Innovation: The Bright Side of Common Ownership?

The common ownership hypothesis has ignited a debate among scholars, policymakers, investors, and other industry stakeholders about the impact of widespread diversified investment on corporate competition. Central to the debate is the claim that when large investors such as asset management companies have significant stakes across competing firms within the same industry, they might dampen competitive incentives. Common ownership can lead companies to refrain from aggressive competitive strategies like price cutting or increased innovation, as these actions could harm the profits of their rival firms, which are also part-owned by the same institutional investors.

Proponents of the common ownership hypothesis suggest that this phenomenon could explain some puzzling trends in the economy, such as reduced business dynamism, elevated profit margins, and diminished consumer surplus. However, critics challenge these interpretations, arguing that the empirical evidence linking common ownership to anticompetitive behavior is not definitive and ignores the impact that common ownership may have for firms competing across multiple industries and for corporate innovation. They caution against regulatory interventions that could disrupt the investment landscape without clear proof of harm. This debate has not only academic implications but also practical consequences, influencing how markets are regulated and how corporate strategies are formulated. Our research dives deeper into this complex issue, exploring how common ownership affects corporate innovation across the U.S. economy.

In our paper (recently accepted at Management Science), we explore the idea that common ownership can influence corporate innovation in two fundamentally different ways. First, it can mitigate the underinvestment in innovation that typically occurs when firms cannot capture the full benefits of their innovations due to technological spillovers to rivals. Second, it might dampen the incentive to innovate by softening the competitive pressures among firms that are commonly owned.

Internalizing Technological Spillovers and Competitive Pressures

A central feature of our theoretical analysis is that it allows for product differentiation, technology spillovers, and common ownership to vary across all firm pairs. This permits us to study common ownership links between firms across the entire economy rather than just in a single industry as in previous studies. Our theoretical model explores the nuanced dynamics of how common ownership influences corporate innovation through two distinct channels: technological spillovers and product market competition.

We show that the effect of common ownership on innovation varies based on the nature and intensity of these spillovers. Specifically, the model suggests that when firms are interconnected through technological relationships—meaning innovations by one firm benefit others due to shared technologies or research domains—common ownership can enhance innovation. This positive impact arises because common owners, holding stakes across these technologically interlinked firms, can internalize the benefits of innovations that spill over to other entities within their portfolio. Thus, common ownership under technological spillovers aligns the incentives across owned firms to push for greater innovation efforts, aiming to maximize the collective success of their investments.

Conversely, the model also considers the scenario where firms are direct competitors within the same product market. In such cases, common ownership can lead to a reduction in innovation. This reduction occurs because common ownership diminishes the competitive incentives among firms to innovate as a means of outperforming each other. Since the same investors benefit from the profits of all competitors, there is less incentive to fund or pursue aggressive innovation strategies that could destabilize the market balance. Essentially, the model predicts that the overall impact of common ownership on corporate innovation is contingent upon the relative dominance of technological versus product market spillovers, making the net effect either positive or negative depending on which type of spillover prevails.

Measuring Market Competition and Technological Dynamics

A cornerstone of our study is the innovative methodology we developed to measure product market competition and innovation spillovers—factors crucial to understanding the effects of common ownership:

1. Product Market Proximity:
We measure product market proximity through an analysis of firm descriptions in regulatory filings. Building on the work of Hoberg & Phillips (2010) and employing their text-based analytical techniques, we assessed the similarity in product descriptions from firms’ 10-K filings. Using natural language processing, we calculated a ‘cosine similarity score’ between the text vectors of different firms. A higher score indicates greater similarity in the products offered by the firms, suggesting closer product market proximity, a lower degree of product differentiation, and thus more intense product market competition.

2. Technological Spillovers:
To capture innovation spillovers, we turned to patent citation data. We analyzed the patents filed by firms and the citations these patents received from others. By examining the overlap in patent citations between firms, we determined the extent of technological relatedness and potential spillovers. This method recognizes that firms influencing each other’s innovation paths may not directly compete in the same product markets but may be linked through shared technologies and research trajectories.

Empirical Findings from Our Investigation

In our empirical analysis, we tested the theoretical predictions by examining a comprehensive dataset of U.S. firms, focusing on the interaction between common ownership, technological spillovers, and product market proximity. The results provide substantive evidence supporting the model’s predictions. We found that common ownership significantly enhances innovation in contexts where technological spillovers are strong. Quantitatively, the data revealed that an increase in common ownership is associated with a statistically significant increase in innovation outputs, such as patent citations and R&D spending, for firms where technological spillovers prevail. This finding underscores the beneficial role of common ownership in fostering innovation through the internalization of positive externalities across commonly owned firms.

However, the impact of common ownership on innovation presents a stark contrast in scenarios characterized by intense product market competition. Here, the empirical evidence indicated a negative relationship. Specifically, in markets where firms are close competitors, an increase in common ownership correlates with a measurable decrease in innovation activities. For instance, a one standard deviation increase in common ownership was associated with a significant reduction in R&D intensity and patent outputs for firms where product market linkages are more important than technological spillovers. This negative effect likely stems from the diminished incentive for firms to innovate aggressively when they are part of a portfolio of commonly owned companies that also include their direct competitors.

The duality of these findings is particularly pronounced when examining the interaction effects in our regression models. The data showed that the positive impact of common ownership on innovation in technologically connected firms could be offset by competitive dynamics in the product market. For example, the positive effect of a standard deviation increase in common ownership on patenting activity was significantly reduced, and sometimes reversed, when the firms involved had high product market proximity. This nuanced view illustrates that the overall effect of common ownership on corporate innovation is highly dependent on the firm-specific balance of technological linkages and market competition. These empirical insights not only validate our theoretical framework but also highlight the complex interdependencies that policymakers and corporate strategists must consider when assessing the implications of common ownership in their respective domains.

Overall our results reveal that an increase in common ownership is associated with a decrease in innovation for about half the firms (i.e., firms with relatively high product market spillovers to other commonly-owned firms). In contrast, for the other half of firms for which technology spillovers to other commonly-owned firms are relatively large, the same increase in common ownership is associated with an increase in innovation.

To address potential endogeneity concerns we use the BlackRock-BGI acquisition to shock the interaction between common ownership and technological proximity. We find limited evidence of a causal effect of common ownership on innovation outputs (citation-weighted patents and stock market value of patents), but not on innovation inputs. We do not find robust causal evidence of a negative effect of common ownership between product market rivals on innovation. Overall, whether the uncovered empirical relationships have a causal interpretation, and thus whether common ownership is indeed a bright side of common ownership remains an open question.

Policy Implications and Strategic Considerations

The findings from our research hold significant implications for both policymakers and corporate strategists. Policymakers, in particular, might need to consider the nuanced effects of common ownership on innovation when designing regulations that aim to foster competitive markets as common ownership despite its anticompetitive product market effects may have procompetitive benefits for innovation. For corporate strategists, understanding the landscape of common ownership within their industries could inform more effective governance and innovation strategies, especially in technology-intensive sectors.

Conclusion

Our research highlights that the relationship between common ownership and corporate innovation is highly contextual and multifaceted. The methodological approaches we developed provide a robust framework for exploring this dynamic. As common ownership continues to rise and become more prevalent in every sector of the U.S. economy, its impact on innovation will remain a pivotal area of study for ensuring healthy market functioning and fostering technological advancement.