This paper analyzes the link between the financial capital structure in LBO (Leveraged Buyout) acquisitions and the agents’ incentives under asymmetric information. We present a static model with three agents: the entrepreneur, the LBO fund and the bank. The first two agents provide complementary and non-observable efforts to enhance the distribution of the project’s revenues. Our results provide evidence that there are no debt-equity contracts that solve the double-sided moral hazard problem; however, the project must be financed jointly by the three partners. Moreover, financing the project through a mixture of debt and equity or solely through equity does not improve the incentive to provide efforts. Under taxation, agents provide low levels of efforts, but the entrepreneur is better off if the level of leverage is the highest to take advantage of the tax deductibility of interests.

Leveraged Buyout, commonly known as LBO,¹ accounts for a significant part of the corporate finance and plays a major role in structuring mergers, acquisitions and transmissions. There are three main facts about LBO finance. First, these projects are financed mostly with debt and a small amount of equity in many countries, most notably in the United States, and hence the term leveraged; these projects are typically financed with anywhere from 60% to 90% debt (Jensen, 1986 and 1989; and Kaplan and Strömberg, 2009). Moreover, there are many kinds of debt with different levels of risk, such as the mezzanine debt, the subordinate debt and the convertible debt. Second, the LBO fund (hereafter he) is an active investor and he is well connected with many industries: he is engaged in the day-to-day operations of the firm, helps to recruit key personnel, negotiates with the suppliers, the bank (hereafter he) and the other financial partners, and advises the entrepreneur (hereafter she) on all the strategic decisions. Finally, the use of convertible securities becomes prevalent in LBO finance. But usually, these securities are very rarely issued in the presence of banks or passive outside equity holders. This paper provides a theory of LBO financing based on a contractual approach. The theoretical model we present focuses on the two first facts and studies the relationship between the financial structure and the agents’ incentives under asymmetric information.

The success of these acquisitions is explained not only by the use of debt, but it depends also on the market conditions, the performance of the Op Co (the acquired company)² and the partners’ abilities. The entrepreneur has technical skills and knows well the company,³ while the LBO fund is an active financier: in addition to the funds, as explained before, he contributes to the project with his business and managerial advice. In practice, whether the entrepreneur is wealth-constrained or not, she asks for financing from both the LBO fund and the bank. Notice that the former is not wealth-constrained, so the two partners are able to finance the project without debt financing.

The questions raised in this paper are the following: Does debt financing increase agents’ incentives in LBO projects under asymmetric information?

These questions are addressed under a double-sided moral hazard problem. In fact, the entrepreneur and the LBO provide simultaneously complementary efforts which influence the distribution of the project’s outcome. We consider a model with three agents: the entrepreneur, the LBO fund and the bank. The entrepreneur may be the manager and/or the employees of the Op Co4 or an outside investor who is interested in the project because its management performs poorly but it has a lot of cash. The entrepreneur is usually wealth-constrained so she asks for advice and funds first from the LBO fund. The latter is a professional outside investor who provides funds to new and high-potential-growth companies. Then, the entrepreneur and the LBO fund sign a first contract, the holding contract, and they establish the holding company (also called the holding or the New Co⁵). If they still need further funds, they can ask for further financing from the bank. Then, they sign a second contract: the debt contract.

The optimal financial contracts have to meet three objectives: (1) each agent recovers at least the cost of his initial investment, (2) to determine the payments of each agent when the project succeeds and when it fails, and (3) to incite the entrepreneur and the LBO fund to provide efficient efforts.

Corporate Governance Journal, Financial Capital Structure, LBO Projects, Under Asymmetric Information, Leveraged Buyout, Leveraged Management Buyout.