Innovation and Institutional Ownership
GAICIL Insights
Wall Street is supposed to be innovation's enemy, forcing managers to chase the next quarter.1 Innovation and Institutional Ownership, by Philippe Aghion, John Van Reenen and Luigi Zingales, finds the reverse. Greater institutional ownership is associated with more innovation, even after accounting for increased R&D and potential endogeneity of institutional ownership.
Two hypotheses compete to explain it. In the lazy manager hypothesis, institutional owners discipline managers who would otherwise avoid the effort of innovation. In the career concerns model, institutional owners raise innovation incentives by reducing managers' career risks, insulating them from punishment for the bad luck that often accompanies risky innovation. The evidence favors career concerns. Investors help most as insurers of courage, with discipline a lesser part of the story.
Three findings tip the balance. First, institutional ownership and product market competition are complements, whereas the lazy manager hypothesis predicts substitution; institutions matter more for innovation when competition is higher and managers are less entrenched. Second, CEOs are less likely to be fired after profit downturns when institutional ownership is higher. Third, using instrumental variables, including S&P500 membership, policy changes and disaggregation by type of institutional owner, the authors argue the effect is causal.
The implication reframes corporate risk. Risk considerations at the managerial level play an important role in preventing innovation. Managers fearing dismissal for failures may avoid risky innovative projects. Institutional owners, by monitoring and understanding the firm, can distinguish bad luck from bad management, reducing career risk and encouraging innovation. Given innovation's positive externalities, the authors suggest considering public policies that reduce innovation risk for managers of publicly traded companies. The obstacle to innovation may sit in the CEO's employment contract.
Where does this leave AI? Artificial intelligence projects are career risk in concentrated form. AI investments are risky, with uncertain returns and long horizons. Managers weighing ambitious AI projects face career risk if they fail. Ownership structures reducing that risk, through informed investors able to tell bad luck from poor decisions, may encourage bolder AI investment. The executive who fears the board will be timid with AI.
Competition amplifies the effect. In competitive markets, innovation is essential for survival, and institutional ownership boosts innovation incentives further. AI markets, characterized by intense competition, may especially benefit from ownership structures supporting managerial risk-taking.
The common narrative takes a hit. Concerns that institutional investors induce short-termism are widespread. This evidence suggests that, on balance, institutional ownership boosts innovation. Corporate governance reformers should take that into account before acting on the narrative.
Governance design follows. Boards and investors tolerating failures from well-conceived risky projects encourage innovation. Practices punishing managers for any setback may discourage the experimentation innovation requires. In the AI era, where experimentation is essential, such practices may be particularly costly. A board's tolerance for intelligent failure is an innovation policy.
Public risk-sharing is an intriguing idea. Mechanisms sharing or insuring innovation risk could encourage more ambitious projects. Given AI innovation's positive externalities, such policies could carry substantial social benefits.
The dismissal finding is the telling detail. Managers of firms with more institutional ownership face less risk of losing their jobs after profit downturns, giving them room for long-term projects. Job security, properly earned, buys patience.
Careful identification strengthens the case. Testing distinct predictions of competing hypotheses and using multiple instruments yields credible evidence on the mechanism, essential for governance and policy design.
Stepping back, ownership structure affects innovation through managerial risk. Institutional owners boost innovation by reducing career risks, especially in competitive markets. As AI demands bold, risky investments, governance structures letting managers take well-considered risks without fear of punishment for bad luck will help firms innovate and grow.
Here is the uncomfortable test for boards facing AI decisions: evaluate the AI program's design and the quality of the bet, separately from its first-year results. Firing a CEO for a well-reasoned AI bet that met bad luck teaches every successor to stop betting.
Introduction
We find that greater institutional ownership is associated with more innovation. To explore the mechanism, we contrast the “lazy manager” hypothesis with a model where institutional owners increase innovation incentives through reducing career risks. The evidence favors career concerns. First, we find complementarity between institutional ownership and product market competition, whereas the lazy manager hypothesis predicts substitution. 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 institutional owner, we argue that the effect of institutions on innovation is causal. (JEL G23, G32, L25, M10, O31, O34)
Takeaway
Given the importance innovation has on growth and the wealth of nations, it is paramount to understand the incentives to innovate at the firm level. This paper tries to do so by studying the relationship between innovation and institutional ownership. Contrary to the view that institutional ownership induces a short-term focus in managers, we find that their presence boosts innovation, even after accounting for an increase in R&D and the potential endogeneity of institutional ownership. This positive impact could derive from the disciplinary effect of institutions on lazy managers or from the reassurance they provide to managers concerned about their career. We develop a simple model that nests these two hypotheses, we are able to derive three implications able to distinguish between them. In all three cases, the data seems to support the career concern model and reject the lazy manager one. Institutions are more important for innovation when competition is higher and when managers are less entrenched. Moreover, the probability of CEO firing after poor performance is reduced with more institutional ownership. The evidence from disaggregating institutional ownership, using policy changes and membership of the S&P500 as an instrument suggest that these relationships do not simply arise from endogenous selection. These results suggest that risk considerations at the managerial level play an important role in preventing innovation. Given the positive externality innovation entails (see Bloom, Schankerman and Van Reenen, 2007), it might be useful to think about public policies able to reduce the innovation risk for managers of publicly traded companies such as greater Board representation of institutional investors.1
This paper has also interesting implications for corporate governance in general. If career concerns, not the desire to live a quiet life or to build an empire, are the main source of managerial agency problems, then many of the public policy prescriptions change. For example, boards composed mostly of outsiders can jeopardize the ability of the board to separate luck from skill in the CEO performance, increasing her risk aversion and jeopardizing innovation (see also Adams and Ferreira, 2005). There are many directions this research could and should be taken. One potentially important omission is that we have abstracted away from the impact institutional owners may have on the design of incentive contracts to overcome the disincentives to innovate (and how this interacts with competition). This would be a fruitful line of future research currently pursued by Manso (2008) and Holden (2008).2
Notes
- Philippe Aghion, John Van Reenen & Luigi Zingales, Innovation and Institutional Ownership, 103 Am. Econ. Rev. 277 (2013), https://doi.org/10.1257/aer.103.1.277. Takeaway source: 7. Conclusions, reproduced from a free author or repository copy (working-paper version). ↩
- Holden, Richard (2008) “Does Competition Make Firms More Efficient?”mimeo, MIT. ↩
Cite as: Philippe Aghion, John Van Reenen & Luigi Zingales, Innovation and Institutional Ownership, 103 Am. Econ. Rev. 277 (2013), https://doi.org/10.1257/aer.103.1.277
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