Adverse Selection in Capital Markets with Heterogeneous Risk Preferences and Beliefs

We study the ability of a manager, who seeks outside financing for a new project, to disclose private information about the project's risk. We assume the manager and the outside investor that offers the best financing terms may have heterogeneous and privately known risk preferences (equivalently beliefs regarding the risk return relationship). In this case, all costly signaling possibilities break down and no information can be credibly disclosed regarding the project's risk, no matter how precise. This general result does not rely on participation constraints nor budget balance concerns meaning no amount of outside taxes or subsidies can resolve it. Further, we show that full disclosure of private information is impossible even if risk preferences are public information. In contrast, when the manager and outside investor have homogeneous risk preferences (equivalently beliefs), then full disclosure of risk is achievable, highlighting important robustness concerns in contracting problems that assume homogeneous agents