How ripped off are passive stock market investors?

A famous activist investor, Mark Rachesky, said in an interview, "We are extremely hands-on, and I've always been a believer that if you are not in control then somebody else is and they aren't looking out for you." (February 11, 2014)

This quote reveals an important lesson for passive investors - no one is looking out for your interests. So why would a passive investor have performed so well over the past century in the U.S. stock market? Why weren't passive investors more ripped off?

Whoever controls a company, whether a large investor or executives, the controller (not owner) is interested in maximizing the controller's value. The controller of the firm can earn by increasing the stock price, but the controller can also earn by extracting private benefits from a company at the expense of the shareholders.

Mark Rachesky is a firm believer that one can gain substantial influence over a company without paying the control premium of an out-right leveraged buy-out or acquisition. For Rachesky, owning 20% of the equity or more already affords him many of the benefits of control. In some sense, Rachesky is leveraging because he control the firm without having to own 100% of the shares.

Large investors like Mark Rachesky are then able to extract private benefits from the company. Assume that a controller of the firm takes out $1 million. If the market is aware of this but did not suspect it, the stock price falls so that the market capitalization of the company falls by $1 million. However, the controller of the firm owns less than 100% of the equity, so the penalty of taking out the $1 million is only a loss on shares proportional to holdings. If own 20% of the stock, then loses $200,000.

Controlling investors can extract many types of benefits. For example, a controlling investor can delay investments or delay providing "activist" advice until the investor has accumulated his or her full stock position. This way the controller does not pay for the value the controller plans to add. The market may have some expectation of the value a controller may add, but this expectation is uncertain and will not be fully priced in to the stock.

Controlling investors can also access board seats and management more easily. This access provides tremendous amounts of valuable information. Often investors focus on sectors where their network sources opportunities. Access to important information is a large private benefit for these controlling investors.

While the equity premium is a puzzle in finance? A related puzzle is why does an equity premium exist when all firms are controlled by someone who also wants private benefits? Perhaps, the equity premium represents the minimum "bribe" to the shareholders to get them to accept the arrangement.