Common Ownership, Executive Compensation, and Product Market Competition

Matthew J. Bloomfield is Assistant Professor of Accounting at The Wharton School of the University of Pennsylvania; Henry L. Friedman is Associate Professor of Accounting at the University of California Los Angeles Anderson School of Management; and Hwa Young Kim is a Ph.D. Student in Accounting at the University of California Los Angeles Anderson School of Management. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here);The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here); New Evidence, Proofs, and Legal Theories on Horizontal Shareholding by Einer Elhauge (discussed on the Forum here); and Horizontal Shareholding by Einer Elhauge (discussed on the Forum here).

Over the last twenty years, the degree of common ownership of large public companies has increased considerably. In 2015, BlackRock Inc. and Vanguard Group were both top-five owners in over half of the publicly listed firms in the U.S. and Canada (Park et al. 2019). Several recent studies have raised concerns that overlapping ownership can lead to anticompetitive product market outcomes (e.g., Azar et al. 2016, Xie and Gerakos 2018). This would happen naturally if managers take actions that are in their shareholders’ best interests and their shareholders seek to maximize the value of their market- or industry-wide portfolio. Some studies have even gone so far as to recommend that antitrust regulators should limit large institutional investors to either holding only a small stake (< 1%) in any industry or holding no more than a single firm per industry (Posner et al. 2017). While the theoretical concern is well-founded, several academics and practitioners have voiced doubts about whether common ownership actually leads to anticompetitive outcomes, largely due to the passive nature of the large common owners and the low plausibility of, for instance, asset managers influencing capital structure, payout policies, board composition, or specific company practices like airline route choices or checking account fees (Hemphill and Kahan 2018, Koch et al. 2021). In short, prior literature does not provide clear evidence of a plausible mechanism through which common ownership could affect product market outcomes in an economically meaningful way.

In our recent study, Common ownership, executive compensation, and product market competition, we examine executive compensation as a plausible potential mechanism whereby common ownership could incentivize managers to pursue anticompetitive strategies. Executive compensation is a plausible mechanism both because managers take actions based on the benefits to themselves, and because institutional owners have significant influence over executive compensation through a variety of channels (e.g., voice, exit, say-on-pay votes, and indirect influence through proxy advisory firms). Walker (2019) observes that “executive incentives are generally viewed as one of the more plausible mechanisms underpinning the broader claim of a link between common ownership and reduced competition.” We focus on compensation incentives tied to revenue.

We first develop a model of oligopolistic competition in which (ostensibly rivalrous) firms are commonly owned. When firms are separately owned, all firms choose to use revenue-based (in addition to profit-based) pay, as this is the value-maximizing strategy. However, in aggregate, all firms using revenue-based pay leads to overproduction that benefits consumers at the expense of firms and their shareholders. Common ownership mitigates this effect because an aggressive strategy by one portfolio firm can hurt a common owner’s other portfolio firms. Therefore, according to our model, common owners should cut back on their firms’ use of revenue-based pay, which leads to anticompetitive product market outcomes relative to the case with separate ownership. Empirically, revenue is widely used as a performance metric in CEO compensation, supporting our hypothesis that altering firms’ use of revenue-based pay could be a plausible mechanism through which common ownership could reduce competition. Accordingly, our main prediction is that common ownership tends to reduce the use of revenue-based pay in executive contracts.

We test this prediction using available data on large public firms’ executive compensation plans. Across a battery of specifications, we find either no association, or a marginally positive association, between cross-ownership and revenue-based pay. Our findings provide no support for the notion that cross-owning block-holders intervene in the contracting process to curtail executives’ incentives to compete aggressively. In short, common owners do not appear to be trying to foster anticompetitive product markets—at least, not through changes to executives’ incentive pay plans.

Notably, cross-ownership is the result of investors’ endogenous portfolio choices, which are based on a multitude of features and decision processes, many of which are unobservable. As such, one conceivable explanation for our [null] findings is that cross ownership causes firms to use less revenue-based pay (as predicted), but simple statistical approaches are incapable of identifying the effect because correlated omitted factors jointly increase both the prevalence of cross ownership and revenue-based pay. Such confounds could bias the estimated results, obscuring any negative effect of cross-ownership on the use of revenue-based pay. To address this concern, we use an event study methodology based on He and Huang (2017). We examine financial institution mergers and identify firms which became commonly owned due to a financial institution merger, rather than due to investors’ portfolio choices. As in our simpler analyses, we find no evidence that firms reduce their use of revenue-based pay after becoming commonly owned due to financial institution mergers.

We next test whether the effects of common ownership on revenue-based pay differ depending on industry and firm characteristics. We conduct the analysis for subsamples where the relationship between common ownership and revenue-based pay is likely to be more prominent. However, we find no evidence for common ownership reducing revenue-based pay in these subsamples, either. A plausible alternative to revenue-based pay would be relative performance evaluation (RPE). Similar to revenue-based pay, RPE rewards executives for taking aggressive actions that benefit them at the expense of rivals. We replicate our main analyses using measures of RPE in place of revenue-based pay and continue to find no evidence that cross-ownership affects compensation plans in a manner consistent with our predictions.

An alternative possibility is that cross-owning block-holders attempt to alter executive incentives, but lack the institutional power needed to do so successfully. To explore this possibility, we examine mutual fund voting behavior in Say on Pay votes. As before, our results provide no support for the notion that common owners are attempting to use the power of their votes to alter executives’ incentive pay plans in the manner predicted.

In sum, across a wide variety of empirical approaches, we find no evidence that common owners attempt to mitigate product market competition by altering executive incentives. Notably, the null results we document do not appear to be attributable to low power. Even the extreme ends of the 95% confidence intervals, the effects estimated represent fairly small economic magnitudes.

This study contributes to the ongoing debate about the effect of common ownership on competition and its policy implications. The academic literature on common ownership provides inconsistent results, which indicates the need for further study and refinement of plausible mechanisms through which common ownership might affect competition. Our study addresses this by examining executive compensation, which is viewed as the ‘path of least resistance’ that common owners can use to soften competition.

The complete paper is available for download here.

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2 Comments

  1. Kiers
    Posted Monday, November 1, 2021 at 1:20 pm | Permalink

    the layman’s term for this is “cartels”. pre WW2 Germany had cartelized industrial structure with cross linked common ownership of firms.

    In the American context, cross ownership means even the industrial firms themselves can invest their spare cash in each other by merely buying a Blackrock index fund. This means their income rises as a direct result of stocks rising, including competitor stocks, a circular dynamic that could lead to market “melt-ups”, the exact opposite of what economics should dictate. Momentum in the stock market becomes everything.

    Nothing is what they teach you anymore. The elite know this, the regulators pose.

  2. Kiers
    Posted Friday, November 5, 2021 at 9:39 am | Permalink

    A paper on such an important topic doesn’t even mention buybacks once. A little too ivory tower?

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