Print
E-MailPaul Borochin is Assistant Professor at the University of Connecticut School of Business. This post is based on a recent paper, authored by Professor Borochin; Jie Yang, Senior Economist at the Board of Governors of the Federal Reserve System; and Rongrong Zhang, Associate Professor at Georgia Southern University College of Business.
Related research from the Program on Corporate Governance includes New Evidence, Proofs, and Legal Theories on Horizontal Shareholding by Einer Elhauge (discussed on the Forum here). The views in the post are solely those of the authors and do not necessarily reflect those of the Federal Reserve System.
In common ownership, the type of the common owner institution matters. Institutional ownership of firms has seen a marked rise in the past few decades, with average institutional ownership share of a firm rising from 20% to 30% in the 1980s to over 65% of the total by the 2010s, with residual retail ownership correspondingly falling from 80% to less than 35% of the firm. (See Borochin, Paul, and Jie Yang (2017). The Effects of Institutional Investor Objectives on Firm Valuation and Governance, Journal of Financial Economics 126.) Over the same period, the fraction of the average firm held by institutions holding blocks of same-industry rivals has risen from 4.5% to 28%. (See He, Jie, J. Huang, 2017, Product Market Competition in a World of Cross Ownership: Evidence from Institutional Blockholdings, The Review of Financial Studies 30.) This not only changes the portfolio properties of the institutional investors, but also has the potential to change the corporate strategies of held firms. Recent studies find opposing effects of common institutional ownership on the competitive behavior of firms:
On the one hand, Elhauge (2016) and Azar, Schmalz, and Tecu (2018) propose an alternative benefit stemming from changes in firm competitive behavior: common ownership of same-industry firms incentivizes both investors and managers to maximize portfolio rather than firm profits leading to anti-competitive outcomes. (See Elhauge, E., 2016, Horizontal Shareholding, Harvard Law Review 129 discussed on the Forum here, and Azar, J., M. Schmalz, I. Tecu, 2018, Anti-competitive Effects of Common Ownership, Journal of Finance 74.) On the other, He and Huang (2017) argue that common institutional ownership can facilitate collaboration between firms by resolving incomplete contracting issues, and directly or indirectly facilitate information sharing between same-industry rivals. (He, Jie, J. Huang, 2017, Product Market Competition in a World of Cross Ownership: Evidence from Institutional Blockholdings, The Review of Financial Studies 30, discussed on the Forum here) In our paper, we seek to reconcile these findings by documenting countervailing effects of common ownership by institutional type.
We find that the identity and investment objectives of the institutional owner matter in the determination of the dominating effect. Specifically, we document two countervailing effects of ownership structure of firms by financial institutional owner type: higher common ownership by “dedicated”, or focused and long-horizon, financial institutions promotes innovation as measured by patent applications. Furthermore, this type of common ownership promotes more pathbreaking exploratory innovation. We observe a reverse effect for common ownership by “transient”, or diversified and short-horizon, financial institutions. Furthermore, common ownership by quasi-indexer”, or diversified long-horizon institutions, has some aspects of both. These differential effects of common ownership by institution type provide a potential resolution to the ongoing debate in the literature.
We identify these effects using a difference-in-differences regression around mergers of different types of financial institutions for firms whose same-industry peers are held by the other party in the deal. The control firms in the model are those without same-industry peers in the portfolio held by the other party in the financial institution M&A deal. These mergers of different types of financial institutions provide an exogenous shock to the level of ownership by the acquiring type within the firm. They also provide a similarly exogenous shock to the between-firm network structure of institutional ownership of firms in our sample. The financial institutions’ M&A decisions are likely unrelated to the policies of the firms they own, providing a clean identification of the effect of the resulting changes in institution ownership level by type.
We also study the effects of industry competition on this relationship. Variation in industry concentration, and therefore in competition, in industries such as the US airlines may amplify the effects of common ownership in two ways as described by Aghion et. al. (2005): increased neck-and-neck competition may increase incentives to innovate to set the firm apart from its competitors, but may also discourage lagging firms to innovate to catch up to competitors. (See Aghion, P., Bloom, N., Blundell, R., Griffith, R. and Howitt, P., 2005. Competition and innovation: An inverted U relationship. The Quarterly Journal of Economics, 120.) The degree of competition determines which effect dominates. We find that common ownership effects become stronger in high-competition industries. These are the industries in which the disincentive to catch up through innovation dominates, suggesting that common ownership matters more for innovation as it relates to maintaining parity with one’s competitors rather than as it relates to trying to surpass them.
Finally, we consider whether these common ownership effects to extend to other corporate policies besides innovation. To investigate this implication, we consider firm-specific differences from industry medians for several key financial ratios. The intuition behind this test is that firms will follow industry trends if they do not actively seek a competitive advantage, and thus less competitive firms will have financial ratios that more closely follow industry medians. Meanwhile firms that are actively trying to compete will be more likely to deviate from standard financial policies within the industry. Indeed, we find significant and different effects for common ownership by different institutional types on a number of financial measures. In particular, we observe notably different financing outcomes from increases in common ownership by “dedicated’’ versus “quasi-indexer’’ institutions, with the former leading to more debt and the latter to more equity financing.
These results paint a more nuanced picture of the effects of common ownership as discussed by Elhauge (2016), and help resolve contradictory findings in the literature regarding the anti-competitive findings of common ownership by Azar, Schmalz, and Tecu (2018) versus the market power enhancing findings of He and Huang (2017).
The complete paper is available here.
