Investments and Risk Transfers

Abstract

We demonstrate a novel link between relationship-specific investments and risk in a setting where division managers operate under moral hazard and collaborate on joint projects. Specific investments increase efficiency at the margin. This expands the scale of operations and thereby adds to the compensation risk borne by the managers. Accounting for this investment/risk link overturns key findings from prior incomplete contracting studies. We find that, if the investing manager has full bargaining power vis-a-vis the other manager, he will underinvest relative to the benchmark of contractible investments; with equal bargaining power, however, he may overinvest. The reason is that the investing manager internalizes only his own share of the investment-induced risk premium (we label this a "risk transfer"), whereas the principal internalizes both managers' incremental risk premia. We show that high pay-performance sensitivity (PPS) reduces the managers' incentives to invest in relationship-specific assets. The optimal PPS thus trades off investment and effort incentives.

Keywords: incomplete contracting, hold-up, risk externalities, overinvestment, pay performance sensitivity (PPS)

JEL Classification: D86, M52, D02