Private investment and public equity returns

Because of external financing costs, private business owners often need to self-finance new investment projects. These self-financing needs create an incentive for business owners to hold financial assets whose payoffs are positively correlated with self-financing needs. If this effect is aggregated, expected returns on financial assets should be negatively correlated with aggregate private investment self-financing needs. To test the cross-sectional asset pricing implications of this conjecture, we use realized noncorporate investment growth and future forecasted noncorporate investment growth as proxies for self-financing needs. We find that our private investment model can explain a good share of the cross-sectional returns of size-, value-and distress-sorted equity portfolios, almost as well as the Fama-French factors. In contrast to the Fama-French model, however, we find the signs on our estimated coefficients to be consistent with our theoretical predictions. (C) 2011 Elsevier Inc. All rights reserved.