Martin Schmalz, assistant professor of business administration and finance at the University of Michigan, speaks about the anti-competitive effects of common ownership, a situation in which competing firms operating in the same industry share identical major shareholders.
The issue of common ownership, a situation in which competing firms operating in the same industry share identical major shareholders, has been getting attention recently in discussions on antitrust policy in the U.S. and in Europe.
In order to better understand the broader implications of common ownership, we recently interviewed Martin Schmalz, the NBD Bancorp Assistant Professor of Business Administration and Assistant Professor of Finance at the University of Michigan’s Ross School of Business, who studied this issue extensively.
In his Q&A with ProMarket, Schmalz spoke about the anti-competitive effects of overlapping ownership of competitors, and what antitrust agencies can do to mitigate the rise of common ownership.
Q: In your paper “Anti-Competitive Effects of Common Ownership,” you (and co-authors José Azar and Isabel Tecu) examined the effects common ownership has had in the airline industry, and found that ticket prices are 3-11 percent higher as a result. Can you briefly describe the literature that preceded your paper?
Our empirical paper on the airline industry was preceded by decades of theoretical research predicting that common ownership changes the objective function of the firm to internalize the profits of competitors, and therefore has the potential to harm competition. It also followed several papers that empirically showed that firms’ largest shareholders are indeed diversified within industries—but none of them showed empirically that these ownership patterns mattered for outcomes. This literature is too large to do justice in this interview, but the most closely related are given in the below footnote.((Hart (1979), Rotemberg (1984), Farrell (1985), Bresnahan & Salop (1986), Reynolds & Snapp (1986), Gordon (1990), Flath (1991, 1992), Bolle & Güth (1992), Malueg (1992), Admati, Pfleiderer, and Zechner (1994), Hansen & Lott (1996), Gilo (2000), O’Brien & Salop (2000), Gilo, Moshe & Spiegel (2006), Rubin (2006), Davis (2008), Azar (2012, 2016).)) To me personally, the Princeton dissertation of my classmate and coauthor José Azar was the first point of contact to that literature. He has since expanded his paper to include a new theory of the firm and an equilibrium model of oligopoly/monopsony.
One key reason why that literature only had a limited impact for a long time is that people recognized there were diversified investors–but they didn’t know those were the largest investors in the ownership structure of firms! (Before looking at the data, I certainly thought Bill Gates was Microsoft’s largest shareholder, much larger than diversified mutual funds such as BlackRock or Vanguard–but I was wrong.)
A second reason is that few people challenged the widely held—but erroneous—belief that diversified “passive” institutional investors take no influence on portfolio firms. Some audiences of our paper even professed that mutual funds with passive investment strategies don’t vote their shares. That is of course a dangerous misconception. Clearing up such misconceptions, and complementing the rich theoretical literature with empirical evidence that its predictions hold true in the data is the focus of our agenda.
That said, it’s actually quite troubling or at least surprising that, to some people, the problem is assumed to not exist unless researchers show empirically that the effects predicted by basic incentive theory actually play out in the data. To explain why that’s surprising, consider that the typical approach in antitrust is to ask two questions: are there incentives for anti-competitive behavior? And is there ability to implement the incentives? If the answer to both questions is “yes,” there is a problem. In the case of present-day common ownership structures, there is little doubt that the answer is “yes” to both questions. Even Jack Bogle, the founder of Vanguard, in a recent interview conceded that the influence of mutual funds on their portfolio firms has become so considerable that perhaps it was time for regulators to give some thought to the issue.
Q: When did common ownership in the asset management industry, with the asset management business concentrated among a few big firms, become a serious issue?
The growth of “passive” investing, combined with consolidation in the asset management industry, has driven the growth of common ownership for decades, but the trend has accelerated considerably in the past 10 years or so. One reason for this trend is that fewer and fewer people hold individual shares in their portfolios, but instead move to diversified funds, just as we teach our students in business school they should! A second reason is mergers between asset managers, most importantly the acquisition of BGI by BlackRock in 2009.
Let me give you an idea of how big these firms have become as a result, relative to other shareholders. The Economist reported (based on data compiled by my Michigan colleague Jerry Davis) in 2013 that BlackRock was the largest shareholder of one fifth of all U.S. publicly traded firms—and the firm has become considerably larger since then, with now $5 trillion assets under management. As of this summer, I count that BlackRock is also the largest shareholder of 33 of the FTSE 100 companies (and within the Top 5 shareholders in 89 of the FTSE 100), one third of the DAX 30, etc. The Icelandic competition authority tells me that among the top two Telecom providers, the top two insurance companies, and in other industries, four of the five largest shareholders are identical. In short, at this point, the phenomenon is very widespread.
But of course nothing is new under the sun. Around the turn of the last century, concentrated ownership positions—effectuated through voting trusts or otherwise—were part of the reason why antitrust laws and regulations were developed in the first place. Congress in the 1940s discussed the dangers to society of mutual funds gaining control of U.S. corporations (Roe, 1990). A few weeks ago, closing the circle, The Wall Street Journal likened the power of the big mutual funds to those of JP Morgan and Rockefeller a century ago. So we really just rediscovered a phenomenon that has been occurring and reoccurring for a long time.
Q: What do you think is the most important channel through which the asse
t management companies collude? What are the signals? They are not controlling shareholders, they don’t sit on boards. How does the mechanism of collusion work when we’re dealing with asset managers, and not with regular investors or shareholders?
First, we make a concerted effort not to refer to the phenomenon we study as “collusion.” Collusion is a technical term, a legal term, that refers to an agreement between firms, e.g. not to cut prices or to expand output. But that is not what we have in mind at all.
The whole trick of common ownership is that you need no collusion for higher prices to obtain, because common ownership reduces the incentives to compete in the first place. The reason is that competing less aggressively can be in the unilateral interest of each firm in isolation. When the most important shareholders have reduced interests in their firms competing, why would the firms still compete? If you operate under the premise that by and large, firms act in the interest of their dominant shareholders, you really shouldn’t be surprised that common ownership leads to less competition, even absent nefarious theories about “collusion” (which we never even entertain in our joint papers).((That said, it is possible that common ownership makes coordinated effects more likely: when a common owner tells each portfolio firm that he thinks they should increase prices and decrease output, it is not illegal for each of the CEOs of the firms addressed to guess that the investor probably said the same thing to the competitors she owns as well, and it is not illegal for the same CEO to guess that the other CEOs will adjust their strategies accordingly. This way, common ownership could also increase coordination between firms. But our empirical work doesn’t clearly distinguish between such a pattern or uncoordinated effects, so you will not find us making claims to that effect.))
After clarifying the vocabulary, let’s talk about the mechanism. Perhaps the most important insight from thinking about this is that common owners need not do anything for common ownership to have effects on firms’ strategic behavior. It is enough that so-called “passive investors” that own various firms in the same industry crowd out active investors that concentrate their holdings in one firm, and who would otherwise push these firms to increase market shares, or compete harder in other ways.
To understand this better, ask yourself: Who would push commonly owned firms to compete harder with each other? The big diversified shareholders have the power to push for more competition, but no incentives to do so. Typically smaller activist investors that hold stakes only in one form have the incentives, but not enough power on their own. So when diversified shareholders are more powerful than undiversified ones, it becomes a lot less likely that powerful shareholders ask firms to compete more aggressively.
Of course, pushing portfolio firms to compete against each other would be absurd. Shareholders understand that market share is a zero sum game—if one firm wins, the other firm loses. If you own only one firm, then seeing your firm winning market share at the expense of competitors can be an attractive perspective. But if you own all the firms to a roughly equal extent, you can never win on both ends of your portfolio, and on net you lose: if all firms compete harder, aggregate profits will be lower (though, in the simplest static model, welfare will increase because consumer surplus rises faster than profits drop). Therefore, it doesn’t make sense for a diversified investor to push his portfolio firms to steal market share from each other, and I don’t think any of the large diversified mutual funds claims they do that.
In short: common owners can reduce competition by doing nothing at all—other than crowding out shareholders who would have pushed for more competition. So the often-heard common owners’ defense “but we don’t tell portfolio firms to compete less against each other” is really not a defense at all.
Second, you ask about boards—I take that more broadly to be a question on voting. True, employees of the big mutual funds do not typically sit on boards themselves. But they don’t need to do that in order to have an influence on the firms they own. They are still typically the most powerful voting shareholder when it comes to electing directors—and they would do harm to their portfolio and their investors if they helped appoint directors that are likely to push for more competition between their portfolio firms. Proxy access (i.e., the ability to nominate directors) comes on top of that. And when a handful of diversified funds each hold perhaps five percent of a firm, and all other shareholders are much smaller, most voting models would tell you that the diversified funds control the firm. So it’s unclear why the belief exists that these investors are not controlling shareholders.
You might ask: is it realistic to think that one can know in advance that some directors are more likely than others to push for more competition? Let’s look at a recent case. An investment manager at Warren Buffett’s Berkshire Hathaway was asked to join the board of JP Morgan a few weeks ago. Berkshire Hathaway is also the largest shareholder of Wells Fargo, and a very large shareholder of various other banks. I’d be surprised if this new board member were to propose a huge price war between JP Morgan and the banks in Berkshire’s portfolio, wouldn’t you?
A similar logic arguably played out in a high-profile proxy fight last year at DuPont, when BlackRock, Vanguard, and State Street voted against an activist investor, Nelson Peltz’s Trian fund. Trian had, among others, explicitly asked for more relative performance evaluation, changes in CEO compensation and more investment in R&D that would allow DuPont to increase its market share. (And remember, market share is something one company can only increase when its competitors lose it.) The fact is that BlackRock, Vanguard, and State Street were among the largest holders of both DuPont and its largest competitor Monsanto, and held large blocks of shares of other competitors as well (such as Bayer). Their vote prevented Peltz from implementing his ideas, which would have led to a regime of tougher competition between these firms (even if that was just a side effect of what he wanted to achieve, and even if the big funds rejected his proposals for reasons that have nothing to do with competition).
This is not an unusual case. We know from the finance literature that activist campaigns tend to be followed by increases in market share by the target firms at the expense of their rivals. You can see from this example that you don’t have to sit on the board yourself—it’s enough to prevent the election of directors that would take steps to increase competition. If you read Pershing Square’s latest letter to shareholders, you will see that at least some activists become increasingly frustrated with mutual funds effectively controlling corporations, by deciding which activist campaigns go through and which ones fail. Many activists even shun firms in which the “passive funds” control large stakes, because they anticipate the failure of their campaign.
The third mechanism is closely related to one of the objectives Peltz pushed for at DuP
ont: relative performance evaluation and the structure of CEO compensation. As previously discussed on ProMarket, when shareholders that own competitors become more powerful relative to owners of only a single firm, the firms’ top managers seem to get paid increasingly less for their own firm’s performance but more for the performance of their rivals. In theory, that can be a good or a bad thing: it could be good if the incentives made these firms cooperate more in socially beneficial ways. But such pay packages also give managers reduced incentives to compete. In short, taking an influence on executive pay seems like a potentially powerful way of influencing firm strategies. And that is something the big funds say is a topic in almost half of all “engagement” meetings.
Fourth, while most “engagement” conversations between mutual funds and their portfolio firms are private, some conversations between owners and portfolio firms about firm strategy and even product pricing became public. For example, a common owner of all U.S. airlines stocks called on Southwest Airlines to “boost their fares but also cut capacity.” You will also find discussions about route-level capacity decisions in recorded earnings calls of the airlines. Deutsche Bank and its largest shareholder, BlackRock, make their preferences for merger strategy known in newspapers. In the spring, Bloomberg reported that three major funds invited executives of pharma firms to a Boston hotel to discuss drug pricing amid a challenging political climate. I could go on. Even mutual fund managers themselves say that their engagement is not dissimilar from that of “active” investors.
So I honestly don’t understand how some researchers rationalize the idea that investors don’t talk to portfolio firms about strategy. As one former legal counsel of an asset manager told me: “we have never been bothered by anyone about this.” Influencing portfolio firms’ strategy is also not illegal—as long as the shareholders inform the antitrust authorities about what they are doing. So given they can do it, why would they not?
So we know that, in addition to crowding out less diversified owners, common owners (i) vote, (ii) affect the structure of top management pay, and (iii) talk to their portfolio firms about their preferred strategies. That brings us back to the principles of antitrust: if economic agents have incentives and the ability to implement them, we should expect them to do so do so. That’s all you need to realize there is a potential problem.
Q: Can you explain the difference between banks and airlines, in terms of common ownership and other anti-competitive incentives?
The crucial difference between the airlines and the banking industry is that in airlines you “only” have a common ownership problem. In banking, you have a common ownership problem, but in addition you have a cross-ownership problem. Banks tend to hold significant stakes in their competitor banks at the same time, typically through their asset management divisions. If they hold these stocks just on behalf of investors in their funds, the direct impact on their bottom line from competing more or less aggressively with that portfolio firm/competitor may not be very large, but they can still vote the shares they hold in your competitor. They probably won’t vote them in ways that harm your own firm.
Q: When we look at the banking industry, what is the result of the combination between the common ownership problem and the cross ownership problem?
In the banking industry, José Azar, Sahil Raina, and I show that the local deposit markets become less competitive when the banks operating in that market become more commonly owned. Let me explain how we measure the competitive outcomes here. If you want to store your money in a bank you pay a price for that. For example, you pay a fee for having a checking account or for your money market account. How high that fee is depends on how many banks are around in your county, but also on the ownership structure of these banks, i.e., on the joint effect of cross ownership and common ownership.
A more subtle point might be that the interest rate that the bank pays you on your account is another form of charging you a price. Say the interest rate if you buy government bonds is 1 percent, but you might not get the full percent, but only 0.5 percent or 0.2 percent from your bank if you put it into a CD or money market account. That spread is another form of a price that the bank charges you for storing your savings. And that interest rate spread is larger when the banks in your country are more commonly owned.
(Note: This is the first of two posts concerning the dangers of common ownership. A second piece by Martin Schmalz, commenting on recent policy proposals, will appear soon as well.)