WORKING PAPER SERIES 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. Philippe Aghion Department of Economics Harvard University 1805 Cambridge St Cambridge, MA 02138 and NBER paghion@fas.harvard. edu John Van Reenen London School of Economics Centre for Economic Performance Houghton Street London WC2A 2AE ENGLAND and NBER j.vanreenen@lse.ac. uk Luigi Zingales Graduate School of Business The University of Chicago 5807 S. Woodlawn Avenue Chicago, IL 60637 and NBER luigi.zingales@gsb.uchicago. edu 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-