The Benchmark Inclusion Subsidy

We study the impact of evaluating the performance of asset managers relative to a portfolio on firmsu0027 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 are effectively subsidized by the asset managers. This benchmark inclusion arises because asset managers have incentives to hold some of the equity of firms in the regardless of the risk characteristics of these firms. Contrary to what is usually taught in corporate finance, we show that the value of an investment project is not governed solely by its own cash-flow risk. Instead, because of the inclusion subsidy, a firm inside the would accept some projects that an identical one outside the would decline. The two types of firmsu0027 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 cash-flow risk of an investment, the larger the inclusion subsidy; the subsidy is zero for safe projects. Benchmarking also leads fundamental firm-level cash-flow correlations to rise. We review a host of empirical evidence that is consistent with the implications of the model.