Optimal Portfolios with Monitoring, Private Benefits of Control, and Budget Constraints

Abstract

This paper develops a model that combines features of portfolio theory and corporate governance research. The model analyzes the problem of how large investors form optimal equity portfolios when the return on each investment depends on the size the investment. The optimal solution counterweighs the benefits of higher returns through private benefits of control and monitoring of firm management with the costs of higher transaction prices and bearing diversifiable risk. The general model predicts that controlling investors will monitor more the firms in which they can appropriate more private benefits of control. Large investors are more likely to buy controlling blocks in smaller firms, firms with higher private benefits of control, and firms where the trading costs of buying large blocks are smaller. A special case is numerically solved using an integer-programming algorithm. The numerical analysis shows that investor utility is strictly increasing in available capital for purchasing controlling blocks. The optimal portfolios of large investors dominate the portfolios of small investors both in terms of expected return and risk. The classical result that the efficient frontier is the same for all investors regardless of their wealth does not hold in the setting of this paper.