SME investment and financing under asymmetric information

• Published date: 01 November 2022
• Author: Yao Wang,Hai Zhang,Zhiming Zhao
• Date: 01 November 2022
• DOI: http://doi.org/10.1111/eufm.12342

DOI: 10.1111/eufm.12342

ORIGINAL ARTICLE

SME investment and financing under

asymmetric information

Yao Wang

1,2

|Hai Zhang

3

|Zhiming Zhao

1

1

School of Business, Xiangtan University,

Xiangtan, China

2

School of Finance, Renmin University of

China, Beijing, China

3

Department of Accounting & Finance,

Strathclyde Business School,

Glasgow, UK

Correspondence

Zhiming Zhao, School of Business,

Xiangtan University, Yanggutang Street,

Yuhu District, Xiangtan 411105, Hunan

Province, P. R. China.

Email: zmzhao@xtu.edu.cn

Abstract

We investigate the investment timing and financing

decisions of financially constrained small and

medium‐sized enterprises (SMEs) in a real‐option

setting with asymmetric information. ‘Bad’firms

can sell over‐priced securities by mimicking in a

pooling equilibrium. However, ‘good’firms can se-

parate from bad firms by imposing an adverse se-

lection cost for mimicry only when the benefit of

being recognized as the ‘good’type outweighs the

investment distortion costs. Further, asymmetric

information induces good firms to accelerate in-

vestment, leading to investment distortion and

higher guarantee costs. Equity‐for‐guarantee swap

not only mitigates SMEs' financing constraints but

also reduces the investment and finance distortions.

KEYWORDS

asymmetric information, equity‐for‐guarantee swap, least‐cost

equilibrium, real option, SME financing

JEL CLASSIFICATION

G11, G14, G32

Eur Financ Manag. 2022;28:1347–1375. wileyonlinelibrary.com/journal/eufm © 2021 John Wiley & Sons Ltd.

|

1347

EUROPEAN

FINANCIAL MANAGEMENT

We thank the editor (John A. Doukas) and an anonymous referee of European Financial Management for helpful

comments to improve this paper. We also acknowledge useful comments from Ding Chen, Tom Hall, Zhaojun Yang,

Hongda Zhong, as well as participants on 2019 Paris Financial Management Conference at IPAG Business School

(France), and seminars at Strathclyde Business School. This study is financially supported by National Natural Science

Foundation of China (Project Nos. 71801185 and 72171207), Natural Science Foundation of Hunan Province in China

(Project Nos. 2019JJ50610).

1|INTRODUCTION

The development of small and medium‐sized enterprises (SMEs) plays an essential role in

promoting a country's economic development, innovation, and employment. However,

significant financing constraints due to financial frictions have disproportionately affected

SMEs in the wake of economic shocks (Christodoulou et al., 2021; Ferrucci et al., 2021).

Innovative financial contracts, such as equity‐for‐guarantee swaps (EGS), are important in

mitigating such financing constraints.

1

More precisely, an SME finances a risky project using

equity‐for‐guarantee swaps (EGS), which secures guaranteed debt—at the expense of equity

dilution in favor of an external insurer (see details in H. Wang et al., 2015; Yang, 2020; Yang &

Zhang, 2013 among others). However, virtually all the existing models consider EGS financial

instrument only in a perfect information setting. As information asymmetry between SMEs and

external investors exacerbates financing constraints (Andrikopoulos, 2009), it is important to

investigate the impact of asymmetric information on SME investment and financing decisions.

The following research questions are of special concern: How does EGS affect SMEs' invest-

ment strategies? How does the information advantage party, SMEs owners, create a credible

signal to external investors? What role does asymmetric information play in affecting SMEs'

external financing cost?

To answer these questions, we develop a real option model of SME investment and fi-

nancing decisions with EGS under asymmetric information. Our model generates a rich set of

testable predictions and offers insights in how asymmetric information affects SMEs' equili-

brium investment strategies and financing constraints. To be specific, EGS is a financial con-

tract signed among three parties–a bank/lender, an insurer, and an SME/borrower and it

specifies that an SME gets bank loan guaranteed by the insurer and it pays the insurer equity

shares instead of the normal guarantee fees. Most existing research of EGS, see Yang and Zhang

(2013), H. Wang et al. (2015) and Song et al. (2021) among others, show that EGS effectively

alleviates SMEs' financial constraints and dominates traditional credit‐guarantee‐schemes in

markets with perfect information. However, those models provides almost no insight regarding

whether such mitigating effects of EGS still hold under asymmetric information and how

information asymmetry affects SMEs investment and financing decisions.

Following Morellec and Schürhoff (2011), we adopt a signaling approach to analyze the

internal mechanism of the market games of SME investment. We assume that the market has

two types of SMEs: high‐type (high cash flow) firms and low‐type (low cash flow) firms. The

quality of cash flow is private information known only to SMEs owners, creating asymmetric

information between the SMEs and external investors. After investment, the project generates a

cash flow that follows an arithmetic Brownian motion (ABM). ABM was chosen because of the

following reasons. First, cash flow approximated by geometric Brownian motion (GBM) is

always positive while SME cash flow might be negative. Second, for GBM cash flow, investors'

response to price changes follows Weber's Law, driving variation to zero if price approaches

zero (Blaug, 1997). However, with the usual constant‐volatility in ABM, variation in price

remains constant regardless of the price level. Third, ABM has also been extensively used in

option pricing research, for instance, in Smith (1976), Alexander et al. (2012), Hugonnier et al.

(2014), Brooks and Brooks (2017), and Choi et al. (2019), among others.

1

For example, Song et al. (2021) demonstrate that innovative credit guarantee scheme with EGS can effectively increase

SMEs' borrowing capacity.

1348

|

EUROPEAN

FINANCIAL MANAGEMENT

WANG ET AL.