Investor Demand, Financial Market Power, and Capital Misallocation
46 Pages Posted: 23 Nov 2021 Last revised: 15 Jun 2022
Date Written: November 19, 2021
Fluctuations in investor demand dramatically affect firms' valuation and access to capital. To quantify their real impact, we develop a dynamic investment model that endogenizes both the demand- and supply-side of capital. Strong investor demand elevates equity prices and dampens price impacts of issuance, facilitating investment and financing, while weak investor demand incentivizes firms to opportunistically repurchase shares, crowding out investment. We estimate the model using indirect inference by matching the endogenous relationship between investors' portfolio holdings and firm characteristics. Our estimation suggests that investor demand is an important driver of misallocation, compared with real investment and debt market frictions. Eliminating excess demand reduces dispersion in the marginal product of capital by 11.68% and TFP losses by 13.14%. Investor demand also generates a heavy right tail in the firm size distribution---large excess demand provides firms with market power and opportunities to profit from their financial market transactions, contributing to the emergence of superstar firms.
Keywords: investor demand, capital misallocation, demand estimation, financial market power.
JEL Classification: G30, G10, G20, E22
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