An Assignment Model of Monitored Finance

We develop an incentive contracting model of firm formation. Entrepreneurs of private equity firms who differ in net worth are required to borrow from institutional investors in order to finance start up projects. Investors, who differ in monitoring efficiency, may choose to monitor their borrowers at a cost. Non-verifiability of both entrepreneurial effort and monitoring gives rise to double-sided moral hazard problems, and leads to market failure. Individuals with high monitoring efficiency invest in lownet worth firms following a negatively assortative matching pattern since monitoring efficiency and net worth are strategic substitutes in mitigating incentive problems. The equilibrium debt obligation of the entrepreneur and expected firm value are in general non-monotone with respect to net worth. We solve the model numerically in order to analyze the effects of changes in the distributions of monitoring efficiency and net worth on the equilibrium loan contracts.