Institutional Blockholders and Innovation

Innovation and technology are the main engines driving the US economy. Corporate shareholders have the power to direct firms’ decisions. The number of institutional investors who hold large shares of ownership of certain firms has risen drastically in the last few years, as well as the ownership stakes that these investors own. Increases in the concentration of ownership of a given investor in a firm lead to increases in their influence on firms’ investment decisions, potentially affecting firms’ future innovation and growth.

In Barcelona School of Economics Working Paper 1390, “Institutional Blockholders and Corporate Innovation,” Bing Guo, Dennis C. Hutschenreiter, David Pérez-Castrillo, and Anna Toldrà-Simats combine several datasets from databases such as Compustat and Thomson Reuters to study the role of institutional blockholders, i.e., institutional investors owning a 5% or larger share of ownership in one firm. The authors shed light on how blockholder ownership affects the outcome of investments in innovation and firms’ innovation output.

Who are the institutional blockholders? 

Institutional investors’ ownership of US firms has increased substantially from 38% in 1990 to 71% in 2012, as shown in Figure 1. Moreover, the ownership stakes by these investors have also increased in size, increasing firms’ blockholder ownership (see also Figure 1). Although several studies assume that institutional investors are homogenous, it is widely observed that they are heterogenous in their preferences. One crucial aspect is their preferences for diversifying their portfolios: while some investors hold small stakes in firms, blockholder investors hold large ones.

Figure 1: Institutional and Block Ownership in US publicly traded companies over time

Institutional blockholders alleviate short-term pressure on managers and induce firms to invest more in research and development (R&D).

One way that a firm can invest in innovation is through internal research and development (R&D). Blockholders, by holding significant shares in a company, have the power to influence firms’ decisions to invest in R&D.

To measure the impact of blockholders on R&D accurately, it is crucial to address the selection problem, because institutional investors’ influence on firms and their willingness to become blockholders is not random.

The authors address this selection problem using a quasi-natural experiment, exploiting exogenous variation in blockholder ownership due to financial institutions’ mergers. When two financial institutions merge, and both are investors in a given firm, the combined ownership stake of the merged entity is larger, leading to increases in the presence.

The authors show empirically that these merger events increase the probability that an institution becomes a blockholder. They also show that the increase in blockholder ownership increases R&D investment by 0.9% and 0.5% in the first and the second years after the merger event, respectively. This phenomenon is attributed to blockholders’ longer-term goals. While some investors seem to focus on short-term profits, blockholders care more about the long-term and trade less frequently. Hence, blockholders alleviate the pressure on managers to generate short-term profits, which sometimes lead them to cut R&D. 

The results reveal a positive impact of blockholders on R&D to increase their investment in R&D.

However, blockholders lead firms to acquire fewer external innovations.

Apart from R&D, firms can also invest in innovation through external acquisitions, namely, buying other companies with patents, which allows them to adopt external know-how that helps them further develop their patents.

Contrary to the positive effect on R&D, the empirical results indicate that blockholder ownership has a negative impact on acquisitions. Blockholders’ fear of managerial empire-building and dilution concerns may explain why these investors tend to vote against acquisitions, which in turn decreases the acquisition of innovation output and technology from other firms.

Managerial empire-building occurs when managers propose privately beneficial investments to them at the detriment of shareholder value. Examples of empire-building are value-destroying acquisitions that increase managerial reputation and power. Blockholders expect such rent-seeking actions by managers and prevent them by using their influence and voting power. The empirical evidence supports the proposed explanation as blockholder ownership decreases the probability of acquisitions, especially for firms with poor corporate governance, where empire-building is more likely to take place.

The second explanation is due to blockholders’ attempts to prevent dilution. When a firm acquires another company, it needs to finance the acquisition cost either by issuing debt or shares. Firms tend to use the latter to avoid financial and interest-rate burdens. But new share issuances dilute the ownership of existing blockholders and diminish their power to control firms’ decisions. The authors also provide support for this explanation using empirical analysis.

The overall impact on innovation may not be as positive as expected.

On the one hand, blockholders reduce the pressure on firms to make short-term profits. Hence, they induce firms to invest in R&D. On the other hand, the increase in blockholder ownership leads to lower innovation acquisitions. While blockholder ownership is generally expected to impact innovation and technology positively, the overall effect on innovation is negative because the acquisition of external innovation and internal R&D investment are complementary. Hence, even if firms increase R&D, the returns to internal R&D investment are lower because of the reduced investment in external innovation.