A Tale of Two Networks: Common Ownership and Product Market Rivalry

Florian Ederer is Associate Professor of Economics at the Yale University School of Management, and Bruno Pellegrino is Assistant Professor of Finance at the University of Maryland’s Smith School of Business. 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); 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).

The past few decades have seen public equity markets becoming increasingly dominated by a few large, diversified institutional investors such as BlackRock, Vanguard, and Fidelity. This phenomenon has led in turn to a dramatic increase in common ownership (or horizontal shareholding)—an arrangement under which large investors own shares in several competing firms. For antitrust authorities around the world common ownership is high up on the list of emerging threats to competition. The reason is straightforward. If firms make strategic decisions with the intent of maximizing the profits earned by their shareholders, they must take into account how their strategic choices affect the profits earned by competitors that are also owned by the same investors. The implication is that (conditional on firms acting in line with shareholders’ financial interests) common ownership inevitably weakens companies’ incentives to compete, reducing consumer welfare and generating deadweight losses. This theoretical argument is known in the literature as the “Common Ownership Hypothesis.”

Common ownership has increased to such an extent that some antitrust scholars, such as Einer Elhauge, have gone as far as suggesting that common ownership 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. Earlier this year, the Department of Justice and the Federal Trade Commission launched a public inquiry to seek comments on new evidence of M&A’s effects on competition to inform potential revisions to the merger guidelines, including how to deal with common ownership.

While there is growing empirical evidence of the anticompetitive effects of common ownership on prices, quantities, markups, managerial incentives, and profitability in particular industries, little is known about the economy-wide welfare cost of common ownership and its distributional impact. Measuring this welfare cost requires both new economic modeling and large amounts of granular data. It requires information on both the competitive landscape (which firms compete with each other) and asset markets (which firm’s shares each investor holds).

In a new study, we ask: what happens if firms maximize shareholder value (as opposed to profits)? What is the resulting impact of common ownership on corporate profits, consumer surplus, and total welfare across many different industries? Do different assumptions about corporate governance modify the impact of common ownership? In short, we find that the economic impact of common ownership is large and has risen dramatically over the last quarter century, particularly so during the last decade.

To answer these questions, we develop and estimate a new model that includes all public corporations in the United States and uses annual data since 1994. Firms are connected through two large networks: a network of product similarity and a network of common ownership.

Figure 1: The Networks of Product Similarity and Common Ownership

The network of product similarity (top of Figure 1) captures the extent to which firms compete with each other in the product market. Each dot in the graph is a publicly traded firm in the United States, and the networks links represent closeness in the product space. Firms that offer more similar products are closer in product space and therefore compete more intensely with each other; more “isolated” firms face less intense competition, and thus end up charging higher markups. The data underlying this graph is developed by Hoberg and Phillips (2016). Using a methodology developed by Pellegrino (2019), our model uses these data as a “map” of the product market.

The network of common ownership (bottom of Figure 1) reflects which investors own which firms and how much overlap in ownership exists between competing firms. Firms with a large proportion of shares held by the same investors have weaker incentives to compete because doing so would hurt the portfolio profits of their largest and most influential owners. The source data on institutional shareholdings that we use to construct this network come from forms 13(f), which are filed with the SEC by large institutional investors.

The extent to which common ownership diminishes firms’ incentives to compete depends on how much these two networks overlap—in other words, common ownership has the strongest effects on firm pairs that are held by similar few investors and produce similar products. By combining data from firm financials, text-based product similarity, and institutional investor holdings of US publicly-listed corporations from 1994 to 2018, we are able to measure how much the overlap in ownership across firms reduces competitive behavior, as well as the economic toll that this reduction in competitiveness has on consumers.

Figure 2: Deadweight Loss from Common Ownership

Our analysis reveals three broad patterns. First, the welfare costs of common ownership are significant (Figure 2). We estimate that in 2018 the deadweight loss due common ownership amounted to $400 billion, which is equal to about 4 percent of the surplus generated by US public firms. Second, common ownership has large distributional consequences as shown in Figure 3—it redistributes surplus from consumers to corporations. In 2018 alone, common ownership raised aggregate corporate profits by $378 billion (6.6 percent), but lowered consumer surplus by $799 billion (nearly 20 percent). Third, the negative effects of common ownership on total welfare and consumer surplus have grown considerably over the last two decades. Whereas common ownership reduced the total surplus in the economy by a mere 0.3 percent in 1994, this deadweight loss increased more than tenfold to 4 percent over the next quarter century.

Figure 3: Effect of Common Ownership on Profits and Consumer Surplus

These baseline results rely on the assumption that firm managers weigh the profits of their respective shareholders in proportion to the size of their ownership stakes. A common criticism of this assumption is that it does not reflect realistic models of corporate governance and decision-making. For example, agency problems between owners and managers may attenuate or even exacerbate the anticompetitive effects of common ownership (Antón, Ederer, Giné & Schmalz 2020). For this reason, we also investigate how alternative assumptions about corporate governance modify our estimates. Rather than investors directly influencing firm decisions exactly in proportion to their ownership shares, larger investors may exert influence that exceeds the size of their stake. Under such an alternative super-proportional influence assumption, common ownership has nearly identical effects on deadweight loss, corporate profits, and consumer surplus. The anticompetitive effects that we estimate remain large even if we relax the assumption that investors can effectively monitor all the companies in their portfolios (Gilje, Gormley & Levit 2020), or that only block-holders (i.e., shareholders holding 5 percent or more of a company’s stock) can influence management: common ownership still leads to a deadweight loss of 2.5 percent of total surplus, raises firm profits by almost 5 percent, and lowers consumer surplus by almost 13 percent of total surplus in 2018.

In sum, our analysis suggests that the rise of common ownership has the potential to generate significant distortions and the reallocation of surplus in the US economy. However, academic research has only begun to scratch the surface of analyzing the welfare effects of common ownership. Various other consequences of common ownership on firm decision-making, including labor market power, innovation, firm productivity, and dynamic collusion incentives are still waiting to be investigated. In light of the meteoric rise of common ownership and its relevance for antitrust policy and financial regulation, our research presents several reasons for lawmakers and regulators to pay more attention to this issue.

The complete paper is available for download here.

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