The Benchmark Inclusion Subsidy

Kashyap, A K, Kovrijnykh, N, Li, J and Pavlova, A (2018) The Benchmark Inclusion Subsidy. Working Paper. London Business School CEPR Discussion Paper.

Abstract

We study the impact of evaluating the performance of asset managers relative to a benchmark portfolio on firms' investment, merger and IPO decisions. We introduce asset managers into an otherwise standard asset pricing model and show that firms that are part of the benchmark are effectively subsidized by the asset managers. This "benchmark inclusion subsidy" arises because asset managers have incentives to hold some of the equity of firms in the benchmark regardless of the risk characteristics of these firms. Contrary to what is usually taught in corporate fice, we show that the value of an investment project is not governed solely by its own cashflow risk. Instead, because of the benchmark inclusion subsidy, a firm inside the benchmark would accept some projects that an identical one outside the benchmark would decline. The two types of firms' incentives to undertake mergers or spinoffs also differ and the presence of the subsidy can alter a decision to take a firm public. We show that the higher the cashflow risk of an investment, the larger the benchmark inclusion subsidy; the subsidy is zero for safe projects. Benchmarking also leads fundamental firmlevel cashflow correlations to rise. We review a host of empirical evidence that is consistent with the implications of the model.