Although widespread asset ownership is a good thing, it raises a new barrier to disciplining self-serving managers: the dilution-of-ownership problem.
The problem of double-dilution of ownership.
E stablished in 1602, the Dutch East India Company (Verenigde Oostindische Compagnie, VOC) issued transferable shares of stock which could be easily traded on the Amsterdam Stock Exchange. The VOC’s corporate form was designed to solve the problem of businesses becoming too large and complex to be run by a single owner-manager. Instead, the corporation allows specialization with professional investors electing a board of directors to oversee professional managers hired to run the firm’s day-to-day operations.
The benefits of this arrangement also brought costs. In particular, the separation of ownership and management creates a “principal-agent” problem. As articulated by economists Michael Jensen and William Meckling, this problem arises when the interests of the agent (i.e., the manager) are not aligned with those of the principal (i.e., the owner). For example, when the VOC dispatched a delegation to Bengal in 1684, it discovered that managers had established a club called the “Small Company” that “stole money, used the business to buy goods for their own use, and withheld customs charges from the Mughal authorities.” Indeed, managerial corruption was a key factor in the VOC’s dissolution in 1799.
Managerial opportunism is not just about lining one’s pockets through corrupt activities such as embezzlement. In modern times, opportunism frequently involves status-seeking. For example, during the conglomerate craze of the 1960s and ’70s, managers created huge firms consisting of multiple, unrelated businesses under one corporate roof — a waste of shareholder resources. Yet CEOs loved building conglomerate empires because these led to bigger salaries and higher status among their peers.
Deregulation and financial innovation during the latter half of the 20th century led to more widespread stock ownership among the middle class. Although widespread asset ownership within a society is generally a good thing, it raises a new barrier to disciplining self-serving managers: the dilution-of-ownership problem. When ownership is diffused across thousands of small investors, it is very difficult to coordinate action against managerial opportunists. Only “takeover artists” such as Carl Icahn and T. Boone Pickens could halt the conglomerate craze by taking majority ownership — thereby increasing shareholder concentration — then firing managers, selling off unrelated businesses for a profit, and moving on to the next takeover target.
Today’s status game is virtue-signaling: increasing one’s prestige among managerial peers by tying the firm’s brand to the latest progressive cause célèbre. These efforts lead to wasteful expenses (such as costly Super Bowl advertising) and can sometimes lead to the direct destruction of shareholder value (for example, Target, Disney, and Anheuser-Busch collectively vaporizing billions of dollars of shareholder value by such acts of managerial initiative).
Unfortunately, the massive sizes of these multinational corporations present a barrier to the takeover solution employed in the past — one would need substantial financial resources to take control of a company such as Disney, which had a market cap of $162 billion in June 2023. (Elon Musk’s takeover of Twitter is the exception that proves the rule.) It is hard to see how shareholders will overcome the dilution-of-ownership problem this time around.
Today, most people are “investors” in the sense that they own mutual funds. Mutual funds include stock portfolios managed by large financial institutions such as BlackRock, Fidelity, Vanguard, American Century, and Franklin Templeton. Approximately 100 million Americans own mutual-fund shares, usually through employer-sponsored retirement plans, such as 401ks. These people are now twice-removed from the managers running the companies in which their money is invested. We refer to this problem as “double-dilution-of-ownership.” Unlike investors who own shares directly, owners of mutual funds cannot vote in board elections or company general meetings or even register their displeasure by selling shares. Under this arrangement, there is no control of managers by the people supplying them the cash.
The mutual-fund industry is highly concentrated: The top three mutual-fund families control trillions of dollars of other people’s money. They decide which firms to invest in, which shareholder resolutions to support, and whom to vote for in board elections. For example, as of November 26, 2022, BlackRock owned over 6 percent of Disney’s shares, second only to Vanguard’s 7.6 percent. To the extent that BlackRock executives share (or purport to share) the same values as executives at Disney (and they do), it should come as no surprise that Disney’s virtue-signaling is not being curtailed — indeed it is actually being encouraged through so-called ESG investment scoring. (ESG is an investment discipline under which actual or potential portfolio companies are measured against environmental, social and governance standards.) To generalize, ESG’s standards tend to come with a progressive tilt. The higher a company’s ESG score, the more likely it is that certain funds will invest in them.
In response (mainly) to the growing controversy over ESG, stakeholder capitalism, or politicized managements, some of the larger investment management groups, led by BlackRock, are now trying to devolve some voting to underlying investors (if they so choose). It’s a step in the right direction.
Another sign of the increasing focus on this issue has been the appearance of market-based solutions such as investment funds aligned to conservative values or that are explicitly focused solely on investor return. These funds’ small size relative to the BlackRocks of the world will make it difficult to rein in the kinds of opportunistic managerial behaviors described above. Even so, if they attract investors and deliver superior performance, that will be the most effective message of all.
Michael Ryall is the director of policy, and Siri Terjesen is the executive director at the Madden Center for Value Creation at Florida Atlantic University College of Business.