CEP Discussion Paper No 911
February 2009
Innovation and Institutional Ownership
Philippe Aghion, John Van Reenen and Luigi Zingales
Abstract
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 published 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
This paper is produced as part of the project Science, Innovation, Firms and Markets in a Globalised
World (SCIFI-GLOW), a Collaborative Project funded by the European Commission’s Seventh
Research Framework Programme, Contract number SSH7-CT-2008-217436. Any opinions expressed
here are those of the author(s) and not those of the European Commission. 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 pub-
licly traded companies the ideal locus for innovation, managerial agency problems
might undermine the innovation e¤ort of these companies. In publicly traded com-
panies, 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, innova-
tion 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-
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mation on patent citations, ownership, R&D and governance. We show that there
is a robust positive association between innovation and institutional ownership
even after controlling for …xed e¤ects and other confounding in‡uences. Institu-
tions have a small and positive impact on R&D, but a larger positive e¤ect on
the productivity of R&D (as measured by future cite-weighted patents per R&D
dollar).
To uncover the source of this relationship we build a model that nests the
two main reasons for this positive e¤ect. The simplest explanation is manager-
ial slack: managers may prefer a quiet life but institutional investors force them
to innovate. An alternative explanation is based on career concerns. Innovation
carries a risk for the CEO: if things go wrong for purely stochastic reasons, the
board will start to think he is a bad manager and may …re him. This generates a
natural aversion to innovation. If incentive contracts cannot fully overcome this
problem, increased monitoring can improve incentives to innovate by “insulating”
the manager against the reputational consequences of bad income realizations.
According to this view, institutional owners have better incentives (they typically
own a large share of the …rm) and abilities (they typically own stock in many …rms
so they b ene…t from economies of scope in monitoring) to monitor. This more
e¤ective monitoring will therefore encourage innovation. The lazy manager hy-
pothesis predicts that product market competition and institutional ownership are
substitutes: if competition is high then there is no need for intensive monitoring as
the manager is disciplined by the threat of bankruptcy to work hard. In contrast,
our career concern model predicts that more intense competition reinforces the
positive e¤ect of institutional investment on managerial incentives.
We …nd that the positive relationship between innovation and institutional
ownership is stronger when product market competition is more intense (or when
CEOs are less “entrenched” due to protection from hostile takeovers), which is
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consistent with the career concerns hypothesis and inconsistent with the “lazy
manager”one. Another implication of the career concern model is that the deci-
sion to …re the CEO is less a¤ected by a decline in pro…tability when institutional
investment is high. We …nd this is indeed the case. While in the absence of a
large institutional investor a decline in pro…t leads to a high probability the CEO
is dismissed, this probability drops when institutional investors own a substantial
amount of stock.
Next, we try to uncover which institutions have the biggest impact on innova-
tion by using Bushee (1998) classi…cation. We …nd that quasi-indexed institutions
(to use Bushee’s classi…cation) have no association with innovation, while other
forms of institutional owners have an equally positive association with innovation.
We also show that the e¤ect of these non-indexed institutional owners on inno-
vation appeared to grow stronger after the 1992 change in the American Proxy
Rules that increased their in‡uence.
Finally, we argue that the correlation b etween institutional ownership and
innovation is not primarily due to a selection mechanism whereby institutions are
simply better at selecting the companies who will innovate more in the future.
We also show that the exogenous increase in institutional ownership that follows
the addition of a stock to the S&P500, has a positive e¤ect on innovation, even
for the non-indexed investors.
While there is a large literature on the e¤ect of …nancing constraints on R&D
(for surveys see Bond and Van Reenen (2007) and Hall (2002)), there is very
little on the relation between institutional ownership and innovation. Notable
exceptions are Francis and Smith (1995), who …nd a positive correlation b etween
ownership concentration (which includes institutions) and R&D expenditures and
Eng and Shackell (2001), who …nd a positive correlation of institutions with R&D.
In a similar vain, Bushee (1998) …nds that cuts in R&D following poor earnings
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