Soft Information Production and Investment in Specific Assets

Abstract

We analyse how soft information acquired at a cost by a lender affects the debt contract between the lender and a project manager, and the manager’s incentive to invest in a specific asset. Under certain conditions, the lender chooses to acquire soft information about the profitability of the manager’s specific investment. The lender can increase the accuracy of the soft information by incurring greater costs. The project requires a debt financed general asset about which hard information is revealed. This information allows for a debt covenant, which allows the lender to terminate the project early. This ability contributes under specific conditions to the total return on the project, which is divided between the lender and the manager in a manner that depends on competitive condition in the loan market. We show how the manager’s incentive to invest in the specific asset is increasing in the accuracy of the soft information for a range of parameters. Under different conditions, the manager chooses a debt contract that does not rely on soft information and does not incorporate a debt covenant.