Bridge over ocean
1 May 2013 CFA Institute Journal Review

Agency Costs, Mispricing, and Ownership Structure (Digest Summary)

  1. Gregory G. Gocek, CFA

In corporate reorganizations, when sufficient opportunity is available in the form of equity mispricing, parent companies often seize advantages and offer fairly bleak prospects for outside investors.

What’s Inside?

The potential conflicts of interest that motivate controlling shareholders pose hazards to investors during corporate reorganizations. Effective market pricing that internalizes related agency costs and limits such detriments may not exist when the involved equity is overvalued. Using stock market data that track spinoffs of subsidiaries in Japan, the authors investigate the impact on minority owners. They find evidence of value transfers to parent firms when larger equity stakes in subsidiaries are sold. Additionally, when there is greater market overvaluation at the time of spinoffs, the holdings of minority owners historically underperform. Finally, after reversion of mispricing, parent firms often repurchase their subsidiaries at large discounts to valuations at the time of listing, receiving positive abnormal returns at the repurchase announcement.

How Is This Research Useful to Practitioners?

The authors pose the latest challenge to long-accepted theories that corporate ownership is organized to maximize firm value, with minority investors fully anticipating potential abuses by controlling shareholders and suitably charging for their outside capital. Additionally, they offer an explanation for the basis of the equity carve-out decision. Rather than seek otherwise unavailable capital to finance profitable projects, owners strive for market timing to offer shares at premium equity valuations. But such external stock market mispricing facilitates the creation of ownership structures that are prone to agency problems. These structures are often dismantled once prices correct themselves—a “have your cake and eat it too” proposition for manipulative insiders.

The authors stress the importance of pursuing a deep understanding of the business setting. The legal hurdles are low for motivated expropriators in Japan because of the weak nature of both transfer-pricing regulation, which affects intracorporate exchanges, and corporate reorganization rules, which affect minority squeeze-outs, related-party transactions, and usurped business opportunities.

How Did the Authors Conduct This Research?

Japan Company Handbook data of the listings of subsidiaries of Japanese public companies are tracked at five-year intervals for 1980–2005 (including 1987), with subsidiaries defined as entities whose corporate parents owned at least 20% of their equity both before and after the listing. Post-listing ownership of both the parent and subsidiary firms are checked to ensure that no substantial overlap exists between the groups. This process allows the authors to account for differential effects of equity mispricing and focuses their research on firms in which the parent maintains effective control but owns a relatively small percentage of the cash flows. Market value and stock return data to track post-listing performance are sourced from DataStream.

The authors perform statistical tests and in most cases calculate risk-adjusted returns using the standard Fama–French risk factors. After establishing the parent firms’ financial constraints prior to listing and the cumulative monthly returns of parents and subsidiaries for three years after the listing, they use regression analyses to produce data tables for the book-to-market ratio of new listings, the cumulative three-year returns (at one-year intervals) following subsidiary listings, the risk-adjusted returns for the full sample and two subsets of subsidiaries, the comparative risk-adjusted returns of subsidiary versus nonsubsidiary listings, and the returns from ownership changes after listings, gained via either a buy-and-hold strategy or reacquisition by the original parent.

Abstractor’s Viewpoint

The authors emphasize an aggregate influence on controlling shareholder sell-off decisions. Namely, when market mispricing induces higher misvaluations, corporate reorganizations accelerate and, given weak minority shareholder protections, benefit the issuers. Although they do not theorize on the source of such mispricing, the authors point to investor underestimation of agency problems in the misperceptions of conflicts of interest, even after prominent disclosure of such risks. Their work offers a foundation for reforms in corporate governance, such as increased prevalence of independent directors or avoidance of the inefficient ownership structures of pyramids, business groups, and dual-class shares prone to deadweight losses incurred to cover resource diversions. As Occam’s razor suggests, financial simplicity often works best.

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