Long-Term Financial Contracts can Mitigate the Adverse Selection Problem in Project Financing

This paper shows that long-term contracts can be used in competitive financial markets to separate entrepreneurs of different abilities. In equilibrium, poor entrepreneurs are financed with a sequence of standard-debt contracts. Good entrepreneurs are financed with a modified contract in which the terms of the second part of the contract are contingent upon whether default is observed at the first date. Sorting is achieved through the contingent term in the contract. In equilibrium, good entrepreneurs will typically pay high interest rates to start with, followed by relatively lower rates later if they are successful. The solution in the paper is contrasted with the use of collateral.