Abstract
We study the role of hidden savings in optimal contracts for delegated asset management. The principal uses the agent’s access to capital to manipulate his precautionary motive and reduce the cost of providing incentives. After bad outcomes, the agent’s consumption is somewhat insured, and he is punished instead with less access to capital and lower growth. As a result, in addition to an equity constraint, the optimal contract requires a leverage constraint to be implemented. Hidden investment limits the principal’s ability to provide incentives, but doesn’t change the contract’s qualitative features. We provide a sufficient analytical condition for the validity of the first-order approach: if the agent’s precautionary motive falls after bad outcomes, the contract is globally incentive compatible. This condition holds in the optimal contract and in a broader class of contracts.
Host: Bård Harstad