No 911 February 2009 Innovation and Institutional Ownership

We find that institutional ownership in publicly traded companies is associated with more innovation (measured by cite-weighted patents). To explore the mechanism through which this link arises, we build a model that nests the lazy-manager hypothesis with career-concerns, where institutional owners increase managerial incentives to innovate by reducing the career risk of risky projects. The data supports the career concerns model. First, whereas the lazy manager hypothesis predicts a substitution effect between institutional ownership and product market competition (and managerial entrenchment generally), the career-concern model allows for complementarity. Empirically, we reject substitution effects. Second, CEOs are less likely to be fired in the face of profit downturns when institutional ownership is higher. Finally, using instrumental variables, policy changes and disaggregating by type of owner we find that the effect of institutions on innovation does not appear to be due to endogenous selection. JEL Classifications: O31, O32, O33, G20, G32 Keywords: Innovation, institutional ownership, career concerns, R&D, productivity This paper was produced as part of the Centre’s Productivity and Innovation Programme. The Centre for Economic Performance is financed by the Economic and Social Research Council. Acknowledgements We would like to thank Tim Besley, Patrick Bolton, Florian Ederer, Oliver Hart, Mark Saunders, David Scharfstein, Jean Tirole, and participants in seminars at the New Orleans AEA, Chicago, CIAR, LSE, MIT/Harvard, NBER, Stanford and ZEW Mannheim for helpful comments and assistance. Brian Bushee, Darin Clay, Adair Morse and Ray Fisman have been extremely generous with their comments and helping us with their data. Van Reenen gratefully acknowledges the financial support of the ESRC through the Centre for Economic Performance, Zingales the Initiative on Global Markets and the Stigler Center at the University of Chicago. Philippe Aghion is a Professor of Economics at Harvard University. John Van Reenen is Director of the Centre for Economic Performance and Professor of Economics at the London School of Economics. Luigi Zingales is Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. Published by Centre for Economic Performance London School of Economics and Political Science Houghton Street London WC2A 2AE All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published. Requests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. © P. Aghion, J. Van Reenen and L. Zingales, submitted 2009 ISBN 978-0-85328-344-7 Innovation is the main engine of growth. But what determines a …rm’s ability to innovate? Innovating requires taking risk and forgoing current returns in the hope of future ones. Furthermore, while any type of …nancing is plagued by moral hazard and adverse selection, the …nancing of innovation is probably the most vulnerable to these problems (Arrow, 1962) since the information that needs to be conveyed is hard to communicate to outsiders. This paper is a …rst attempt at analyzing the corporate governance of innovation and more speci…cally the role of institutional owners in fostering (or retarding) innovation. While the ability to diversify risk across a large mass of investors makes publicly traded companies the ideal locus for innovation, managerial agency problems might undermine the innovation e¤ort of these companies. In publicly traded companies, the pressure for quarterly results may induce a short term focus (Porter, 1992). And the increased risk of managerial turnover (Kaplan and Minton, 2008) might dissuade risk-averse senior managers from this activity. Finally, innovation requires e¤ort and “lazy”managers might not exert enough of it. Hence, it is especially important to study the governance of innovation in publicly traded companies, which account for a large share of the private investments in Research and Development (R&D). Probably the most important phenomenon in corporate governance in the last thirty years has been the remarkable rise in institutional ownership. While in 1970 institutions owned only 10% of publicly traded equity, by the start of 2006 they owned more than 60% (see Figure 1). Thus, in this paper we focus on the role of institutional ownership on the innovation activity of publicly traded companies. Did the rise in institutional ownership increase short-termism, undermining the innovation e¤ort? Or did it reassure managers, making them more willing to strike for the fence? To answer these questions we assemble a rich and original panel dataset of over 800 major US …rms over the 1990s containing time-varying infor-