Private Investment and Public Equity Returns

Abstract

Owners of non-publicly-traded businesses who face significant external financing costs should have a hedging preference for financial assets whose returns are positively correlated with self-financing needs. If this effect is aggregated, expected returns on financial assets should correspond negatively with aggregate private investment self-financing needs. To test the cross-sectional asset pricing implications of this conjecture, we use realized noncorporate investment growth and future forecasted noncorporate investment growth as proxies for self-financing needs. We find that our private investment empirical specification can explain a good share of the cross-sectional returns of size-, value- and distress-sorted equity portfolios, almost as well as the Fama-French factors. However, in the Fama-French model, the estimated risk premium for the market factor is significantly negative. This contradicts traditional portfolio-diversification theory. Our specification, in contrast, generates estimated risk premia whose signs accord our story of private investment self-financing needs. We also consider how our results compare to the return-on-equity and investment factors of Chen, Novy-Marx and Zhang (2011), and find that our models are not coextensive. Finally, we consider how our results depend on credit boom versus credit crunch conditions and find that returns behave in a way that is consistent with our private investment story.