L þ qð1 hG Þ½p G 1: B½qhG þ ð1 qÞhB q > ð1 qÞhB ½1 p
ð10Þ
Since the RHS of (10) is positive, this condition can only be satisfied if qhG + (1 q)hB > q, or that q < 1þhhBBhG . In other words, refinancing must be more likely when the firm is financed via the arm’s length market, which occurs exactly when the ex-ante probability that profits are high is greater than the probability that the firm is of high quality. This requirement arises because arm’s length finance leads to inefficient continuation decisions, which causes the firm’s financing to be more expensive than if the firm were known to be of high quality. If this condition is satisfied, there always exists some level of B > 0 such that (10) is satisfied. Define B* as the cutoff level of B such that arm’s length financing is preferred:
B ¼
B þ qð1 hG Þ½p G 1 ð1 qÞhB ½1 p : qhG þ ð1 qÞhB q
ð11Þ
Uninformed finance will be preferred for all B > B*, and bank finance for all B < B*.9 Since managers are concerned about securing their private benefit B in period 2, they choose uninformed financing precisely when it is likely that the information revealed to an inside lender will be negative. They choose the source of financing that provides a noisier signal of firm quality in order to maximize the chance of receiving their private benefit. 4. Predation and the choice of financing arrangements We now incorporate the possibility of predation by supposing that there is another firm already active in the product market which can take actions, such as cutting prices or increasing output levels, in order to deter entry or to drive entrants out. Specifically, we assume that this incumbent firm has sufficient internal funds to invest in each period without having to access external credit markets and obtains profits of pD (‘‘duopoly” profits) in period 1 if another firm has entered. In period 2, it obtains profits of pM (monopoly) if the entrant has exited, and pD otherwise, where pM > pD. In period 1, the incumbent can, at a cost of C, prey on an entrant by increasing the probability that the entrant obtains low profits pL in the first period from (1 hi) to c(1 hi), where c > 1.10 This implies that the probability that output is high in period 1 changes from hi to (1 c(1 hi)). The incumbent does not know whether the entrant is a good or a bad firm, but holds the same prior beliefs q that the entrant is of type G. In a model of Cournot competition, for example, this could simply mean that the predatory firm increases its output beyond the static Nash equilibrium level. The cost would then be the loss in profits from the (statically) non-optimal action. We assume that predation can only take place in the first period. This is without loss of generality, since predation would never be optimal in the second period given that this represents the final period. 9 Note that we have ignored the cost c of becoming informed that the bank needs to pay. Incorporating this cost does not change the analysis in any qualitative way, other than loosening the constraint that B has to satisfy, making arm’s length financing more desirable. The LHS of (10) becomes B[qhG + (1 q)hB q] + c, so that if c is large enough, arm’s length financing is preferred even if the ex-ante probability of high profits is not greater than the probability the firm is good. 10 This is similar to Bolton and Scharfstein’s (1990) interpretation of predation.
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If refinancing decisions are made contingent on profit realizations, investors should take into account their expectations regarding the possibility of predation. We therefore allow investors to update the probability they assign a firm being good after observing p, taking into account that the incumbent firm may have engaged in predatory behavior. Anticipating that predation has taken place, upon observing p investors update their beliefs on borrower type as follows.
lLc Pði ¼ GjpL ; cÞ ¼
qcð1 hG Þ ¼ Pði ¼ GjpL Þ qcð1 hG Þ þ ð1 qÞcð1 hB Þ
ð12Þ
and
lHc Pði ¼ GjpH ; cÞ ¼
qð1 c þ chG Þ qhG > qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ qhG þ ð1 qÞhB
¼ Pði ¼ GjpH Þ;
ð13Þ
so that the posterior probability that a firm is good increases after observing pH. However, the overall probability that p = pH decreases. 4.1. Incumbent’s predation decision In this section we rationalize the incumbent’s predation decision. Predation will never be optimal on a bank-financed entrant since its renewal probability will not depend on realized first period profit. However, it might be rational to prey on an arm’s length financed entrant. The benefit of predation will be given by the difference between the profits the incumbent obtains as a monopolist, and those it obtains in a duopoly situation: (pM pD). This benefit is only obtained when the incumbent is successful in driving the firm out, which occurs whenever profits are low. Since predation increases the probability that profits are low by a factor of c > 1, the increase in the probability of the entrant obtaining low profits is (c 1)(1 h). Therefore, the total benefit of predation to the incumbent is
BI ðhÞ ðpM pD Þðc 1Þð1 hÞ:
ð14Þ
Notice that BI(h) is decreasing in h, so that BI(hB) > BI(hG). We make the following assumption concerning the optimality of predation: Assumption 4.
BI ðhB Þ > C;
but BI ðhG Þ < C:
This assumption states that predation is only optimal on low quality firms. High quality firm should typically be harder to drive out of the market, and since predatory practices are costly, they should not be undertaken if they are not expected to be successful. Therefore, predation will be optimal only if the expected benefit of predation is positive:
E½Benefit ¼ qBI ðhG Þ þ ð1 qÞBI ðhB Þ > C:
ð15Þ
We can now see, using Assumption 4, that if there are a large number of low quality firms (if q is small) then predation will be optimal for the incumbent. Conversely, if most firms are good (q large), predation will not be optimal. 4.2. Arm’s length and bank financing As before, we require that investors break even in each period. We follow a similar approach to that in the previous section, and suppose that the payment made when profits are low is equal to pL. Letting DiAc ðpi Þ represent the debt payment in period i when profits are punder arm’s length financing, we solve for the breakeven value of D1Ac ðpH Þ when D1Ac ðpL Þ ¼ pL :
D1Ac ðpH Þ ¼
1 c½qð1 hG Þ þ ð1 qÞð1 hB ÞpL : qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ
ð16Þ
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Similarly, for period 2 payments, conditional on p = pH, we let D2Ac ðpL Þ ¼ pL , and solve for
D2Ac ðpH Þ ¼
1 ½lHc ð1 hG Þ þ ð1 lHc Þð1 hB ÞpL
lHc hG þ ð1 lHc ÞhB
:
ð17Þ
Recall that lHc > lH, so that D2Ac ðpH Þ is lower under predation than under no predation. Nothing has changed for the case of bank financing. Moreover, since the possibility of remaining in the market next period does not depend on the firm’s realized profit, but rather on its type, which is observed by the bank, it is never rational to prey on a bank financed firm. Therefore, the payments DiB ðpÞ will be identical to those given in (7). 4.3. Firm’s financing decision under the possibility of predation Finally, we consider the firm’s choice of financing source. The expected payoff to the firm from obtaining uninformed finance is:
B þ ½qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ fpH D2Ac ðpH Þ þ ½lHc hG þ ð1 lHc ÞhB ½hG D2Ac ðpH Þ þ Bg:
ð18Þ
For the bank debt market, the expected return to the firm is given by (9). From (9) and (18) we obtain the necessary condition for arm’s length finance to be preferred to bank finance:
G pH B½qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ q > qð1 c þ chG Þ½1 p B pH þ ð1 qÞð1 c þ chB Þ½1 p G þ ð1 qÞp B c½qð1 hG Þ þ qp G 1: þ ð1 qÞð1 hB ÞpL þ q½p
ð19Þ
In order for this condition to hold, we need two conditions to be satisfied: 1. Since the RHS of (19) is greater than zero (see below), the LHS must also be positive in order for arm’s length finance to be preferred. We therefore need that q(1 c + ch G) + (1 q)(1 c + chB) > q so that the LHS of (19) can be nonnegative.11 2. The private benefit B must be sufficiently large. Let B** be the value of B that satisfies (19) with equality. It is clear that B** > B*, the cutoff value of B such that arm’s length financing is preferred under no predation. This can seen by differentiating the RHS of (19) with respect to cto obtain
G 1 þ ð1 qÞ½pH 1 þ hB ð1 p B Þ; qð1 hG Þ½p which is greater than zero. Therefore, for c > 1, the RHS of (19) is greater than the RHS of (10). This is true since the RHS of (19) evaluated at c = 1 reduces to the RHS of (10). In summary, arm’s length financing, even if optimal when there was no possibility of predation, may cease to be optimal when an incumbent firm has the possibility of preying to drive the entrant out of the market. More generally, the set of parameters for which uninformed financing is optimal under the threat of predation is a strict subset of that under no predation: for all B 2 (B*,B**), bank finance will be optimal when predation by the incumbent is a possibility. As before, condition (1) above states that a minimal requirement for arm’s length finance to be preferred is that the probability of refinancing be greater than if the firm were bank financed. The firm does not want the information that it is of low quality to get out, and so chooses the form of financing that relies on a noisier signal. Of course, this leads to an inefficiency to the extent that bad firms 11 Again, adding a cost of monitoring c loosens the constraint on B and on the probability of success. In particular, the LHS of (19) becomes B[q(1 c + chG) + (1 q)(1 c + chB) q] + c, so that arm’s length financing may be preferred when c is large even if the probability that profits are high under predation is less than the ex-ante probability that the firm is good.
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sometimes obtain financing, so that the firm is forced to pay a higher interest rate on its debt. Since financing is more costly, the firm will only choose arm’s length financing if its private benefit is large. Summarizing this discussion, we can now see that if (15) is satisfied, in equilibrium a firm obtaining public debt financing will be preyed upon with hopes of inducing exit. From Assumption 4, (15) will be satisfied if there are a large number of low quality firms (if q is small) so that predation will be optimal for the incumbent. Conversely, if most firms are good (q large), predation will not be optimal. Of course, for large q, we know from (19) that bank finance will be preferred anyway, so that the predation decision becomes moot. We should note that firms and investors make their financing decisions anticipating whether predation will take place. Since predation indeed takes place, investors’ beliefs in assuming predation are rational. As in much of the signal-jamming literature, predation takes place even though no one is fooled by the predatory practices. However, predation does change the informativeness of the profit signal, and it increases the probability that the firm is denied financing for period 2. In contrast to other signal-jamming models of predation (e.g., Fudenberg and Tirole, 1986), predation here can be successful in equilibrium. 5. Extension: asset tangibility and financing source The analysis above can be extended to incorporate other features, such as the effect of asset tangibility and collateral value, which are likely important considerations for financing arrangements. In our model, the predatory decision relies on the fact that the entrant’s cash flow is important for repaying the loan. Lenders to firms that are able to collateralize their debt rely less on the firm’s cash flows since their claim is secured by other means. Therefore, we would expect there to be a lower incentive to prey on firms with a high fraction of tangible assets and, consequently, these firms should have a reduced need to rely primarily on informed financing. A simple way to formalize this discussion is as follows. Suppose that a firm has some assets in place e The actual value A of these assets will become known by whose initial (random) value is given by A. the end of the first period. These assets can be pledged to a financier in case full repayment is not B < 1, and that E½pjpL lL p G þ ð1 lL Þp B < 1, where made. We have assumed throughout that p E[pjpL] represents a firm’s expected project return if the first period return was low (pL). Since B . Therefore, there clearly exist values of A > 0 such that p B þ A < 1 lL > 0, it must be that E½pjpL > p but E[pjpL] + A > 1. For such values of A, predation will not succeed in driving out the entrant since this entrant can still offer sufficient repayment to a financier even if he delivers a low cash flow in the first period. From an ex ante perspective, this clearly influences a firm’s choice of source of financing since firms that anticipate higher realized values of their assets A should be less inclined to rely on informed financing. 6. Conclusion and discussion This paper has analyzed the incentives a firm may have to obtain informed versus uninformed financing when faced with the possibility of predation by a rival firm. One implication of the analysis is that firms entering into markets with established, cash-rich firms should be more likely to rely on bank (i.e., informed) credit over other sources of financing. Moreover, this effect should be greatest in less competitive industries, where the benefit of inducing the exit of a competitor accrues to the preying firm. To the best of our knowledge, the issue of how firms choose between different sources of financing when faced with the prospect of aggressive product market competition has not been studied. Houston and James (1996) analyze empirically firms’ mix between bank and public debt, which have been interpreted as informed and uninformed, respectively. However, their focus has been on studying the importance of the hold-up problem that may arise under bank lending (Rajan, 1992) rather than on product market considerations. Krishnaswami et al. (1999) study firms’ placements of private debt, focusing primarily on contracting and flotation costs as key determinants of the choice between private and public debt issues. While the literature has been supportive of the differences between
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private/bank (i.e., informed) and public (i.e., uninformed) debt, a formal test of our model would require focusing on the financial arrangements and conditions of firms within a given product market. Along these lines, Chevalier (1995) shows that the financial structure of rivals has an influence on firms’ pricing decisions, with prices in markets where a leveraged buyout (LBO) has occurred falling primarily when rivals of the LBO firm have low leverage. Chevalier argues that this evidence suggests rivals may be preying on LBO firms. Our work suggests that similar findings may obtain when focusing on differences between sources of financing rather than degrees of leverage. References Benoit, J.-P., 1984. Financially constrained entry in a game with incomplete information. RAND Journal of Economics 15, 490– 499. Bolton, P., Scharfstein, D., 1990. A theory of predation based on agency problems in financial contracting. American Economic Review 80, 93–106. Brander, J., Lewis, T., 1986. Oligopoly and financial structure. American Economic Review 76, 956–970. Chevalier, J., 1995. Do lbo supermarkets charge more? An empirical analysis of the effects of lbos on supermarket pricing. Journal of Finance 50, 1095–1112. Diamond, D., 1991. Monitoring and reputation: the choice between bank loans and directly placed debt. Journal of Political Economy 99, 688–721. Fudenberg, D., Tirole, J., 1986. A signal-jamming” theory of predation. RAND Journal of Economics 17, 366–376. Houston, J., James, C., 1996. Bank information monopolies and the mix of private and public debt claims. Journal of Finance 51, 1863–1889. Krishnaswami, S., Spindt, P., Subramaniam, V., 1999. Information asymmetry, monitoring, and the placement structure of corporate debt. Journal of Financial Economics 51, 407–434. Milgrom, P., Roberts, J., 1982. Predation, reputation, and entry deterrence. Journal of Economic Theory 27, 280–312. Perotti, E., von Thadden, E.-L., 2005. Dominant investors and strategic transparency. Journal of Law, Economics, and Organization 21, 76–102. Poitevin, M., 1989a. Collusion and the banking structure of a duopoly. Candadian Journal of Economics 22, 263–277. Poitevin, M., 1989b. Financial signalling and the ”deep-pocket” argument. RAND Journal of Economics 20, 26–40. Rajan, R., 1992. Insiders and outsiders: the choice between informed and arm’s-length debt. Journal of Finance 47, 1367–1400. Saloner, G., 1987. Predation, mergers, and incomplete information. RAND Journal of Economics 18, 165–186. Sharpe, S., 1990. Asymmetric information, bank lending and implicit contracts: a stylized model of customer relationships. Journal of Finance 45, 1069–1087. Snyder, C., 1996. Negotiation and renegotiation of optimal financial contracts under the threat of predation. Journal of Industrial Economics 44, 325–343. Von Thadden, E.-L., 1995. Long-term contracts, short-term investment, and monitoring. Review of Economic Studies 62, 557– 575.
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Finance Research Letters journal homepage: www.elsevier.com/locate/frl
Informed lending as a deterrent to predation Robert Marquez Boston University School of Management, Department of Finance, 595 Commonwealth Ave., Boston, MA 02215, United States
a r t i c l e
i n f o
Article history: Received 1 February 2010 Accepted 4 September 2010 Available online 17 September 2010 JEL classification: L12 G2 G3 G32
a b s t r a c t Predatory practices have been rationalized by positing some information problem between entrant firms and their financiers. We argue that an effective way to deter product market predation is to obtain credit from an informed source, who can disentangle a firm’s expected profitability from its realized profits. Bank finance is often seen as a way of obtaining informed financing. We thus offer a rationale for choosing between bank financing and public debt financing based on its implications for competition in the product market. Ó 2010 Elsevier Inc. All rights reserved.
Keywords: Predation Bank financing Competition
1. Introduction There is a broad literature studying the interaction between product markets and capital structure.1 In particular, a number of papers analyze whether product market ”predation” can ever be rational, given that if such behavior occurred in equilibrium, it ought to be fully anticipated and hence actions might be taken either to prevent it or to avoid it. Much of this literature rationalizes predation by positing an information asymmetry, either across firms by assuming that entrants lack some information about the product market or about other competitors,2 or between entrant firms and their financiers.3 However, there is a relatively small literature considering how the type of debt – informed versus uninformed – affects firms’ product market behavior. We argue that one fundamental factor facilitating (and rationalizing) predation is the asymmetry of information that may exist between a new firm and its creditors. An
1 2 3
E-mail address: [email protected] Brander and Lewis (1986) is a classic study on the effect of limited liability and leverage on firms’ product market strategies. See, e.g., Milgrom and Roberts (1982), Fudenberg and Tirole (1986), Saloner (1987), or Benoit (1984). See Bolton and Scharfstein (1990), Poitevin (1989), or Snyder (1996).
1544-6123/$ - see front matter Ó 2010 Elsevier Inc. All rights reserved. doi:10.1016/j.frl.2010.09.001
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effective way of preventing product market predation may therefore be to obtain credit from an informed source. If creditors lack information regarding firms’ prospects, they must base loan renewal decisions on observed profitability. Predation that is aimed at lowering a firm’s perceived returns may then decrease that firm’s probability of obtaining financing in the future. A firm that can obtain financing from an ‘‘insider” who is able to disentangle a firm’s expected profitability from its realized profits would not be subject to this kind of predation: a competitor would have no incentive to prey if it has no hopes of driving the entrant out. However, informed finance comes at a cost, since firms may wind up being informationally locked into their lenders (see Sharpe, 1990; Rajan, 1992 and von Thadden, 2005). Also, information acquisition is costly, and this must be weighed against the benefits of deterring product market predation. Firms may also have incentives to hide from creditors information that might reveal them to be bad credit risks. This leads firms to obtain financing from creditors who rely on noisier signals of quality. Bank finance has often been seen as a form of informed financing that enables the creditor to make efficient project continuation decisions (see, e.g., Von Thadden, 1995). This paper therefore establishes a tradeoff between contracting with a bank in order to prevent predation and contracting in the public debt market in order to prevent informational lock-in but as a result being subject to inefficient expost continuation decisions. Thus, this paper provides a rationale for why firms might choose to obtain a bank loan instead of accessing the public debt market that does not rely on the formation of reputation, as in Diamond (1991). A related work is that by Poitevin (1989), who studies how rival firms may benefit from borrowing from the same source (e.g., the same bank) in order to limit competition, thus benefitting from a form of collusion. In our paper, a similar effect of softening competition arises if all firms borrowed from an informed lender, or had deep pockets. Perotti and von Thadden (2005) study the strategic role of firm transparency on product markets, and how dominant lenders such as banks may discourage transparency as a way of limiting competition. This protects the bank’s claim since it protects weaker firms from more aggressive product market competition. This is similar to our argument that firms financed by an informed lender are less likely to be preyed upon. 2. A simple model of competition and financing An entrepreneur has an investment project to undertake in each of two periods and needs financing in each period. The investment requires a capital inflow of $1. The project can return two different profit levels, pH and pL, with probabilities hi and 1 hi, respectively. These profit levels are contractible. hi can take one of two different values, hG and hB, with hG > hB. There is a prior probability q that an entrepreneur is of type G and 1 q that it is of type B, and this is common knowledge to all parties. Entrepreneurs do not know their own type i but rather learn it in the course of investing. The return on each project is, conditional on type, i.i.d. across the two periods. There are two possible sources of financing: (1) a bank or (2) an arm’s length public debt market. We assume that a creditor from the public debt market is only able to observe what is public information to all parties, which includes the realization of profits each period. In contrast, a bank can, at a cost of c, observe not only realized profits, but also the entrepreneur’s type, hi.4 The market for credit is competitive, both in the public debt market and in the banking market. Entrepreneurs derive some benefits from being in charge. Specifically, the entrepreneur earns a non-pecuniary benefit B in each period in which the investment project is undertaken. B may also represent a portion of cash flows that is not pledgeable to an investor and is always subject to appropriation by the entrepreneur.5 We assume:
4 The usual justification for this is that public debt holders are generally a disperse group, so that if there is any cost to monitoring in order to obtain this information, a free-rider problem will prevent any of them from investing in information acquisition. 5 Similar results are obtained if banks have some monopoly power and therefore earn rents, or if the costs of bank monitoring are sufficiently high and must ultimately be borne by the entrepreneur.
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Assumption 1.
p G hG pH þ ð1 hG ÞpL > 1 > hB pH þ ð1 hB ÞpL p B Assumption 2. Define
h ¼ qhG þ ð1 qÞhB : Then hpH þ ð1 hÞpL > 1 Assumption 1 states that only high quality projects should obtain financing. Assumption 2 states that, ex ante, the expected pledgeable return on any project is positive. We also assume that p B þ B > 1, so that an unconstrained entrepreneur would always undertake the project, even when he knows himself to be of the low type hB. The fact that the private benefit B cannot be pledged to a financier therefore introduces an inefficiency of financing. All parties are risk neutral. Entrepreneurs consume any net profits each period, so that they need to finance the full amount for the following period externally. 6
3. The choice between bank or public debt financing Since creditors in the arm’s length market only observe the realization of profits after each period, after observing either pH or pL these creditors will update the probability they assign to the firm of being good as follows.
qhG : qhG þ ð1 qÞhB qð1 hG Þ Prði ¼ GjpL Þ ¼ : qð1 hG Þ þ ð1 qÞð1 hB Þ
lH Prði ¼ GjpH Þ ¼
ð1Þ
lL
ð2Þ
3.1. Financing in the public debt market An arm’s length creditor can only condition its refinancing decision on the realizations of profits. B > 1, so that refinancing after observing G þ ð1 lH Þp Note that, by Assumption 2, we have that lH p pH is optimal. We further assume that: Assumption 3. period).
lL p G þ ð1 lL Þp B < 1 (termination is optimal after observing low profits in the first
Given that the firms are able to obtain competitive bids from the arm’s length market, creditors will compete until they obtain zero profits in equilibrium. We restrict our analysis to one period contracts and assume that creditors must break even each period.7 Let D1A ðpÞ represent the payment made to the creditor contingent on the realization of profits p in period 1. Limited liability for the firm implies that D1A ðpi Þ 6 pi ; i ¼ H; L. In order for the financier to break even, we require that:
½qhG þ ð1 qÞhB D1A ðpH Þ þ ½qð1 hG Þ þ ð1 qÞð1 hB ÞD1A ðpL Þ P 1:
ð3Þ
Since there are no information asymmetries at the time of contracting, any contract that guarantees creditors an adequate return will be optimal. Therefore, without loss of generality we can let D1A ðpL Þ ¼ pL , and solve for D1A ðpH Þ as:
6 Dewatripont and Maskin (1995) make the same assumption in their comparison of centralized versus decentralized economies. Allowing firms to save each period complicates the algebra but does not qualitatively change the results. 7 A long term contract could stipulate that the firm needs to pay the creditor a premium in period 2 irrespective of whether a loan is taken or not. Since there is no question of moral hazard in project choice or effort decision, we believe the restriction to one period contracts is immaterial.
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D1A ðpH Þ ¼
1 ½qð1 hG Þ þ ð1 qÞð1 hB ÞpL : qhG þ ð1 qÞhB
ð4Þ
We can perform a similar calculation for period two, assuming creditors must break even in period two, that they update their prior probability that the firm is good using Bayes’ rule, and that they only refinance if the profit realization was high. Again, letting D2A ðpÞ represent the profit-contingent payoff in period 2, and letting D2A ðpL Þ ¼ pL , we obtain
D2A ðpH Þ ¼
1 ½lH ð1 hG Þ þ ð1 lH Þð1 hB ÞpL : lH hG þ ð1 lH ÞhB
ð5Þ
3.2. Bank financing Since banks observe a firm’s quality, hi, after granting a loan, they can make their refinancing based on hi. We assume that anyone denied funding or seen leaving their old bank is believed to be of type hB, and consequently will be unable to obtain funding anywhere else. This gives all bargaining power to the bank in period 2, so that the bank is able to extract all the surplus from the firm. This reflects the idea of ”informational capture” established in Sharpe (1990), Rajan (1992), and von Thadden (2004), and these beliefs are consistent with various standard refinements. To see this, define the beliefs by a lender approached for a period 2 loan by an entrepreneur who obtained a loan in period 1 from a different bank as l = Pr(i = Hjswitch). Our assumption is that l = 0. To show that these beliefs are consis B > 1. Then it would be G þ ð1 lÞp tent, suppose to the contrary that beliefs l are such that lp optimal to offer financing to anyone switching, and since the market is competitive it would be at terms reflecting the beliefs l. Since under the proposed equilibrium each good firm staying with its old bank has all its surplus extracted in the second period, both good and bad firms would find it optimal to switch. But given this, it is not a best response for the prior bank to charge a rate that extracts the entire surplus, since it would be strictly better off charging a lower rate only to the firms identified as good. Under such a proposed equilibrium strategy by the old bank, however, only bad firms would switch, implying that the beliefs l described above are inconsistent. Using arguments of this kind, one can show that the only consistent beliefs are l = 0, as posited. We note, however, that though banks extract all the surplus from the firm in period 2, the banking market is nevertheless competitive ex ante, so that in the first period the banks will offer better terms and bid away all the rents.8 Letting DiB ðpÞ represent the payoff the bank receives in period i as a function of the realized profit p, we can set D2B ðpL Þ ¼ pL and D2B ðpH Þ ¼ pH . Thus, the bank’s expected return in the second period will be h GpH + (1 hG)pL 1, since only those firms known to be of high quality will obtain financing. However, this occurs only with probability q. Therefore, we need to find D1B ðpL Þ and D1B ðpL Þ to satisfy:
½qhG þ ð1 qÞhB D1B ðpH Þ þ ½qð1 hG Þ þ ð1 qÞð1 hB ÞD1B ðpL Þ þ q½hG pH þ ð1 hG ÞpL 1 P 1: ð6Þ Again, without loss of generality we can consider a contract that sets D1B ðpL Þ ¼ pL , so that satisfying (6) with equality yields:
D1B ðpH Þ ¼
1 þ q ½qð1 hG Þ þ ð1 qÞð1 hB ÞpL q½hG pH þ ð1 hG ÞpL : qhG þ ð1 qÞhB
ð7Þ
8 We could equally well assume that banks must break even each period, or that they are limited in their second period surplus extraction by the availability of credit to a firm from the arm’s length market when its profit realization is high. This latter assumption would imply that banks need to charge somewhat higher rates in period 1. The extreme surplus extraction assumption is primarily for analytical convenience.
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3.3. The firm’s financing decision The firm will choose the type of financing that gives it the highest expected surplus ex-ante. Recall that with arm’s length financing, refinancing occurs with an ex-ante probability qhG + (1 q)hB, and with bank financing it occurs with probability q. The payoff to the firm when it obtains uninformed finance is
½qhG þ ð1 qÞhB fpH D1A ðpH Þ þ ½lH hG þ ð1 lH ÞhB ½hG D2A ðpH Þ þ Bg þ B:
ð8Þ
We compare this to its payoff when it obtains bank financing:
½qhG þ ð1 qÞhB fpH D1B ðpH Þg þ qB þ B:
ð9Þ
Eqs. (8) and (9) provide a condition for arm’s length financing to be preferred to bank financing:
L þ qð1 hG Þ½p G 1: B½qhG þ ð1 qÞhB q > ð1 qÞhB ½1 p
ð10Þ
Since the RHS of (10) is positive, this condition can only be satisfied if qhG + (1 q)hB > q, or that q < 1þhhBBhG . In other words, refinancing must be more likely when the firm is financed via the arm’s length market, which occurs exactly when the ex-ante probability that profits are high is greater than the probability that the firm is of high quality. This requirement arises because arm’s length finance leads to inefficient continuation decisions, which causes the firm’s financing to be more expensive than if the firm were known to be of high quality. If this condition is satisfied, there always exists some level of B > 0 such that (10) is satisfied. Define B* as the cutoff level of B such that arm’s length financing is preferred:
B ¼
B þ qð1 hG Þ½p G 1 ð1 qÞhB ½1 p : qhG þ ð1 qÞhB q
ð11Þ
Uninformed finance will be preferred for all B > B*, and bank finance for all B < B*.9 Since managers are concerned about securing their private benefit B in period 2, they choose uninformed financing precisely when it is likely that the information revealed to an inside lender will be negative. They choose the source of financing that provides a noisier signal of firm quality in order to maximize the chance of receiving their private benefit. 4. Predation and the choice of financing arrangements We now incorporate the possibility of predation by supposing that there is another firm already active in the product market which can take actions, such as cutting prices or increasing output levels, in order to deter entry or to drive entrants out. Specifically, we assume that this incumbent firm has sufficient internal funds to invest in each period without having to access external credit markets and obtains profits of pD (‘‘duopoly” profits) in period 1 if another firm has entered. In period 2, it obtains profits of pM (monopoly) if the entrant has exited, and pD otherwise, where pM > pD. In period 1, the incumbent can, at a cost of C, prey on an entrant by increasing the probability that the entrant obtains low profits pL in the first period from (1 hi) to c(1 hi), where c > 1.10 This implies that the probability that output is high in period 1 changes from hi to (1 c(1 hi)). The incumbent does not know whether the entrant is a good or a bad firm, but holds the same prior beliefs q that the entrant is of type G. In a model of Cournot competition, for example, this could simply mean that the predatory firm increases its output beyond the static Nash equilibrium level. The cost would then be the loss in profits from the (statically) non-optimal action. We assume that predation can only take place in the first period. This is without loss of generality, since predation would never be optimal in the second period given that this represents the final period. 9 Note that we have ignored the cost c of becoming informed that the bank needs to pay. Incorporating this cost does not change the analysis in any qualitative way, other than loosening the constraint that B has to satisfy, making arm’s length financing more desirable. The LHS of (10) becomes B[qhG + (1 q)hB q] + c, so that if c is large enough, arm’s length financing is preferred even if the ex-ante probability of high profits is not greater than the probability the firm is good. 10 This is similar to Bolton and Scharfstein’s (1990) interpretation of predation.
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If refinancing decisions are made contingent on profit realizations, investors should take into account their expectations regarding the possibility of predation. We therefore allow investors to update the probability they assign a firm being good after observing p, taking into account that the incumbent firm may have engaged in predatory behavior. Anticipating that predation has taken place, upon observing p investors update their beliefs on borrower type as follows.
lLc Pði ¼ GjpL ; cÞ ¼
qcð1 hG Þ ¼ Pði ¼ GjpL Þ qcð1 hG Þ þ ð1 qÞcð1 hB Þ
ð12Þ
and
lHc Pði ¼ GjpH ; cÞ ¼
qð1 c þ chG Þ qhG > qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ qhG þ ð1 qÞhB
¼ Pði ¼ GjpH Þ;
ð13Þ
so that the posterior probability that a firm is good increases after observing pH. However, the overall probability that p = pH decreases. 4.1. Incumbent’s predation decision In this section we rationalize the incumbent’s predation decision. Predation will never be optimal on a bank-financed entrant since its renewal probability will not depend on realized first period profit. However, it might be rational to prey on an arm’s length financed entrant. The benefit of predation will be given by the difference between the profits the incumbent obtains as a monopolist, and those it obtains in a duopoly situation: (pM pD). This benefit is only obtained when the incumbent is successful in driving the firm out, which occurs whenever profits are low. Since predation increases the probability that profits are low by a factor of c > 1, the increase in the probability of the entrant obtaining low profits is (c 1)(1 h). Therefore, the total benefit of predation to the incumbent is
BI ðhÞ ðpM pD Þðc 1Þð1 hÞ:
ð14Þ
Notice that BI(h) is decreasing in h, so that BI(hB) > BI(hG). We make the following assumption concerning the optimality of predation: Assumption 4.
BI ðhB Þ > C;
but BI ðhG Þ < C:
This assumption states that predation is only optimal on low quality firms. High quality firm should typically be harder to drive out of the market, and since predatory practices are costly, they should not be undertaken if they are not expected to be successful. Therefore, predation will be optimal only if the expected benefit of predation is positive:
E½Benefit ¼ qBI ðhG Þ þ ð1 qÞBI ðhB Þ > C:
ð15Þ
We can now see, using Assumption 4, that if there are a large number of low quality firms (if q is small) then predation will be optimal for the incumbent. Conversely, if most firms are good (q large), predation will not be optimal. 4.2. Arm’s length and bank financing As before, we require that investors break even in each period. We follow a similar approach to that in the previous section, and suppose that the payment made when profits are low is equal to pL. Letting DiAc ðpi Þ represent the debt payment in period i when profits are punder arm’s length financing, we solve for the breakeven value of D1Ac ðpH Þ when D1Ac ðpL Þ ¼ pL :
D1Ac ðpH Þ ¼
1 c½qð1 hG Þ þ ð1 qÞð1 hB ÞpL : qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ
ð16Þ
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Similarly, for period 2 payments, conditional on p = pH, we let D2Ac ðpL Þ ¼ pL , and solve for
D2Ac ðpH Þ ¼
1 ½lHc ð1 hG Þ þ ð1 lHc Þð1 hB ÞpL
lHc hG þ ð1 lHc ÞhB
:
ð17Þ
Recall that lHc > lH, so that D2Ac ðpH Þ is lower under predation than under no predation. Nothing has changed for the case of bank financing. Moreover, since the possibility of remaining in the market next period does not depend on the firm’s realized profit, but rather on its type, which is observed by the bank, it is never rational to prey on a bank financed firm. Therefore, the payments DiB ðpÞ will be identical to those given in (7). 4.3. Firm’s financing decision under the possibility of predation Finally, we consider the firm’s choice of financing source. The expected payoff to the firm from obtaining uninformed finance is:
B þ ½qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ fpH D2Ac ðpH Þ þ ½lHc hG þ ð1 lHc ÞhB ½hG D2Ac ðpH Þ þ Bg:
ð18Þ
For the bank debt market, the expected return to the firm is given by (9). From (9) and (18) we obtain the necessary condition for arm’s length finance to be preferred to bank finance:
G pH B½qð1 c þ chG Þ þ ð1 qÞð1 c þ chB Þ q > qð1 c þ chG Þ½1 p B pH þ ð1 qÞð1 c þ chB Þ½1 p G þ ð1 qÞp B c½qð1 hG Þ þ qp G 1: þ ð1 qÞð1 hB ÞpL þ q½p
ð19Þ
In order for this condition to hold, we need two conditions to be satisfied: 1. Since the RHS of (19) is greater than zero (see below), the LHS must also be positive in order for arm’s length finance to be preferred. We therefore need that q(1 c + ch G) + (1 q)(1 c + chB) > q so that the LHS of (19) can be nonnegative.11 2. The private benefit B must be sufficiently large. Let B** be the value of B that satisfies (19) with equality. It is clear that B** > B*, the cutoff value of B such that arm’s length financing is preferred under no predation. This can seen by differentiating the RHS of (19) with respect to cto obtain
G 1 þ ð1 qÞ½pH 1 þ hB ð1 p B Þ; qð1 hG Þ½p which is greater than zero. Therefore, for c > 1, the RHS of (19) is greater than the RHS of (10). This is true since the RHS of (19) evaluated at c = 1 reduces to the RHS of (10). In summary, arm’s length financing, even if optimal when there was no possibility of predation, may cease to be optimal when an incumbent firm has the possibility of preying to drive the entrant out of the market. More generally, the set of parameters for which uninformed financing is optimal under the threat of predation is a strict subset of that under no predation: for all B 2 (B*,B**), bank finance will be optimal when predation by the incumbent is a possibility. As before, condition (1) above states that a minimal requirement for arm’s length finance to be preferred is that the probability of refinancing be greater than if the firm were bank financed. The firm does not want the information that it is of low quality to get out, and so chooses the form of financing that relies on a noisier signal. Of course, this leads to an inefficiency to the extent that bad firms 11 Again, adding a cost of monitoring c loosens the constraint on B and on the probability of success. In particular, the LHS of (19) becomes B[q(1 c + chG) + (1 q)(1 c + chB) q] + c, so that arm’s length financing may be preferred when c is large even if the probability that profits are high under predation is less than the ex-ante probability that the firm is good.
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sometimes obtain financing, so that the firm is forced to pay a higher interest rate on its debt. Since financing is more costly, the firm will only choose arm’s length financing if its private benefit is large. Summarizing this discussion, we can now see that if (15) is satisfied, in equilibrium a firm obtaining public debt financing will be preyed upon with hopes of inducing exit. From Assumption 4, (15) will be satisfied if there are a large number of low quality firms (if q is small) so that predation will be optimal for the incumbent. Conversely, if most firms are good (q large), predation will not be optimal. Of course, for large q, we know from (19) that bank finance will be preferred anyway, so that the predation decision becomes moot. We should note that firms and investors make their financing decisions anticipating whether predation will take place. Since predation indeed takes place, investors’ beliefs in assuming predation are rational. As in much of the signal-jamming literature, predation takes place even though no one is fooled by the predatory practices. However, predation does change the informativeness of the profit signal, and it increases the probability that the firm is denied financing for period 2. In contrast to other signal-jamming models of predation (e.g., Fudenberg and Tirole, 1986), predation here can be successful in equilibrium. 5. Extension: asset tangibility and financing source The analysis above can be extended to incorporate other features, such as the effect of asset tangibility and collateral value, which are likely important considerations for financing arrangements. In our model, the predatory decision relies on the fact that the entrant’s cash flow is important for repaying the loan. Lenders to firms that are able to collateralize their debt rely less on the firm’s cash flows since their claim is secured by other means. Therefore, we would expect there to be a lower incentive to prey on firms with a high fraction of tangible assets and, consequently, these firms should have a reduced need to rely primarily on informed financing. A simple way to formalize this discussion is as follows. Suppose that a firm has some assets in place e The actual value A of these assets will become known by whose initial (random) value is given by A. the end of the first period. These assets can be pledged to a financier in case full repayment is not B < 1, and that E½pjpL lL p G þ ð1 lL Þp B < 1, where made. We have assumed throughout that p E[pjpL] represents a firm’s expected project return if the first period return was low (pL). Since B . Therefore, there clearly exist values of A > 0 such that p B þ A < 1 lL > 0, it must be that E½pjpL > p but E[pjpL] + A > 1. For such values of A, predation will not succeed in driving out the entrant since this entrant can still offer sufficient repayment to a financier even if he delivers a low cash flow in the first period. From an ex ante perspective, this clearly influences a firm’s choice of source of financing since firms that anticipate higher realized values of their assets A should be less inclined to rely on informed financing. 6. Conclusion and discussion This paper has analyzed the incentives a firm may have to obtain informed versus uninformed financing when faced with the possibility of predation by a rival firm. One implication of the analysis is that firms entering into markets with established, cash-rich firms should be more likely to rely on bank (i.e., informed) credit over other sources of financing. Moreover, this effect should be greatest in less competitive industries, where the benefit of inducing the exit of a competitor accrues to the preying firm. To the best of our knowledge, the issue of how firms choose between different sources of financing when faced with the prospect of aggressive product market competition has not been studied. Houston and James (1996) analyze empirically firms’ mix between bank and public debt, which have been interpreted as informed and uninformed, respectively. However, their focus has been on studying the importance of the hold-up problem that may arise under bank lending (Rajan, 1992) rather than on product market considerations. Krishnaswami et al. (1999) study firms’ placements of private debt, focusing primarily on contracting and flotation costs as key determinants of the choice between private and public debt issues. While the literature has been supportive of the differences between
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private/bank (i.e., informed) and public (i.e., uninformed) debt, a formal test of our model would require focusing on the financial arrangements and conditions of firms within a given product market. Along these lines, Chevalier (1995) shows that the financial structure of rivals has an influence on firms’ pricing decisions, with prices in markets where a leveraged buyout (LBO) has occurred falling primarily when rivals of the LBO firm have low leverage. Chevalier argues that this evidence suggests rivals may be preying on LBO firms. Our work suggests that similar findings may obtain when focusing on differences between sources of financing rather than degrees of leverage. References Benoit, J.-P., 1984. Financially constrained entry in a game with incomplete information. RAND Journal of Economics 15, 490– 499. Bolton, P., Scharfstein, D., 1990. A theory of predation based on agency problems in financial contracting. American Economic Review 80, 93–106. Brander, J., Lewis, T., 1986. Oligopoly and financial structure. American Economic Review 76, 956–970. Chevalier, J., 1995. Do lbo supermarkets charge more? An empirical analysis of the effects of lbos on supermarket pricing. Journal of Finance 50, 1095–1112. Diamond, D., 1991. Monitoring and reputation: the choice between bank loans and directly placed debt. Journal of Political Economy 99, 688–721. Fudenberg, D., Tirole, J., 1986. A signal-jamming” theory of predation. RAND Journal of Economics 17, 366–376. Houston, J., James, C., 1996. Bank information monopolies and the mix of private and public debt claims. Journal of Finance 51, 1863–1889. Krishnaswami, S., Spindt, P., Subramaniam, V., 1999. Information asymmetry, monitoring, and the placement structure of corporate debt. Journal of Financial Economics 51, 407–434. Milgrom, P., Roberts, J., 1982. Predation, reputation, and entry deterrence. Journal of Economic Theory 27, 280–312. Perotti, E., von Thadden, E.-L., 2005. Dominant investors and strategic transparency. Journal of Law, Economics, and Organization 21, 76–102. Poitevin, M., 1989a. Collusion and the banking structure of a duopoly. Candadian Journal of Economics 22, 263–277. Poitevin, M., 1989b. Financial signalling and the ”deep-pocket” argument. RAND Journal of Economics 20, 26–40. Rajan, R., 1992. Insiders and outsiders: the choice between informed and arm’s-length debt. Journal of Finance 47, 1367–1400. Saloner, G., 1987. Predation, mergers, and incomplete information. RAND Journal of Economics 18, 165–186. Sharpe, S., 1990. Asymmetric information, bank lending and implicit contracts: a stylized model of customer relationships. Journal of Finance 45, 1069–1087. Snyder, C., 1996. Negotiation and renegotiation of optimal financial contracts under the threat of predation. Journal of Industrial Economics 44, 325–343. Von Thadden, E.-L., 1995. Long-term contracts, short-term investment, and monitoring. Review of Economic Studies 62, 557– 575.