Inside Ownership, Agency Costs and Equity Valuation: Evidence from REITs

We investigate relations between inside ownership, managerial expenses and equity valuations. Our engine of analysis —Real Estate Investment Trusts (REITs) —provides a unique and rich framework for analysis since we can calculate extremely accurate measures of asset replacement costs, and hence relative valuation (Tobin's Q). Further, the nature of the financial statements allows us to examine the impact of insider ownership on agency costs since we can accurately measure the costs of the entire management team. Our results show that firms with greater insider holdings tend to invest in assets with lower systematic risk and use less debt in their capital structure. Also, managerial expenses are generally lower as inside ownership increases. Finally, higher levels of insider ownership are associated with higher multiples of cash flows and hence, higher relative valuation. 1. Introduction One of the more contentious issues in the finance literature concerns the relation between ownership structure and firm valuation or financial performance. Various authors have taken at least three tracks towards theoretically predicting these relations. One track, which dates at least as far back as Jensen and Meckling (1976), argues that the existence of shareholders who are not managers gives rise to potential agency problems. Under this " agency cost " paradigm, managers may have incentives make decisions that are in their, but not their shareholders', best interests. Jensen and Meckling argue that increases in inside ownership mitigate the potential for such costs since actions that do not benefit shareholders punish the managers through their wealth stakes in the firm's equity. A second track argues the contrary: that agency costs in fact increase with inside ownership. Under this paradigm, greater inside ownership makes the coalition of the requisite votes required to discipline—especially the ultimate disciplinary action of removal via take-over—increasing difficult 1. A third track investigates the relation between changes in inside ownership and subsequent performance. Under this paradigm, managers are assumed to have access to non-public information and to trade for