In Search of A Unicorn
37 Pages Posted: 15 Dec 2021 Last revised: 16 Dec 2021
Date Written: December 12, 2021
The search of valuable investment opportunities is one of the fundamental responsibilities of corporate managers. Existing studies of this search process usually model the investment opportunity as a binary signal and the role of the manager ends when such signal arrives. This paper studies a dynamic agency model in which investors delegate a manager to find valuable investment opportunities arriving stochastically with two novel features. First, investment targets arrive in different levels of quality that are only observable to the manager. Second, once the investment target is chosen, the same manager is also in charge of the ensuing production process and can continue to utilize his superior information about the target to extract rents from the investors. These novel features imply an adverse selection problem interacting with a moral hazard problem. The optimal contract features progressively lower threshold for investment if a suitable target is not found in time. The investment threshold can be both higher or lower than the first-best along the equilibrium path, consistent with both the under- and over-investment behaviors observed in practice. The theoretical predictions of the model offer empirically relevant hypotheses regarding the strategies and returns of mergers and acquisitions, hedge function activism, or special purpose acquisition companies.
Keywords: information friction, dynamic agency, adverse selection, optimal contracting, merger & acquisition
JEL Classification: G32, D86, M11
Suggested Citation: Suggested Citation