Ownership Dynamics and Asset Pricing with a Large Shareholder

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Abstract
A large shareholder who undertakes costly effort to improve a firm's dividends faces a tradeoff. Decreasing her stake in the firm will likely lower the share price (as the market anticipates a reduction in effort), while holding it fixed implies a less diversified investment portfolio. Moreover, in a dynamic setting a time -consistency problem emerges: once her stake is reduced, the incentive to reduce it further may increase since the large shareholder is less exposed to the resultant price declines. We analyze a multi -period general equilibrium model for the optimal ownership policy of a large shareholder. We consider the case in which the large shareholder can commit to an ownership policy, and the case in which such commitment is impossible. Absent commitment, the problem is similar to durable goods monopoly: the share price today depends on the shares expected to be sold in the future. We show that the large shareholder's stake ultimately converges to the competitive price-taking allocation, even though this solution entails inefficient monitoring. With continuous trading, if the moral hazard problem is small, then the large shareholder trades immediately to the price-taking allocation. With sufficient moral hazard, however, the large shareholder adjusts his stake gradually over time. While the ownership policy (and therefore the dividend process) is complicated in this case, our results produce a simple formula for the equilibrium share price in this setting: the ownership policy of the large shareholder can be ignored, and today's share price is simply the present value of dividends given constant holdings by the large shareholder, but adjusted by a risk premium that reflects the large shareholder's (rather than investors') risk aversion. We apply our model to provide a rationale for both IPO underpricing and the use of lockup provisions. Finally, we generalize our results outside the moral hazard framework. † This paper originally circulated with the title, "Optimal Trading by a Large Shareholder." We are

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