The Benchmark Inclusion Subsidy

We study the effects of evaluating asset managers against a benchmark on corporate decisions, e.g., investments, M&A, and IPOs. We introduce asset managers into an otherwise standard model and show that firms inside 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 their risk characteristics. Due to the benchmark inclusion subsidy, a firm inside the benchmark values an investment project more than the one outside. The same wedge arises for valuing M&A, spinoffs, and IPOs. These findings are in contrast to the standard result in corporate finance that the value of an investment is independent of the entity considering it. We show that the higher the cash-flow risk of an investment and the more correlated the existing and new cash flows are, the larger the subsidy; the subsidy is zero for safe projects. We review a host of empirical evidence that is consistent with the model's implications.