Large Shareholder Activism, Risk Sharing, and Financial Market Equilibrium

TLDR

The paper models a large investor who uses costly monitoring technology that influences securities’ expected payoffs. Share allocations arise from trading among risk‑averse investors in a market where the large investor’s monitoring technology is costly. The analysis shows that, despite a free‑rider problem, risk‑sharing can induce monitoring; in some equilibria the allocation is Pareto efficient and all investors hold the market portfolio regardless of the monitoring technology, while in others risk‑sharing distortions arise and monitoring can lower expected payoffs.

Abstract

We develop a model in which a large investor has access to a costly monitoring technology affecting securities' expected payoffs. Allocations of shares are determined through trading among risk-averse investors. Despite the free-rider problem associated with monitoring, risk-sharing considerations lead to equilibria in which monitoring takes place. Under certain conditions the equilibrium allocation is Pareto efficient and all agents hold the market portfolio of risky assets independent of the specific monitoring technology. Otherwise distortions in risk sharing may occur, and monitoring activities that reduce the expected payoff on the market portfolio may be undertaken.