This paper examines the effects of the agency costs on firm performance in 156 Chinese publicly listed companies with private ultimate owners between 2002 and 2007. The ultimate owners’ agency costs are measured by the divergence between cash flow rights and control rights. Agency costs are shown to negatively and significantly affect firm performance, as measured by Tobin’s Q. A major contribution of this paper is to identify connected party transactions as a channel through which such agency costs exert negative impact firm performance. Evidence from the public record of law violations of those firms lends further support to the “tunneling” view on the connected party transactions. The paper also shows that the larger the divergence, the less likely that firm managers will implement value-increasing industrial diversification. The last finding remains a puzzle.