Is Control Friction Always Hurting Outside Investors? Implications from a Theoretical Study

Abstract

We analyze the financial and welfare implications of corporate control frictions. Our dynamic stochastic model features control-ownership wedge where outside investors have imperfect control over the decisions of their firm, and a rich opportunity set available to the firm that allows it to trade unconstrainedly in financial markets. The model makes numerous predictions. A deterioration of the protection for outside investors initially depresses but later on raises the firm’s dividend payouts. The firm’s controlling agent exploits the control friction by over-investing and taking more aggressive positions in the stock market. The empire building motive of the controlling agent at a higher degree of control friction may actually drive up the firm valuation. The controlling agent generally gains from a lower degree of investor protection and the implied utility gains are higher for a lower investment risk, a lower degree of risk aversion, and a lower equity risk premium.