A new study shows that the supposed tradeoff between better corporate governance and more competitive product markets may not exist. More commonly-owned firms have weaker managerial incentives, which may both reflect worse governance and reduced incentives to compete for managers.
The common ownership hypothesis suggests that when large investors own shares in more than one firm within the same industry, those firms may have reduced incentives to compete. Firms can soften competition by raising prices, reducing investment, innovating less, or limiting entry into new markets. Empirical contributions document the growing importance of common ownership and provide evidence to support the theory.
Prominent antitrust law scholars whose work was previously featured in this publication, claim that common ownership “has stimulated a major rethinking of antitrust enforcement” and constitutes “the greatest anticompetitive threat of our time.” Indeed, the Department of Justice, the Federal Trade Commission, the European Commission, and the OECD have all acknowledged concerns about the anticompetitive effects of common ownership and have even relied on the theory and evidence of common ownership in major merger cases.
But because managers rather than investors control firm operations, and because managers may not know the extent of their main investors’ shareholdings in other firms, skepticism that common ownership affects product market outcomes may be warranted. In particular, skeptics note the lack of a clear mechanism that recognizes these agency frictions and informational constraints. This has fueled a vigorous debate about whether existing evidence on common ownership has a plausible causal interpretation and, if it does, how to effectively address the resulting regulatory, legal, antitrust, and corporate governance challenges.
For example, SEC Commissioner Robert J. Jackson writes that it was “far from clear how—even if top managers receive an anticompetitive signal from their pay packages—those incentives affect those making pricing decisions throughout the organization. […] For these reasons, I worry that the evidence we have today may not carry the heavy burden that, as a Commissioner sworn to protect investors, I would require to impose costly limitations.”
Similarly, FTC Commissioner Noah Phillips remarked that “areas of research that I, as an antitrust enforcer, would like to see developed before shifting policy on common ownership [are] whether a clear mechanism of harm can be identified.”
There is plenty of anecdotal evidence of direct interventions by common owners. BlackRock, Fidelity, and Amundi called on “drug companies to put aside any qualms about collaborating with rivals” in light of the Covid-19 pandemic. Twelve oil investors’ coordinated governance intervention to change executive incentives with the aim of reducing output and increasing portfolio firm profits. Similarly, a coalition of common shareholders successfully pressured major oil competitors to commit to fixed emissions targets. In a recent paper, Nathan Shekita documents over 30 separate competition-related interventions by common owners in many other industries.
However, our paper shows that a more subtle, indirect mechanism can implement diversified shareholders’ anticompetitive interests even if regulators were to prevent the use of voice as a particular governance mechanism for direct interventions. Crucially, the mechanism does NOT rely on (i) owners having access to sophisticated market-level incentives or communications to steer product market behavior in different markets, (ii) top managers’ knowledge of the ownership structure of either their own firms or their competitors, (iii) top managers making detailed market-specific strategic choices (e.g., setting prices), or (iv) explicit or tacit collusion among managers, firms, or shareholders. Nonetheless, it explains a plethora of existing empirical evidence on the anticompetitive effects of common ownership.
The mechanism’s central driving force is that performance-sensitive managerial compensation encourages productivity-improving managerial effort, which in turn has two effects. First, productivity-improving managerial effort increases firm profitability and is thus desirable for all owners. Second, with endogenous product prices, productivity enhancements also increase how aggressively the firm competes in the product market. The latter channel indirectly reduces the profitability of competing firms and thus stands in conflict with the interests of common owners who also hold shares in other firms in the same industry. Common owners therefore optimally choose to be passive owners who are more willing to tolerate managerial slack and productive inefficiency at their portfolio firms, because doing so leads to less intense competition, higher product market prices and larger profits for the other firms in which they hold shares. Therefore, our analysis predicts a negative relationship between common ownership and the performance-sensitivity of top management incentives. Managers of firms with large common owners are allowed to “enjoy the quiet life.”
Our analysis clarifies widespread misconceptions about the mechanism of common ownership. For example, in a series of award-winning papers, Lucian A. Bebchuk, Alma Cohen, and Scott Hirst have argued that because common owners such as index fund managers have “incentives, which would lead them to limit intervention with their portfolio companies […] it is implausible to expect that index fund managers would seek to facilitate significant anticompetitive behavior.” Our framework explains why common owners have an incentive to remain passive and not to intervene with portfolio companies, so we agree with the first part of that statement. However, it does not follow that this passivity makes the anticompetitive effects of common ownership implausible. In fact, it is precisely the lack of intervention when setting high-powered incentives for top managers or “excessively deferential treatment of managers,” as Bebchuk and Hirst call it that leads to less competitive product market behavior.
Therefore, there is no conflict between favoring more effective engagement by institutional investors and being concerned about the anticompetitive effects of common ownership. Weak governance and weak competition are jointly optimal for common owners. This insight calls into question policy prescriptions that aim to reduce common owners’ governance efforts. Such an intervention would weaken both governance and competition at the same time. Our mechanism is also distinct from an alternative reason for weak governance by index funds, namely the higher cost of engagement due to a large number of portfolio firms. It may well be possible that common ownership strengthens the governance of unrelated firms, but weakens the governance of competing firms.
Our analysis also shows that within the same industry, more commonly-owned firms optimally have weaker managerial incentives and compete less aggressively than less commonly-owned “maverick” firms which give stronger incentives to their top managers, set lower prices, and obtain greater market shares. Moreover, commonly-owned firms compete less aggressively in markets in which they face other commonly-owned firms than in markets in which they face maverick firms. Thus, our proposed firm-level mechanism explains the previously documented market-level correlations between common ownership and product prices (positive), output (negative), and product market concentration (negative).
In our empirical analysis, we estimate that more common ownership is associated with a substantial reduction in CEO wealth-performance sensitivity. This estimate is of similar magnitude as the effect of firm volatility on managerial incentives and remains robust to using various alternative measures of managerial incentives, common ownership, and industry definitions. Using a difference-in-differences design we investigate whether the negative relationship between the strength of managerial incentives and common ownership is also present when we only use the variation in common ownership from additions of industry competitors to the S&P 500 index. Index incumbents (i.e., firms that were already in the S&P 500 index before a competitor was added) experience a significant increase in common ownership after the inclusion of industry competitors in the S&P 500. Following such index additions of industry competitors, the compensation of index incumbents’ CEOs becomes significantly less sensitive to their firms’ performance. This negative effect on CEO incentives is gradual: it is not present before the inclusion of the competitor into the index and increases in magnitude over time following the index inclusion event.
Our analysis is also related to the broader debate on what the objectives of the firm are or should be. Several large institutional investors such as BlackRock and TIAA-CREF have argued for stronger stakeholder capitalism which takes the interests of stakeholders other than owners (e.g., employees and consumers) into account and seeks to internalize the externalities that companies impose on “the society where they work and operate,” as well as to support broader goals of social responsibility, including climate change and race issues. In our analysis, we make the arguably less ambitious claim that investors can influence companies to partially internalize the externalities that their corporate conduct imposes on other firms in the same investors’ portfolio.
In summary, our analysis provides a plausible governance mechanism that connects common ownership and anticompetitive product market outcomes, explains existing empirical evidence on product markets, and provides new empirical evidence on managerial incentives. Finally, it challenges the validity of the ubiquitous and fundamental assumption in economics and finance that the objectives and competitive behavior of firms are independent of their shareholders’ interests.