Investor Protection and the Demand for Equity

1. Investor Protection and the Demand for Equity Mariassunta Giannetti Stockholm School of Economics, CEPR and ECGI and Yrjö Koskinen Boston University School of Management and CEPR

2. Motivation • This paper: How investor protection affects the demand for equityand what are the implications • Law and Finance literature: Investor protection affects the supply of equity • Existing controlling shareholder sells part of the company to outside investors • Outside investors always participate, if break-even condition met

3. Motivation (2) • Anecdotal evidence suggests that the demand for equity is important • I simply would not buy a company with poor corporate governance.” • CFO, USD 3bn European Private Bank • New empirical evidence (Giannetti and Simonov, forthcoming JF) suggests that outside investors avoid companies or countries with corporate governance problems • Why?

4. Main idea (1) • Investor protection affects how cash flows are split between investors who enjoy only security benefits and investors who enjoy both security benefits and private benefits of control • Weak investor protection laws increase wealthy investors’ demand for equity • Increased incentives to become a controlling shareholder, because extraction of private benefits easier • Weak investor protection laws decrease portfolio investors’ demand for equity • Lower incentives to participate in domestic market • Higher incentives to invest abroad

5. General results (1) • Prices and returns • Increased demand from wealthy investors increases stock prices • Prices become too high with respect to security benefits, because prices reflect demand from investors interested in control • Expected returns become too low for non-controlling investors

6. General Results (2) • Limited domestic stock market participation • Investors with small amount of wealth may want to opt out the domestic stock market when investors are poorly protected • Ownership is more concentrated when investor protection is poor • Wealth distributionmatters for ownership concentration if the market for control is segmented • Canada (Morck et al, 2003) • Rajan and Zingales (2003): Explanation for the Great Reversal?

7. General Results (3) • Home equity bias • In weak investor protection countries • Wealthy investors may want to become controlling investors in the domestic stock market when investor protection is poor • In strong investor protection countries • Portfolio investors from a country with good investor protection prefer to invest there • Good country bias • Portfolio investors from countries with poor investor protection invest more abroad • Bad country bias • Foreign controlling shareholders want to invest in countries with poor investor protection

8. Outline • Modeling approach • Empirical evidence • Existing evidence • New evidence

9. Model setup (1) • Two countries, Home and Foreign • Home and Foreign differ in the level of investor protection • Fixed participation costs: it costs c to participate in each stock market • Two assets in each country • Risk free asset, zero return • Risky asset, fixed supply normalized to 1 • Risky asset payoffs identically distributed and positively correlated for Home and Foreign • No short sales or borrowing

10. Model setup (2) • Heterogeneous investors • Investors differ in the amount of initial wealth • Participation to the stock market is costly • Investors have the opportunity to become a controlling shareholder by holding a stake • Controlling shareholders can divert part of the cash flow • No dead-weight loss • B shared pro-rata between controlling shareholders • Investor protection affects private benefits of control, B • Transfer from portfolio investors to controlling shareholders

11. Model setup (3) • Investors maximize the expected utility from final period wealth and private benefits (if they acquire control)

12. Model setup (4) • Equilibrium • Portfolio investors’ demand + controlling investors’ demand = supply • Prices determined in equilibrium • Market for control • Segmented – only domestic investors can acquire control • Integrated – all investors can acquire control

13. Timing • At t=0, domestic and foreign investors make their portfolio decisions • At t=1, before the random cash flows are realized, investors who have acquired control rights have the opportunity to extract private benefits • At t=2, cash flows net of private benefits are distributed to all investors

14. Equilibrium I • Market for control segmented: • Portfolio investors invest more in the country where investors well protected • Expected returns increasing in the level of protection • If wealth distribution same, returns higher in the high investor protection country • If wealth distribution is relatively even there are no controlling shareholders in equilibrium even if investor protection is poor

15. Equilibrium II • Market for control integrated: • If Home has poorer investor protection than Foreign • Portfolio investors participate more in Foreign • Security returns are lower at Home • Ownership is more concentrated at Home • Ownership concentration does not depend any longer on domestic wealth distribution • If wealth distribution the same, Home receives net inflow of FDI, whereas Foreign receives net inflow of portfolio investment

16. Empirical evidence • Existing evidence • Ownership more concentrated when investor protection poor • La Porta et al. 1998 • Stock returns are lower in equilibrium when investor protection is poor • Gompers, Ishiii, and Metrick, 2003 • Core, Guay and Rusticus, 2004; • Cremers and Vinay, 2004; • Yermack, 2004; and • Lombardo and Pagano, 1999

17. Empirical evidence (2) • Existing evidence (continued) • Foreigners invest less in countries where ownership is concentrated and investor protection is weaker • Compatible both with supply and demand channels • Dahlquist et al. 2003; Dahlquist and Robersson, 2001 • Aggarwal et al., 2002 • Lins and Warnock, 2004: Independent effect of corporate governance • Foreign direct investment to countries with weak investor protection • Kelley and Woidtke (2002) • New evidence • Stock market participation positively related to investor protection • Portfolio investors’ hold more foreign equity in countries with weak investor protection

18. Investor protection and stock market participation • Hand collected data on stock market participation (various sources)

19. Investor protection and foreign equity holdings

20. Institutional investors’ holdings of foreign equity

21. Conclusions • Investor protection and corporate governance affect portfolio choices and stock returns • Investor protection affects differently the demand for equity • Good investor protection increases demand from portfolio investors, because security benefits are higher • Good investor protection reduces demand from controlling shareholders, because private benefits are lower • Model provides a theoretical justification for lower stock returns when investors are poorly protected • Prices reflect demand from controlling shareholders