Seniority Orders Between Inside Debts and External Debts

In this paper, we study the seniority orders between a firm's external debts and its inside-debt compensation to its manager, and analyze how different seniority orders influence equilibrium inside debt and external debt, as well as efficiency. We find the equilibrium inside debt varies with different seniority orders and is contingent on the borrowing amount. Specifically, if the borrowing amount is small, the equilibrium inside debt is the smallest when the external debt has the seniority and is the largest when the inside debt has the seniority. However, if the borrowing amount gets sufficiently large, the results are reversed. We also analyze how the liquidation value upon bankruptcy affects the equilibrium external debt given different seniority orders, and our analysis shows that the external debt may increase in the liquidation value.In addition, we examine an extension with asset diversion. We find that, contrary to conventional wisdom, assigning seniority to the manager's inside-debt compensation does not mitigate the manager's asset diversion. In fact, asset diversion is more severe when the manager's inside-debt compensation has the seniority over the external debts. We further find that, in the presence of a risk-averse manager, when the threat of asset diversion is very severe while the manager is not very risk-averse, it is efficient to assign seniority to external debts, which dampens asset diversion and also limits the increase in risk premium due to asset diversion. On the other hand when asset diversion is negligible and risk aversion is the dominant concern, it is efficient to assign seniority to inside debt to protect the manager from the inherent project risk and reduce risk premium