Academic journal article Journal of Corporation Law

The Hidden Costs of Private Benefits of Control: Value Shift and Efficiency

Academic journal article Journal of Corporation Law

The Hidden Costs of Private Benefits of Control: Value Shift and Efficiency

Article excerpt

I. INTRODUCTION AND INQUIRY

This paper examines how two legal regimes governing transfers of control (the "Market Rule" and the "Equal Opportunity Rule") affect the initial public offerings (IPOs) through their influence on private benefits of control. Not only ex post efficiency costs, but also the value-transfer nature of private benefits may thwart efficient IPOs by creating a wedge between discounted stock priced to reflect private benefits of control and the value that the initial owner will really capture. As this paper shows, the two legal regimes generate this wedge through different mechanisms that center, respectively, on competition in the market for control block (for the Market Rule) and asymmetric information about private benefits of control (for the Equal Opportunity Rule).

As economic researchers have found, the controlling shareholder structure, as opposed to diffuse ownership, dominates corporate ownership around the world.1 Even in the United States, where large companies are commonly diffusely held, IPOs generally create an ownership structure in which initial owners retain majority ownership.2 As is well-known, controlling shareholders can extract private benefits of control,3 which influence patterns of ownership structure and external financing by impeding controlled firms from issuing equity to investors and dissuading existing controllers from breaking up their control block.

La Porta, et al. have found that the magnitude of private benefits of control correlates negatively with the incidence of IPOs as well as the size of equity market.4 Given this recent finding, an obvious but important question is: "What features of private benefits of control hamper controllers from taking IPOs, and equity financing in general?" A generic response would be that private benefits of control reduce the value of public shares, which results in a corresponding discount in the stock price, thus discouraging initial owners from selling their stock.5 This answer may not follow, however, given that the discount for private benefits in pricing stock in an IPO merely reflects the private benefits of control that he or she will eventually capture.

Private benefits of control may undermine the value of a company because their extraction (or the possibility of their extraction) generates suboptimal decisions. This efficiency-costs aspect of private benefits of control clearly impedes an initial owner from taking her firm public, given that this owner must internalize the entire wealth effects of private benefits of control so long as the stock market anticipates these effects.6

Inherent in private benefits of control, however, is the transfer of value from minority shareholders to the controlling shareholders (the value-shift aspect). In contrast to the efficiency-costs aspect of private benefits, it is not entirely clear whether (and if so how) the value-shift aspect of private benefits of control also impedes IPOs. Shifts in value alone that do not impose efficiency costs do not affect returns to initial owners so long as stock prices truly reflect these shifts. Thus, the value-shift aspect of private benefits does not necessarily hinder initial owners from going public. Accordingly, the critical question is: How is the value-shift aspect of private benefits reflected in the IPO pricing?

This paper sheds light on the value-shift nature of private benefits. Part II sets up the framework of analysis. From the widespread recognition that controllers differ in their ability to extract private benefits, we may distinguish the maximum limit from the actual size of private benefits that a particular controller will divert. Part III presents the analyses for each rule, which respectively show how the value-shift nature of private benefits alone cuts the payoffs that the initial owner may realize through an IPO. The two rules yield disparate mechanisms because they differ in whether they allow the initial owner to sell, after the IPO, the control block, in order to augment the size of private benefits. …

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