Investment Under Uncertainty, Heterogeneous Beliefs and Agency Conflicts

We develop a structural model to investigate the effects of asymmetric beliefs and agency conflicts on dynamic principal-agent relationships. Our model differs from previous models by incorporating three key features in a unified framework: (i) asymmetric beliefs and risk attitudes, (ii) actions by both parties, and (iii) endogenous termination of the relationship. We show how the inter-temporal tradeoff between the benefits of agent optimism and the costs of risk-sharing affects dynamic incentive contracts. Optimism has a first-order effect on incentives, investments and output, which potentially reconciles the private equity puzzle. The effects of asymmetric beliefs lead to optimal contracts with features consistent with observed venture capital and R&D contracts. Our results also lead to potentially testable implications for the effects of project characteristics on contractual features. To obtain quantitative guidance on the effects of asymmetric beliefs, we calibrate our structural model to data on pharmaceutical R&D projects. The analysis of the calibrated model shows that optimism significantly influences project values, and that permanent and transitory components of risk have opposing effects on project values and durations