Secondary Markets, Animal Spirits, and Corporate Investment

I examine the direct effects of secondary markets on firm investment and innovation. I find that market downturns cause pharmaceutical companies to abandon early-stage drug developments irrespective of drug quality or future investment value. I show that financing constraints appear to drive this behavior. My results indicate that secondary markets have important feedback effects, distinct from information feedback channels, that permanently reduce innovation. ∗Chris Mace is with the David Eccles School of Business at the University of Utah (chris.mace@eccles.utah.edu). I would like to thank Julian Atanassov, Jonathan Brogaard, Jeffrey Coles, Mariassunta Giannetti, Davidson Heath, Gerard Hoberg, Ben Iverson, Jiacui Li, Elena Patel, Matthew Ringgenberg, Nathan Seegert, and the seminar participants at the University of Utah and the FMA Doctoral Student Consortium for their helpful comments and suggestions. Theoretically, capital markets promote innovation by selectively allocating capital to firms with the greatest innovative potential (Schumpeter, 1942; Solow, 1957; Wurgler, 2000). This effect is thought to be concentrated in primary markets, where firms and investors interact. Although secondary markets do not involve capital flowing to or from the firm, it is well documented that market prices contain information that influence firm investment decisions (Grossman, 1976; Edmans, Goldstein, and Jiang, 2012, 2015). In this paper, I extend this literature by showing that secondary markets have a direct effect on firm investment that is not driven by price informativeness. More specifically, I find that secondary markets can result in financing frictions that permanently reduce investment and innovation. I first examine whether market downturns influence firm investment. Because aggregate market fluctuations do not provide firms with feedback on individual investment decisions, this allows me to examine whether secondary markets affect investment through channels separate from the feedback effects of market prices. One potential confound of this approach is that secondary markets and investment value tend to co-move with consumer demand. To control for this endogenous relationship, I use the pharmaceutical industry as a natural laboratory because drug demand is largely insensitive to changes in market conditions. For example, the firm AbbVie makes the rheumatoid arthritis medication Humira. I find that consumers who need this medication purchase it independent of aggregate market conditions. Overall, I find that aggregate movements in secondary markets do, in fact, drive firm-level investment decisions. More specifically, I show that market downturns lead pharmaceutical companies to permanently abandon drug development, even when the value of these investments is insensitive to market fluctuations. I further show that financing frictions drive this behavior, and that drug abandonment occurs independent of drug quality or innovative potential. My results provide novel evidence that market downturns reduce the ability of primary markets to convey information on project quality, thereby impairing the ability of secondary markets to efficiently allocate capital. Put differently, investment appears to be driven by “animal spirits” rather than investment quality (Keynes, 1937; Akerlof and Shiller, 2010; Aggarwal, 2014). In many ways, the pharmaceutical industry provides an ideal setting for evaluating whether secondary markets influence investment and innovation. First, because pharmaceutical demand is driven by the incidence and distribution of disease, market fluctuations have little impact on