Incentive Contract, Equity Pooling, and Optimal Securitization Design

Abstract

This paper examines the optimal security design and financing structure for investment funds, considering investors with heterogeneous risk preferences. The private equity (PE) fund serves as an information intermediary that plays a crucial role in aligning incentives and facilitating financing activities. To address the potential misalignment between incentive structures and financing requirements, we develop an integrated framework that incorporates both internal moral hazard and external financing decisions. Our analysis demonstrates that optimal equity incentives effectively align the interests of fund manager and PE fund, thereby enhancing fund performance. The results indicate that the optimal financing mechanism comprises a “waterfall” structure consisting of equity, senior bonds, and junior bonds. Furthermore, we find that pooling equity and issuing asset-backed securities substantially reduce financing costs, although these costs increase with the size of the financing gap. The dual information asymmetry framework offers novel insights into structured financing and corporate growth strategies.