The emerging phenomenon of common ownership, where one (or a group of) large institutional investors, such as mutual funds or hedge funds, own several companies in the same industry poses a number of major challenges to firm executives, competition regulators and policymakers. The potential impact of common ownership on, for example, competition between firms partly owned by the same investors is a serious concern and has widespread implications.
Empirical work in this field investigates the consequences of common ownership but takes the ownership decision as given. A major challenge arises in this case because we know much less about investors’ incentives to become common owners in the first place.
In the paper “Ownership and Competition,”. Alessio Piccolo and Jan Schneemeier take an innovative approach on our way to understand better how common ownership emerges and its impact on societal welfare through competition and risk diversification. The authors endogenize the composition of shareholder portfolios. The paper’s major objective is to investigate to what extent competitive financial markets, where informed (institutional) investors and uninformed (retail) investors interact, lead to socially desirable ownership structures in equilibrium. Doing so, Alessio and Jan answer two questions: (a) whether market forces lead to a balance between undiversified and diversified (i.e., common) ownership; and (b) what are the externalities engendered by common ownership, to other investors and product market consumers.
In the model, an increase in the number of common owners has two distinct effects on their trading returns. First, there is a standard trading effect: more common ownership pushes up the demand for firms’ shares, increasing their price and decreasing common owners’ returns. Second, there is a novel ownership effect: as the fraction of common owners increases, managers of firms owned by these investors internalize spillover effects and compete less aggressively. This generates first order effects on product prices and, therefore, on firm profits. Institutional investors are better informed than retail investors, who lack comprehensive information about firms. As a result, stock prices do not fully reflect the impact of common ownership on firm profits. If this impact is underpriced, the ownership effect increases common owners’ returns; otherwise, it reduces them.
The interactions between these effects provide a number of novel insights. First, when the ownership effect moves against the trading effect and offsets it, there is strategic complementarity among common owners: as common ownership increases, investing in all firms within the same industry becomes more attractive. This incentivizes some of the undiversified investors in the industry to diversify and become common owners. Stated differently, when investors can influence competition, common owners crowd out undiversified investors. What is the immediate consequence of this result? Such crowding out exacerbates the anti-competitive effects of common ownership.
Second, if the ownership effect moves in the same direction as the trading effect, it reinforces the strategic substitutability among common owners. This is likely to happen when common owners are in a powerful position that allows them to tunnel profits from the least to the most efficient firms in the industry. In this case, common owners’ ability to influence competition reduces their returns. The implication is that the level of common ownership in an industry is generally uninformative about their influence on competition.
The main results can be seen graphically in the two graphs below:
The authors proceed to explore welfare implications of common ownership. So far, the literature has argued along two dimensions: diversification benefits and anti-competitive costs, leading to an ambiguous effect of common ownership on welfare. Alessio and Jan show that common ownership may also lead to diversification costs: when tunneling occurs, common ownership increases the volatility of undiversified portfolios and may increase the overall risk borne by investors. Therefore, the existing literature might underestimate the welfare cost of common ownership.
Finally, the model in the paper generates novel empirical predictions. If investors influence competition: (i) there can be complementarities among common owners; and (ii) the volatility of firm profits increases with common ownership. The complementarity is more likely to arise in larger and less concentrated industries (because tunneling is less likely), and implies that common owners’ returns should be larger in industries with more common ownership.