WEB–APPENDIX A

DEAL TERMS

In this appendix we discuss how the terms of a financial deal can fine-tune the capabilities financiers utilize in a deal's governance. In particular, the informational conditions under which a deal is originated, and the likely evolution of that information, have important implications for selecting deal terms.

A.1 COSTS OF DEALS

Deals with differing attributes will usually be arranged at differing interest rates in order to compensate for the risk or uncertainty involved. The difference between the effective interest rate¹ charged to a client and the interest cost of funds to the financier will vary according to the deal's particular attributes, the governance capabilities of the financier, and the competitiveness of the environment in which the financing is arranged. For example, a market exchange of bonds is usually a risky deal based on information publicly available to both parties. In such a transaction the difference between financiers' total interest cost and the effective rate paid by the client will not usually be large, especially if the market is competitive. On the other hand, financing a new business venture represents a deal under uncertainty, and the parties are likely to have quite different information about possible payoffs. The interest premium for facing uncertainty, and for incurring transactions and information processing costs, is therefore likely to be greater—in some cases very much greater—than in the bond deal. Moreover, the markets for financing business ventures are not as likely to be competitive, meaning that financier profit margins will likely be higher than in the first example.

A.1.1 Transactions Costs

From the client's perspective, transaction costs include both direct and indirect costs. Direct transaction costs are those the client pays to the financier. Indirect transaction costs are those paid to others, but the outlays still comprise part of the client's expenses. For example, the owner of a small business might look long and hard to find someone interested in investing long-term capital in his business, and would have to bear the costs of continuing to search for an accommodating financier until one is found, referred to as search costs.

From the financier's perspective, a deal's transactions costs include the financier's costs of raising the funds, the marginal costs of assessing the deal, a contribution to the financier's fixed costs, and an allowance for a profit margin. The magnitude of the charges depends on the financier's efficiency, the competitiveness of the market served, and the kind of deal information that must be obtained, both at the outset when the deal is being negotiated (ex ante information obtained by screening) and subsequently as the deal is being worked through (ex post information obtained from monitoring). If a financier is to stay in business over the longer term, all costs, whether through interest charges, explicit fees, or a combination of the two, must be covered.

A.1.2 Screening and Monitoring Costs

Screening costs are the ex ante costs a financier incurs to assess a funding proposal, while monitoring costs are the ex post costs involved in the deal's continuing governance. Since screening costs are usually the sum of a fixed setup cost and an ex ante variable cost, the average cost of screening individual deals can be expected to decline as the number of deals screened increases. The same is likely to be true of monitoring costs.

The average cost of administering a deal is the sum of its screening costs and monitoring costs, along with the cost of making any adjustments that monitoring indicates would be desirable. While scale economies explain why this average cost function will likely decline with transaction volume, other factors can affect the function's position and how it is likely to shift. First, the position of the screening cost function will be higher for deals with greater informational differences between clients and financier. Second, the screening cost function may shift downward as financiers gain experience with a particular type of deal and, thereby, learn how to screen it more efficiently. Monitoring costs differ according to the kinds of information differences involved, and a monitoring cost function can also shift as a result of learning. Finally, as shown later in this appendix, both screening and monitoring costs can be greater in deals where it is necessary to manage the effects of asymmetric information.

The potential volume of a given deal type is determined by the intersection of the demand and supply curves for the financing type. If client demand is relatively great, many deals are likely to be completed, and per deal screening costs will be low because financiers can take advantage of both scale economies and learning effects. However, the economics of screening can work to deter the entry of a new supplier to a market, especially if the cost function shifts downward as the number of completed deals increases. In such circumstances, the financier who first enters a market can gain a first mover advantage over subsequent entrants, particularly if the skills the financier acquires are experiential and therefore difficult to communicate.² Potential new entrants may not be willing to set up innovative financing arrangements because they see existing financiers as having entrenched advantages that are difficult to overcome.

The economics of screening can also work to inhibit the viability of new deals. First, financiers have to incur costs to determine whether or not the deal is viable. Moreover, financiers' perceptions of economic viability depend in part on the skills they have already acquired. To illustrate, there are high fixed costs to setting up venture capital firms, both because the personnel in a new firm need to learn how to screen prospects, and because any one person can only supervise a limited number of venture investments. Even if a venture firm has some personnel with screening experience, their skills are acquired principally through experience rather than in a classroom setting. As a result any new employees have to gain similar experience, and at any given time existing firms may not be able to accommodate the entire market's demands for financing. Nevertheless, unless there is enough unsatisfied demand to cover the fixed costs of setting up a new firm, the supply deficiency may persist.

A.2 INFORMATIONAL CONDITIONS

The information available to a financier affects a deal's estimated profitability and determines the kinds of reports required from the client. When financiers take on familiar deals, they are likely to treat the transactions routinely, especially in the absence of informational asymmetries. For example, the purchaser of a government Treasury bill has access to almost all potentially relevant information when the purchase is made. On the other hand, the venture capitalist investing in a growing firm has much less precise ex ante information, particularly when the firm's principal asset is the talent of its owner-manager. Moreover, the venture capitalist is much more likely to refine ex post estimates of the client's potential profitability over the investment's life than is the purchaser of a Treasury bill.

If a financier has less information than the client, he will try to determine whether it is cost-effective to obtain more details. If he thinks it would be, the financier may incorporate his informational requirements in the terms of the deal. Some information may be available ex ante while other information may only be obtainable ex post. For example, a retail client borrowing against accounts receivable might be asked to submit quarterly statements of accounts receivable outstanding, thus keeping the lender's information about the quality of the security updated.

A.2.1 Information and Contract Types

As summarized in the following table, financiers select governance mechanisms according to each deal's informational conditions:

Deals arranged under risk are easier to govern than deals under uncertainty, because they present situations in which complete contracting is possible. The terms of deals arranged under uncertainty cannot usually be specified quantitatively. For example, if the relevant states of nature are observable but not verifiable, it will not be possible to write a complete contract. In still more complex situations it may not even be possible to define the relevant states of nature.

Financings arranged under uncertainty usually provide for the exercise of discretion to compensate for contract incompleteness. For example, the arrangements may provide for relatively intensive monitoring over the deal's life, as well as for flexibility of response to evolving information. If an unforeseen contingency does occur, it may not have been possible to specify in advance what the appropriate adjustments would be.³ For this reason, many incomplete contracts are expressed in terms of the principles to be followed in making adjustments if and when the need for them becomes apparent. Hart (2001) observes that one way of coping with such eventualities is through different forms of financial structure. For example, equity gives shareholders decision rights if the firm is solvent, but debt gives creditors those decision rights if the firm is insolvent.

Another possibility is that whatever financial instrument is used, a preamble to the contract may state principles for renegotiation under certain general conditions that by necessity cannot be well specified in advance since the future is “simply too unclear” (Hart, 2001, p. 1083). The possibility of renegotiation implies that financiers' governance costs will increase, and the increased costs will only be warranted if financiers believe they can reduce possible losses at least commensurately. Financiers will also seek larger interest rate premiums for bearing what they perceive to be greater degrees of uncertainty, and will attempt to recover these costs and premiums from clients. As a result, the client presenting a high-risk deal can expect to pay a higher effective interest rate than a client presenting a less risky deal, and a client presenting a deal under uncertainty can expect to pay a higher effective interest rate than a client presenting a deal under risk.

A.2.2 Informational Asymmetries

While informational asymmetries are not unknown in public market transactions, they have greater importance in private market and in intermediated transactions, mainly because they are more difficult to resolve in the absence of active market trading. Indeed, in intermediated transactions informational differences may persist even after intensive screening. First, financier and client may differ in their estimates of a deal's profitability, in part because they have different information processing capabilities. Second, the parties may have the same ex ante information about a deal, but their ability to keep informed about its progress may differ. Finally, financiers are well aware that clients sometimes provide biased information in attempts to improve the financing terms they can obtain.

It is much more difficult to reach a satisfactory agreement when financier and client differ greatly over a project's viability than when they share the same view. If the asymmetries are great enough, it may only be possible to do the deal at non-market interest rates. In other cases, it may not be possible to reach agreement at any interest rate.

A.2.3 Third-Party Information

Financiers can sometimes reduce information costs through purchasing information rather than producing it in-house. Deal information will be provided by third parties if they can turn a profit doing so. For example, rating agencies like Moody's, Standard & Poor's, and Fitch monitor the creditworthiness of public companies' debt issues and publish their ratings. Companies seeking funds will pay to be rated if by so doing they can reduce their financing costs more than commensurately. Benson (1979) argues that by producing bond rating information and then finding clients interested in purchasing the bonds, underwriters can reduce financing costs to less than they would be if buyers produced the information individually.

REFERENCES

Benson, Earl D. (1979). “The Search for Information for Underwriters and Its Impact on Municipal Interest Cost,” Journal of Finance 38: 871–885.

Hart, Oliver. (2001). “Financial Contracting,” Journal of Economic Literature 39: 1079–1100.