Persuasion in Relationship Finance

Lin William Cong (叢林), Ehsan Azarmsa, Ehsan Azarmsa, - Aug 18, 2017

Relationship finance as seen in bank lending and venture capital features incumbent financiers' observing interim information after initial investment but before continuation decision. We model the entrepreneurs' endogenous information production and subsequent issuance of securities to both the incumbent insider and new outsider financiers as persuasion games with heterogeneous receivers and contingent transfers. Entrepreneurs' endogenous experimentation reduces insider investors' information monopoly, but holds up initial relationship investment. Insider financiers' own information production and interim competition from outsiders can mitigate the hold-up, and jointly explain the empirical non-monotone patterns linking competition and relational lending. Optimal relationship contracts restore first-best outcomes using convertible securities for insiders and residual claims for competitive outsiders. Our findings are robust under continuum action space and partial commitment to information design.

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