Leveraged Buy Out and Tax Saving Advantage : A Double-Sided Moral Hazard Model

This paper offers an explanation for the prevalent use of debt in LBO finance. We consider a double sided moral hazard model with three agents: the entrepreneur, the LBO fund and the bank. The entrepreneur and the LBO fund have to provide efforts in order to improve the productivity of their project; efforts are not observable. Under some restrictive conditions, the debt-equity contracts induce the entrepreneur and the LBO fund to invest efficiently. In the sense, without constraining the debt's payments, we show that the efforts depend on the project's quality. If the project is not very risky, the entrepreneur and the LBO fund provide the first best efforts and they share equally the benefit. If it is highly risky, they provide the second best efforts and the benefit's share given to each agent depends on the impact of his effort on the project's performance. When the bank's payments are constrained to be non-decreasing with the project's payoff, the agents' efforts do not depend on the project's quality. Whether the project is financed through a mixture of debt and equity or solely through equity, the entrepreneur and the LBO fund provide the same levels of efforts.We show that the excessive use of debt is explained by the tax saving advantages: the interests of the debt are tax-deductible which creates additional revenues. But these revenues have no impacts on the agents' incentives