Separation of corporate control from ownership is one of the main features of modern capital markets. Among its many virtues, it allows the participation of small investors in the equity market, increasing the supply of funds, dissipating risks across the economy, and lowering the cost of capital for firms.
Its biggest drawback is the agency conflict between corporate insiders who run the firm and can extract private benefits of control, and outside minority investors who have cash flow rights on the firm, but no control rights (e.g. Berle and Means (1932) and Jensen and Meckling (1976)). This agency conflict is the focus of a voluminous body of research in corporate finance. Recurrent corporate scandals constitute a stern reminder of the existence of these conflicts and of the private benefits exploited by insiders even in the least suspicious markets.
Following Shleifer and Vishny (1997) and La Porta et al. (1998), a large empirical literature has firmly established the existence of large shareholders in many corporations around the world (La Portal et al. (1999)). These shareholders have much larger control rights within the firm compared with their cash flow rights as they obtain effective control through dual class shares, pyramid ownership structures, or cross ownership (Bebchuk et al. (2000)). With the separation of control from ownership, controlling shareholders have the incentives to expropriate outside minority shareholders.
This conflict of interests is at the core of agency conflicts in most countries and is only partially remedied by regulation aimed at protecting minority or outside investors. There is considerable empirical evidence that stock market prices reflect the magnitude of these private benefits derived by controlling shareholders. Firm value increases with the extent of protection of minority investors, and with the stock ownership of controlling shareholders. While it is intuitive that weak investor protection lowers equity prices, the effect of investor protection on equity returns and the interest rate is less obvious conceptually.
In this paper, we provide a model to study the effect of imperfect investor protection on equilibrium asset pricing. We depart from traditional production (investment) based equilibrium asset pricing models in two important ways. First, we acknowledge that the controlling shareholder makes the firm investment decisions in his own interest, which naturally differ from firm value maximization. Second, we embed the separation of ownership and control into an equilibrium asset pricing model in which both the controlling shareholder and outside investors optimize their consumption and asset allocations. Hence, the equilibrium asset prices affect the investment and payout decisions of the controlling shareholder through his preference to smooth consumption over time and, in turn, these investment and payout decisions also affect the equilibrium asset prices.
The controlling shareholder chooses consumption and the risk-free asset holdings in addition to firm investment and payout policies to maximize his lifetime utility. The trade-offs associated with the corporate investment decision in our model differ from the standard value-maximizing ones. First, the controlling shareholder’s marginal benefit to investment is his private marginal return to capital net of the cost of extracting these benefits.
The controlling shareholder’s private return to capital is higher than the observed public return to capital and, in the model as in the data (Barclay and Holderness (1989)), the level of private benefits increases with firm size. Second, the marginal cost to investment has two components, one being the traditional cost due to postponing consumption and the other resulting from an increased volatility in consumption. Motivated by empirical evidence, we assume that capital accumulation is stochastic with the volatility of shocks increasing in the level of investment. Intuitively, more investment generates on average more output in the future, but it also yields more output volatility.
