The Journal of Finance

Presidential Address: Collateral and Commitment

Published: 07/15/2019   |   DOI: 10.1111/jofi.12782

PETER M. DEMARZO

Optimal dynamic capital structure choice is fundamentally a problem of commitment. In a standard trade‐off setting with shareholder‐debtholder agency conflicts, full commitment counterfactually predicts the firm would rely almost exclusively on debt financing. Conversely, absent commitment a Modigliani‐Miller‐like value irrelevance and policy indeterminacy result holds. Thus, the content of dynamic trade‐off theory must depend on the commitment technology. In this context, collateral is valuable as a low‐cost commitment device. Because ex ante optimal commitments are likely to be suboptimal ex post, observed capital structure dynamics will exhibit hysteresis and depart significantly from standard predictions.

Contracting in Peer Networks

Published: 07/14/2023   |   DOI: 10.1111/jofi.13260

PETER M. DEMARZO, RON KANIEL

We consider multiagent multifirm contracting when agents benchmark their wages to those of their peers, using weights that vary within and across firms. When a single principal commits to a public contract, optimal contracts hedge relative wage risk without sacrificing efficiency. But compensation benchmarking undoes performance benchmarking, causing wages to load positively on peer output, and asymmetries in peer effects can be exploited to enhance profits. With multiple principals, a “rat race” emerges: agents are more productive, with effort that can exceed the first best, but higher wages reduce profits and undermine efficiency. Wage transparency and disclosure requirements exacerbate these effects.

Optimal Security Design and Dynamic Capital Structure in a Continuous‐Time Agency Model

Published: 01/11/2007   |   DOI: 10.1111/j.1540-6261.2006.01002.x

PETER M. DeMARZO, YULIY SANNIKOV

We derive the optimal dynamic contract in a continuous‐time principal‐agent setting, and implement it with a capital structure (credit line, long‐term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise.

Leverage Dynamics without Commitment

Published: 12/22/2020   |   DOI: 10.1111/jofi.13001

PETER M. DEMARZO, ZHIGUO HE

We characterize equilibrium leverage dynamics in a trade‐off model in which the firm can continuously adjust leverage and cannot commit to a policy ex ante. While the leverage ratchet effect leads shareholders to issue debt gradually over time, asset growth and debt maturity cause leverage to mean‐revert slowly toward a target. Investors anticipate future debt issuance and raise credit spreads, fully offsetting the tax benefits of new debt. Shareholders are therefore indifferent toward the debt maturity structure, even though their choice significantly affects credit spreads, leverage levels, the speed of adjustment, future investment, and growth.

Diversification as a Public Good: Community Effects in Portfolio Choice

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00676.x

Peter M. Demarzo, Ron Kaniel, Ilan Kremer

Within a rational general equilibrium model in which agents care only about personal consumption, we consider a setting in which, due to borrowing constraints, individuals endowed with local resources underparticipate in financial markets. As a result, investors compete for local resources through their portfolio choices. Even with complete financial markets and no aggregate risk, agents may herd into risky portfolios. This yields a Pareto‐dominated outcome as agents introduce “community” risk unrelated to fundamentals. Moreover, if some agents are behaviorally biased, or cannot completely diversify their holdings, rational agents may choose more extreme portfolios and amplify the effect.

Dynamic Agency and the q Theory of Investment

Published: 11/19/2012   |   DOI: 10.1111/j.1540-6261.2012.01787.x

PETER M. DEMARZO, MICHAEL J. FISHMAN, ZHIGUO HE, NENG WANG

We develop an analytically tractable model integrating dynamic investment theory with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history‐dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens) financing constraints. Financial slack, not cash flow, is the appropriate proxy for financing constraints. Investment decreases with idiosyncratic risk, and is positively correlated with past profits, past investment, and managerial compensation even with time‐invariant investment opportunities. Optimal contracting involves deferred compensation, possible termination, and compensation that depends on exogenous observable persistent profitability shocks, effectively paying managers for luck.

The Leverage Ratchet Effect

Published: 10/10/2017   |   DOI: 10.1111/jofi.12588

ANAT R. ADMATI, PETER M. DEMARZO, MARTIN F. HELLWIG, PAUL PFLEIDERER

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if the new debt is junior and would reduce firm value. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history‐dependent. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.