Agency Costs, Mispricing, and Ownership Structure

This post comes to us from Sergey Chernenko, C. Fritz Foley, and Robin Greenwood at Harvard Business School.

In our NBER working paper, Agency Costs, Mispricing, and Ownership Structure, we propose an explanation based on stock market mispricing for why firms with a controlling shareholder raise outside equity even when they cannot commit not to expropriate minority shareholders. Our main idea is that the controlling shareholder takes advantage of stock market mispricing to offset the burden of agency costs. To the extent that agency costs are deadweight instead of distributional transfers, mispricing facilitates the creation of inefficient ownership structures.

In perfectly efficient markets, minority shareholders anticipate the full extent of agency problems and form unbiased estimates of the cash flows they will receive. If the controlling shareholder is expected to divert resources, minority shareholders price the equity accordingly, and it is the controlling shareholder who ultimately bears all agency costs. Controlling shareholders therefore sell shares to dispersed outside investors only when there are substantial benefits to doing so. The existing literature focuses on motivations related to financial constraints. Our findings suggest another possible, though not mutually exclusive, explanation: equity is sold when it is overpriced. Stock mispricing offsets agency costs and induces a controlling shareholder to raise capital. Higher misvaluations are required to support the creation of ownership structures that give rise to more expropriation.

We test these ideas by studying the public listing of subsidiaries by Japanese corporations. These listings are common in Japan, and in the instances we study, parent companies retain effective control of their subsidiaries post listing, leaving open the possibility that they may take advantage of minority shareholders in the future.

Our empirical evidence is consistent with our three main hypotheses. First, subsidiaries in which the parent firm retains only a minority stake experience poor returns following their listing. Among these subsidiaries, controlling shareholders have effective control but limited cash flow rights, creating incentives for them to divert resources from the subsidiary. Second, performance is poor among subsidiaries for which there is greater ex ante scope for agency problems, namely those that maintain a sales relationship with the parent firm. These subsidiaries earn risk-adjusted returns of -71 basis points per month in the two-year period after listing. Third, a quarter of the subsidiaries listed during our sample period are repurchased by their parent. When such repurchases are announced, shareholders in parent firms and subsidiaries experience positive announcement returns. In the majority of these repurchases, the parent takes the subsidiary private at a discount to the listing price. We interpret these findings as consistent with the idea that controlling shareholders repurchase subsidiaries once mispricing reverts because the costs of diversion are recurring.

Although we test our ideas by looking at subsidiary listings in Japan, the same predictions should apply to other ownership structures that are prone to agency problems, including pyramids, business groups, and dual class shares. Such ownership structures are common around the world, especially in emerging markets. Although financing constraints are likely to be more salient in these settings than in Japan, periods of stock market mispricing could also contribute to the formation of these ownership arrangements.

The full paper is available for download here.

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