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E-MailMartin C. Schmalz is Assistant Professor of Finance at the University of Michigan Ross School of Business. This post is based on a recent paper by Professor Schmalz. Related research from the Program on Corporate Governance includes Horizontal Shareholding (discussed on the Forum here) and The Growing Problem of Horizontal Shareholding (discussed on the Forum here), both by Einer Elhauge; and The Agency Problems of Institutional Investors, by Lucian Bebchuk, Alma Cohen, and Scott Hirst.
A fast-growing literature in finance and industrial organization studies whether and how “common ownership” links affect firm behavior and market outcomes. A new forthcoming paper, available on SSRN, reviews the rich history of thought on this topic. In addition to connecting the existing contributions in the economics and finance literature, the review also points to previous contributions in antitrust law, and offers ideas for future research.
Conceptually, the literature revolves around the question of what is the objective of the firm. Harvard’s Oliver Hart pointed out in the late 1970s that unless firms are price takers or all shareholders have their wealth concentrated in a single firm—and no other interests—shareholders don’t generally agree that the firm’s optimal strategy is to maximize its own value.
Complementing this insight, the late HBS professor Julio Rotemberg showed in 1984 that when shareholders are sufficiently diversified (as is assumed in standard equilibrium models in finance), they are instead interested in the maximization of the value of their portfolios (rather than the value of any individual firm). Given that such portfolios will include competitors, diversification can lead to monopoly outcomes. Indeed, he showed there are circumstances in which all shareholders—including those that don’t hold fully diversified market portfolios—unanimously agree that monopoly behavior (rather than aggressive competition) maximizes their economic interests.
Various contributions have since argued that firms will more generally internalize all and any externalities they impose on other firms to the extent their most influential investors have interests in these other firms.
The literature recognized as early as 1990 that considering such alternative objective functions has the potential to explain a large number of otherwise puzzling phenomena: the scant use of relative performance evaluation in top management incentive contracts, negative bidder returns amid takeover announcements, low levels of investment amid high profits and low real interest rates in the present-day economy, the increase of wealth and income inequality, and so forth.
Despite a documentation of overlapping shareholdings even in the earlier contributions, these predictions were largely considered a theoretical curiosity for many years. This perception changed when empirical work that provides supporting evidence for the predictions emerged in recent years.
A particular question the more recent literature has examined is whether overlapping ownership between competitors due to “passive” diversification—as well as, more commonly, due to active portfolio decisions and the centralization of corporate governance authority between different types of funds—has a causal effect on reduced competition between the commonly owned firms.
The findings of that literature have triggered a legal literature. The perhaps most prominent discussions are by HLS’s Einer Elhauge (HLR paper available here and discussed on the Forum here; a recent extension is available on SSRN as well).
As the new review details, legal scholars had discussed such (then still hypothetical) evidence as a potential violation of various antitrust laws as early as the early 2000s. Even earlier, Harvard Law School’s Mark Roe published a paper as early as 1990 to remind financial economists about the legal limits of institutional ownership, as well as historical precedents of political intervention in response to a perception that “the investment company” took “control of the wealth and industries of our country” in the first half of the 20th century.
Roe further quotes from a 1934 Senate report: “Congress must ‘prevent the diversion of these trusts from their normal channels of diversified investment to the abnormal avenues of control of industry’,” highlighting the conflict of interest that arises when diversified investors gain influence over corporate governance, and which is at the core of the various currently debated policy proposals, the most prominent of which may be by Posner, Scott Morton, and Weyl (available here)
The review concludes with a discussion of open questions for future research. These ideas should be of interest to students of corporate finance, governance, asset pricing, and antitrust law, among other fields. In particular, the insight that shareholders with differing portfolios generally disagree about the optimal firm strategy provides a motivation for studies of shareholder voting, shareholder cooperation and disagreement, and equilibrium ownership structures. The notion that changes in ownership structure can affect firm profitability should also motivate new research at the intersection of industrial organization and asset pricing. Quantitative studies of welfare effects of various policy interventions are needed to guide policy. Variation in antitrust laws across countries necessitate a discussion of existing and desired tools at regulators’ disposal. New questions for corporate law also arise.
It is rare to be presented with the combination of a plethora of open theoretical questions, as-of-yet untested empirical predictions, and policy relevance. The literature on “common ownership concentration and corporate conduct” therefore promises to remain an exciting and dynamic field for the foreseeable future.
The full paper is available for download here.
