You know the theory: When the same big diversified institutional investors own all of the companies, those companies have less incentive to compete with each other. If Airline A and Airline B have the same shareholders, and Airline A cuts prices to win more market share, that simply hurts the shareholders: Overall, the airlines sell the same number of tickets but at lower prices.

We talk about this theory a lot. It is controversial, in part because of disputes about the empirical evidence but mostly, I think, because it doesn’t feel right. That is:

1. Most large diversified asset managers do not think this way: They don’t want to reduce competition, and they do not go around meeting with the managers of their portfolio companies to say “hey you should compete less.”

2. Most corporate executives do not think this way: They don’t care about overall profits for their shareholders; they care about their company’s profits and market share. They care because they are naturally competitive people who want to win, but they also care because they are not diversified shareholders: The executives themselves own a lot of stock in their own firms, so they are motivated to win market share for themselves.

So if you think this theory is right you will need sort of a better mechanism, one that does not rely on the diversified investors actually wanting less competition, or on the corporate managers trying to give it to them.1

Here is a clever one from Zohar Goshen and Doron Levit:

In equilibrium, common owners exert market power indirectly by delegating control rights to other shareholders through broad implementation of “strong” governance structures across their portfolio firms. That is, more firms adopt strong governance under common ownership. These delegated control rights are then leveraged by activists, which pressure managers of their target firms to reduce investments. The aggregate effect of lower investments reduces the demand for labor and lowers wages. Importantly, even though activist hedge funds do not internalize externalities across firms, the cumulative impact of their interventions contributes to anticompetitive outcomes. Effectively, common owners establish a labor market monopsony without resorting to collusion among firms. Consequently, the symbiotic relationship between common owners and hedge fund activists is detrimental to society. It is important to note that common owners need not consciously act as a monopsony or a cartel. The anticompetitive effects follow naturally from common owners’ push for strong governance. The conventional wisdom praises institutional investors for strengthening corporate governance as it mitigates agency costs (Jensen and Meckling 1976). And indeed, institutional investors are consistently pushing toward strong governance structures for publicly traded firms. However, this perspective often overlooks the principal costs inflicted by activist hedge funds. Consequently, common owners who push for strong governance and bolster hedge fund activism, might mistakenly attribute the realized positive returns on their portfolios to the benefits of reduced agency costs rather than acknowledging the role of labor monopsony at play. In other words, the commonly held naive view that strong governance unequivocally enhances shareholder value by reducing agency costs could explain the anticompetitive impact of common ownership. .

They are concerned with labor-market competition rather than product-market competition: Their worry is not “companies with common owners won’t compete on price” but rather “companies with common owners won’t compete to hire workers.” But their mechanism is governance. Schematically it is something like:

1. Big institutional investors like “good governance.” They push companies to adopt good governance structures that give shareholders strong rights to supervise managers. Strong governance structures include things like one share one vote (no dual-class stock), all directors elected every year (no classified boards), independent board chairs, no poison pills etc.

2. Good governance is good for activist hedge funds: It’s hard to win an activist proxy fight at a company with a staggered board and dual-class stock, but it’s easier at a company with shareholder-friendly governance.

3. Activists, in this telling, are bad: They “pressure managers of their target firms to reduce investments.” There is a stereotype that activist investors push for short-term financial engineering rather than long-term investments in the business.

This, in Goshen and Levit’s story, is bad for employees (fewer investments means less demand for workers), but you could tell other stories: “Companies with common owners are more vulnerable to activists, so they do more stock buybacks and invest less in their business, so they don’t compete as effectively to develop new products,” for instance.

I don’t know. But what I like about this story is that it does reflect how investors and managers think:

1. Big diversified investors do care about good governance. The giant asset managers who own every company can’t necessarily develop strong views on how every company should run its business; they focus on systemic stewardship, on doing things that work across their portfolio rather than things that are company-specific. And they do tend to have a broad systematic view that strong, shareholder-friendly governance is good, so all companies should have it.

2. This story doesn’t rely on managers wanting to reduce competition, or wanting to work in the economic interests of their diversified shareholders. It relies on managers being scared of activists, or being kicked out after losing proxy fights.

* * *

---

 

1. Except in the US shale oil industry, where it is all pretty straightforward. View in article

 

---