This paper examines the effects of the agency costs on firm value in 156 Chinese publicly listed companies with individual ultimate owners between 2002 and 2007. The ultimate owners’ agency costs, as measured by the divergence between control rights and cash flow rights, are shown to negatively and significantly affect firm value, as measured by the market-to-book ratio of assets (an approximation of Tobin’s Q). As the agency costs grow, the stock returns decrease around the connected party transaction announcements, and firms are more likely to engage in value-destroying connected party transactions. These effects are particularly strong for some types of connected party transactions, notably loan guarantees and direct fund transfers. Further, as the agency costs grow, the firms violate laws more frequently and the nature of legal violations becomes more severe. Evidence from an exogenous policy shock, the non-tradable share reform confirms that higher agency costs cause more unfavorable stock market reactions to connected party transaction announcements.

The study aims to analyze the role of institutional investors in mediating the interest conflicts between blockholders and minority shareholders in emerging markets. China’s Non-tradable Share Reform provides us a perfect research environment. Before the reform, the ownership of Chinese public firms was concentrated in one or several blockholders. This part of block shares was non-tradable, and tradable shares were held by minority shareholders and institutional investors like mutual funds. Chinese government launched Non-tradable Share Reform in 2005, giving non-tradable shares liquidity rights. At the same time, non-tradable share owners had to compensate tradable share owners, such as offering a certain percentage of shares to them. The compensation schemes were advanced by non-tradable share owners and must be supported by two-thirds of votes cast by tradable share owners. Our study finds that institutional investors did actively participate in voting, but their number and holdings were reversely related with the compensation level. Our results suggest that institutional investors played shareholder activism in this reform, but their activism served for blockholder’s interests rather than minority shareholders’.