Investor Protection , Diversification , Investment , and Tobin ’ s q ∗

We develop a dynamic incomplete-markets model where an entrenched insider, facing imperfect investor protection and non-diversifiable illiquid business risk, makes interdependent consumption, portfolio choice, expropriation, corporate investment, ownership, and business exit decisions. Unlike in the first-best, the insider’s tradeoff between private benefits and under-diversification costs leads to the following results: (1) the firm either overor under-invests, depending on firm size; (2) the insider’s private valuation fundamentally differs from diversified investors valuation;(3) conditional CAPM holds for outside equity; (4) the insider demands an additional idiosyncratic risk premium; (5) the exit option and ownership dynamics are important for the insider to manage business risk. ∗We thank Bernie Black, Patrick Bolton, Peter DeMarzo, Mike Fishman, Steve Grenadier, Yaniv Grinstein, Bob Hall, Ross Levine, Erwan Morellec, Tom Sargent, John Shoven, Suresh Sundaresan, Jeff Zwiebel, and seminar participants at Columbia, Cornell, 2012 WFA for helpful comments. †Cornerstone Research. Email: [email protected]. Tel. 212-605-5017. ‡Columbia University and NBER. Email: [email protected]. Tel.: 212-854-3869. §Columbia University and Shanghai University of Finance and Economics (SUFE), China. Email: [email protected]. In contrast to the common belief that corporations are widely held (Berle and Means (1932)), many corporations around the world, including large publicly traded companies, have controlling shareholders such as founders, founding family members, and States. La Porta, López-de-Silanes, and Shleifer (1999) document controlling shareholders’ concentrated ownership in large firms around the world.1 With weak investor protection, controlling shareholders, whom we also interchangeably refer to as insiders, become entrenched and pursue private benefits at the expense of outside investors. By “investor protection,” we broadly refer to features of institutional, legal, political, regulatory, and market environments as well as corporate governance mechanisms at the firm level, which facilitate financial contracting and contractual enforcement, and protect investors against expropriation by corporate insiders. Agency problems take a variety of forms including outright stealing from the firm, selling the firm’s output to a related party at below market prices, hiring unqualified friends, and selfserving value-destroying investment, just to name a few.2 It is difficult to verify and contract on decisions such as corporate investment, since they often involve managerial discretion and judgment. Penalizing self-serving insiders based on value-destroying investment is difficult, especially under weak investor protection. We take private benefits and corporate investment as non-contractible in our analysis. By holding a concentrated ownership, insiders alleviate agency conflicts with outside investors but incur an under-diversification cost due to imperfect risk sharing, illiquidity, and incomplete markets frictions. We incorporate the key frictions, imperfect investor protection and the insider’s lack of diversification, in an integrated dynamic framework, where the entrenched insider makes interdependent business decisions (private benefits, corporate investment, business exit) and household decisions (consumption-saving and portfolio choice). Using this framework, we address the following questions: What determines corporate investment in firms run by controlling shareholders? How do private benefits of control influence corporate investment and Claessens, Djankov, and Lang (2000) and Faccio and Lang (2002) document concentrated ownership for large public firms in East Asian countries and Western European countries, respectively. For example, see La Porta et al. (2000a) for such a statement in an influential survey on investor protection and corporate governance.