Investment Funds and Airline Ownership Jul/Aug 2018
In March this year, Margrethe Vestager, the powerful Danish EU Commissioner for Competition, gave a speech in Brussels which attracted only modest press coverage but which could have wide-ranging implications for the future ownership structure of airlines. The speech focused on the growing concentration of company ownership, and in particular cross-ownership by investment funds, something which has generated increased attention in North America and Europe. What was particularly interesting, however, was the fact that Ms Vestager specifically mentioned the airline industry in this respect.
As she noted: “In the US, they collect much more complete information than in Europe about exactly who owns which shares. So we can see examples of industries — like the airline business — where some investment funds own shares in all the big companies in the industry. And when investors have an interest in several companies in the same market, they might be better off if those companies don’t compete too hard. If they ease off on trying to outdo each other, so no one wins big — but no one loses big either. And of course, that can mean that consumers lose out.” [Emphasis added]
She went on to say that the European Commission is seeking to establish whether the potential problem already identified in the US exists as well in Europe. “We also need to understand what effect it really has — because even if some investors would benefit from less fierce competition, you can’t just assume that they have the power to make that happen.”
It seems, therefore, that the Commission is at an early stage in its investigation and there can’t be any certainty that something will actually come of it. But it would be foolish to ignore the concerns identified by Ms Vestager. As the US tech giants have discovered to their cost, the Commission (like the Department of Justice in the US) has substantial powers if it concludes that companies are restricting competition and acting against the consumer interest, powers that can prove extremely costly to guilty parties.
The core issue is that today diversified mutual funds and other institutional investors hold an increasing proportion of companies’ shares. Much depends, of course, on how you define such funds. Some have estimated that their joint ownership might be as high as 80% of US stocks; others put the figure as low as 62% in 2015, but even this represented an increase from some 37% in 1980. Thus, it is not surprising that competition authorities have started to question whether opportunities for anti-competitive behaviour are being created, although it is less obvious why the airline industry has been picked on in particular. The answer may lie on Ms Vestager’s reference to the quality and quantity of data available for the industry.
Good quality, publicly available data tend to attract the interest of academics for their research, and it is academics who seem to have been especially active in highlighting the potential problems created by joint institutional ownership of airlines. One study in particular is worth considering: ‘Anti-Competitive Effects of Common Ownership’ by José Azar, Martin C. Schmalz and Isabel Tecu, published in March 2017 in the Journal of Finance (Volume 73/4).
This is a lengthy and very detailed economic analysis which comes to a clear conclusion in relation to the US airline industry: “We find a robust correlation between with-route changes in common ownership concentration and route-level changes in ticket prices… We conclude that a hidden social cost — reduced product market competition — accompanies the private benefits of diversification and good governance.”
Cutting through the jargon, this means that the authors claim to have found evidence that common ownership of airline shares, ie large funds having significant stakes in several carriers, has led to higher fares. The accompanying table shows data for the top ten investors in four of the nine airlines studied in the Fourth Quarter of 2016. Note that American Airlines’ top seven shareholders, who jointly control 49% of the company’s shares, are also among the top ten investors in Southwest Airlines. Similarly, each of Southwest’s largest six shareholders is among the top ten investors in American and Delta and five of them are among the top ten holders of United/Continental stock. (See also Aviation Strategy, November 2016). This pattern is repeated to a greater or lesser extent for all nine airlines included in the study.
(In the table we show updated ownership data for the top four US carriers from recent filings — which if anything show further concentration. For contrast in the table we show the limited data available for the top five carriers in Europe).
The usual way of measuring industrial concentration for competition analysis is the so-called Herfindahl-Hirschman Index (HHI), which involves squaring the market share of each firm competing in a market and then summing the results. An HHI of 0 indicates perfect competition, one of 10,000 shows a total monopoly. Azar, Schmalz and Tecu produce a modified index (MHHI) to reflect the extent to which competitors are also commonly owned by the same investors.
The results show “levels of market concentration that far exceed those indicated by the conventional measure of [such] concentration [ie, HHI]. Common ownership concentration for the average route is more than ten times larger than what would be presumed ‘to be likely to enhance market power’ in the case of a traditional merger, according to the US Antitrust Agencies’ Horizontal Merger Guidelines.” The results of the authors’ calculations suggest that US airline ticket prices are 3 to 7% higher because of common ownership, certainly sufficient to attract the interest of the competition authorities.
As the authors recognise, even if common ownership causes higher prices, that does not necessarily mean that mutual funds actively and consciously pursue anti-competitive practices. But there may be other ways that such investors can influence company behaviour. Competitive pressures may be reduced, for example, by just “doing nothing”, such as by not actively encouraging certain market behaviour which in other circumstances shareholders might be expected to pursue. Similarly, the authors suggest that some common owners “(i) use voice to make understood their preferred product market strategies, that they can (ii) structure incentives, ie pay, of commonly owned firms’ top managers in ways that reward less aggressive competition, and that they can (iii) use the power of their vote to silence dissenting undiversified shareholders that push for more competition.”
Needless to say, this being economics, not everyone agrees with the Azar, Schmalz and Tecu analysis, far from it. A particularly strong counter-argument has been published by Patrick Dennis, Kristopher Gerardi and Carola Schenone. (“Common Ownership Does Not Have Anti-Competitive Effects in the Airline Industry”, published online on 5 March 2018.) They certainly do not disagree on the importance of this subject, pointing out that the risk of funds increasing prices has resonated with both academics and policymakers and put significant pressure on anti-trust authorities to open formal investigations.
They go on to note that the US Congress has even been urged to introduce new legislation withdrawing tax advantages for retirement funds investing in any mutual fund that owns a significant number of shares in multiple firms in the same industry and limiting investors’ “holdings of an industry to a small stake (no more than 1% of the total size of the industry) or [to … ] the shares of only a single ‘effective firm’ per industry.” Others in the US have argued that instead what is required is the enforcement of current legislation, notably the Clayton Act which, it is claimed, already bans the acquisition of stocks that result in a common set of investors owning significant shares in corporations that are horizontal competitors.
Action along these lines would, of course, inevitably have severe consequences for the airline industry and its investors. But any such action would only be necessary if the conclusions about anti-competitive behaviour are correct, and Dennis, Gerardi and Schenone argue strongly that this is not the case. They conclude, on the basis of their own detailed study, that the Azar, Schmalz and Tecu analysis is in fact far from robust and probably misleading. Again the arguments are complex and technical, but the authors (and at least one other study has pointed in the same direction) come to the clear conclusion that the “results indicate the spurious nature of the Azar, Schmalz and Tecu findings, and should be seriously considered by both legal scholars and policymakers who are currently contemplating regulations aimed at decreasing the extent of institutional ownership in product markets.”
It is evident that this debate will continue for some time, and given its complexity and technical nature, it is unlikely to attract much public attention, at least until definitive conclusions are reached. As the recent speech by Commissioner Vestager indicated, policymakers in both Europe and the US are now closely involved. It may be that the most likely outcome is that at the end of the day no regulatory action will be taken, but nevertheless the risk of any action, no matter how tentative, is not something that should be ignored. The impact on the airline industry could be substantial.
There is another aspect to this debate which may also be worth highlighting. Airlines suffer from archaic rules governing the nationality of who can own and control them. Attempts over many years to reform these rules, notably the negotiations between the EU and US to create a fully liberal Trans-Atlantic Aviation Area, have got nowhere. Indeed, if anything it may be the forces of protectionism that are in the ascendancy, as illustrated for example by campaigns to restrict the expansion of the Gulf carriers. IATA appears to have retreated from its reform initiative, and the exit of the UK from the European Union increases the risk that the latter will adopt a less liberal external aviation policy. It looks as though the airline ownership and control rules are here to stay for the foreseeable future.
Yet the debate about common ownership in the industry outlined above highlights one important factor. It is clear that investment funds of various kinds are becoming ever more prominent in the list of shareholders of most publicly-quoted carriers. Many of these funds are enormous, with divers and often secret investors. It can be difficult to determine with any precision who the ultimate shareholders are, and therefore it must be equally difficult to determine the real nationality of airline stakeholders. Many regard the airline ownership and control rules as being harmful to the industry’s economic well-being. It seems that in fact they may be even less fit for purpose than was thought.
INSTITUTIONAL US AIRLINE
SHAREHOLDINGS, 2016 Q4
|State Street GA||3.71%||4.28%||3.76%||3.45%|
|J P Morgan AM||3.79%||1.31%||3.35%|
|PAR Capital Mgt||1.52%||-||5.18%|
|BNY Mellon AM||1.22%|
|Egerton Capital (UK)||1.10%|
|Northern Trust G I||1.02%|
|Altimeter Capital Mgt||3.26%|
|AQR Capital Mgt||2.15%|
Source: José Azar, Matin C. Schmalz & Isabel Tecu: ‘Anti-Competitive Effects of Common Ownership.’ Journal of Finance, 73/4.
INSTITUTIONAL US AIRLINE
SHAREHOLDINGS, 2018 Q2
|T. Rowe Price||13.0%||2.8%||3.0%||1.4%||4,761|
Source: SEC, NASDAQ, Factset latest filings.
INSTITUTIONAL EUROPEAN AIRLINE SHAREHOLDINGS, 2018 Q2
|Shareholder||Air France-KLM||IAG||Lufthansa||Ryanair||easyJet||Exposure (€m)|
Note: Intitutional Investors holding at least 3% of the equity in one or more of the European major airlines. Lufthansa Group data sourced from 2017 Annual Report.
Source: Financial Times, Factset, Company reports.