Institutional cross-ownership and the power of sharing

By Grace Segran

SMU Office of Research and Tech Transfer – The simultaneous ownership of shares in competing firms by institutional investors is a phenomenon known as “common or cross-ownership.” An example would be BlackRock holding shares in both Apple and Microsoft.

So how does it affect managers when an institutional investor intentionally hold shares of competing firms in the same industry?

“When there is cross-ownership, there is information-sharing,” says SMU Associate Professor of Accounting Holly Yang. “This allows managers to make more informed investment decisions and better allocate the firm’s capital.”

Professor Yang, who is also the Co-Director of the School of Accountancy Research Centre, is currently working on publishing a paper entitled “Institutional Cross Ownership of Peer Firms and Investment Sensitivity to Stock Price”. The paper showcases her research on how cross-ownership of industry peers helps institutional investors better acquire industry insights and produce private information, allowing corporate managers to incorporate this information into their decisions.

The controversy

In recent years, financial regulators around the world have been paying a lot of attention to the notion of cross-ownership because they fear that it hurts competition and leads to anti-trust issues.

“Specifically, some people argue that cross-ownership is bad because when competing firms are held by the same investors, it reduces the firms’ incentives to compete with each other and leads to higher prices for consumers,” explains Professor Yang.

“Since companies in certain industries are now owned by only a few mutual fund families, they will have fewer incentives to lower prices, invest in new products or services, or win market share from competitors, if they know that their large shareholders also own significant stakes in their rivals’ companies. This reduces market competition and is detrimental to consumers.”

For example, in the U.S., the top seven shareholders of American Airlines are also among the top-ten shareholders of Southwest and other competitors. Since there’s significant overlap in their ownership, they do not have incentives to reduce airfares or provide better service for competing routes. Even though some studies find that common ownership reduces market competition in the airline or retail banking industry, it has led to a huge debate among academics, regulators, and institutions for a couple of reasons.

First, the airline industry is a very concentrated industry and it is hard for consumers to find substitute carriers. “If one wants to get from California to New York, there’s no feasible option but to fly. Therefore, it’s not clear whether their results can be generalised to other industries,” argues Professor Yang. “Furthermore, these studies usually assume that institutional investors implicitly or explicitly encourage companies to engage in anti-competitive behavior, but the ownership levels of a particular firm are often so little that institutions have no incentive to engage in such activities.”

Professor Yang’s study, however, is one of the few that show an unintended benefit of cross-ownership. “We found in our study that most institutional investors do not hold enough assets to have direct influence over the managers’ decisions,” she explains. “However, they can indirectly affect the managers’ decisions by discovering information unknown to managers and impounding that information into price through trading.

“While managers are more likely to have private firm-specific information, institutional investors are better able to acquire and gain industry insights by holding a portfolio of competing firms in the same industry. Depending on each firm’s manufacturing capacity, pricing strategy, or competitive advantage, some changes in industry landscapes may be more or less favourable to one firm than the other.”

The study

The main research question in Professor Yang’s study is whether and how a firm’s ownership structure affects the managers’ reliance on stock price as a source of new information about their fundamentals. The underlying rationale is that when shareholders hold competing firms in the same industry, they are likely to produce private industry-specific information and impound this information in price through trades.

“To test this conjecture, we look at whether a firm’s sensitivity of investment to stock price increases as its cross-ownership increases,” Professor Yang says. The researchers measured institutional cross-ownership for a sample of U.S. firms from 1981 to 2016 to see whether the investment-to-price sensitivity is higher for firms with higher cross-ownership.

“Consistent with our expectation, we find that a firm’s investment-to-price sensitivity does increase with its level of common ownership. We also find that cross-ownership helps facilitate managerial learning when managers revise earnings forecasts. Overall, our results suggest that cross-ownership of peer firms induces more efficient corporate decisions by helping prices better reflect the investors’ private information.”

Practical implications

A lot of the recent debate on cross-ownership focuses on anti-trust issues and there are even suggestions of imposing a limit on the percentage of shares institutional investors can hold in a particular industry or restricting them to owning only one company in each industry in the U.S.

“While it is premature to say cross-ownership is not beneficial to society, our findings shed light on one of the benefits of cross-ownership that hasn’t been explored,” Professor Yang posits. “Specifically, our results suggest institutional cross-owners play an important price-discovery role in the market, where by discovering information not known to corporate managers and impounding that information into price through trading, it can also have an impact on the real economy.”

Will there be a follow-up study? “Yes,” says Professor Yang. “We find the area of managerial learning quite interesting and are currently working on another project related to managerial learning. It will look at whether managers also learn from their direct interactions with financial analysts.”

Back to Research@SMU Nov 2020 Issue