Hedge Funds and Corporate Innovation

• Date: 01 June 2015
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/fima.12059

Hedge Funds and Corporate Innovation

Ying Wang and Jing Zhao∗

Using National Bureau of Economics Research patent data and hedge fund holdings in US

firms from 1998 to 2006, we examine the effect of hedge fund ownershipon corporate innovation.

Wefind that hedge fund ownership increases both patent quantity and quality,even after controlling

for endogeneity.Hedge funds appear to increase innovation and firm value by increasing research

and development (R&D) productivity and innovationeff iciency ratherthan R&D input. Our study

suggests another channel through whichhedge funds may enhance firm value, contributing to the

literature on hedge fund ownership.

The contribution of our paper is to document that hedge fund ownership of a company increases

corporate innovation. Our findings offer new insights into the controversial role of hedge funds

in corporate innovation. Academics, policy makers, and practitioners have long been concerned

that the short-term focus and frequent trading of hedge funds, whose preference is to deliver

short-term gains to their clients in order to attract more fund inflows, might pressure corporate

managers to underinvest in long-term intangible projects, such as research and development

(R&D) and innovation, in order to meet short-term earnings goals (Graves and Waddock, 1990;

Jacobs, 1991; Porter, 1992; Bushee, 1998). This myopic investment behavior by corporate man-

agers has been argued to undermine competitiveness and stifle technological innovation (Jacobs,

1991). However, it is plausible that hedge funds may also be a solution to this myopia problem.

The sophistication and concentrated ownership of hedge funds can mitigate the free rider prob-

lem associated with shareholder activism and allow them to monitor corporate managers more

effectively, thus promoting innovation and enhancing long run firm value (Rubin, 2007; Brav

et al., 2008; Edmans, 2009; Klein and Zur, 2009).

Using a sample of hedge fund holdings in US firms and National Bureau of Economic Research

(NBER) patent data from 1998 to 2006, we examine the effect of hedge fund ownership on

corporate innovation. We document a statistically and economically significant positive relation

between hedge fund ownership and a firm’s future patent quantity and quality as proxied by

the number of patents, citation intensity, a generality measure that captures how broadly the

patent impacts future descendants, and an originality measure that proxies for how original the

patent is relative to its predecessors. For instance, a 1SD increase in hedge fund holdings (i.e.,

10.62%) is associated with an increase of 3.6% to 6.2% (3.6% to 7.5%) in patent count (citations),

and an increase of 6.7% to 7.5% (roughly 4.4%) in generality (originality).

We wish to thank Raghavendra Rau (Editor) and an anonymous referee, whose insightful comments and suggestions

have substantially improved this paper. We also benefit from helpful comments and suggestions of Xin Chang, Chris

Clifford, Na Dai, Jesse Ellis, LauraField, Nickolay Gantchev, Thomas Hanson, Jiekun Huang, Puneet Jaiprakash,Srini

Krishnamurthy,Alfred Liu, Chunbo Liu, Michelle Lowry, Chris Muscarella, Mark Walker,Richard Warr, and participants

at the 2012 Financial Management Association Annual Meeting, 2013 Eastern Finance Association Annual Meeting,

and 2014 Midwest Finance Association Annual Meeting. Jing Zhao gratefully acknowledges research support fromthe

Faculty Researchand Professional Development Fund (FRPD) at North Carolina State University.

∗Ying Wang is an Assistant Professor of Finance in the School of Business and Center for Institutional Investment

Management, University at Albany, State University of New York in Albany,NY. Jing Zhao is an Assistant Professor of

Finance in the Department of Business Management, Poole College of Management, North Carolina State University in

Raleigh, NC.

Financial Management •Summer 2015 •pages 353 - 385

354 Financial Management rSummer 2015

While our results suggest a positive effect of hedge fund ownership on innovation, they are

also consistent with two alternative explanations. First, the positive association may be driven by

other unobservable factors correlated with both hedge fund ownership and innovation.In addition,

hedge funds maychoose, ex ante, to invest in fir ms with greater potential for successful innovation.

While using firm f ixed effects mitigates endogeneity arising from firm-specific, time-invariant,

omitted variables, we employ three additional tests to further address the endogeneity issue. First,

we conduct change-on-change regressions. Second, we construct two instrumental variables,

namely an S&P 500 inclusion dummy and the state-level intensity of hedge fund ownership, and

undertake a two-stage least squares/instrumental variable (2SLS/IV) analysis. Finally, we follow

Wintoki, Linck, and Netter (2012) and apply a dynamic panel generalized method of moments

(GMMs) estimation. Our results remain robust after controlling for endogeneity.

Overall our findings suggest that hedge fund ownership promotes both patent quantity and

quality. This effect is stronger when hedge funds collectively have larger holdings (i.e., block-

holdings) in the firm and, as such, more effectively influence corporate managers’ decisions,

and when hedge fund ownership in the firm constitutes a larger proportion of total assets under

management by the fund.

We then investigate the underlying mechanism through which hedge funds affect innovation.

Hedge funds appear to promote innovation primarilyby enhancing R&D productivity and innova-

tion efficiency rather than increasing R&D input. Prior literature suggests three channels through

which hedge funds may enhance innovationefficiency. First, hedge funds may motivatetheir port-

folio firms to alter the composition of R&D programs by allocating more resources to innovative,

productive, and high quality projects, while reducing unproductiveand marginal R&D (Almeida,

Hsu, and Li, 2013). Additionally,hedge funds may learn from the patenting experiences and inno-

vation expertise of firms in their investment portfolios and facilitate knowledge diffusion among

them, thereby enhancing both innovation quantity and quality of those firms (Gonzalez-Uribe,

2013). Finally, Aghion, Reenen, and Zingales (2013) find that institutional investors have only a

small positive effect on R&D,b ut a large positive effect on patenting innovation, suggesting that

the main effect of ownership is to alter quality and/or productivity of R&D rather than stimulate

more R&D input.

Toprovide further evidence concerning the mechanism, we explore cross-sectional heterogene-

ity. The positive effect of hedge fund ownership on innovation efficiency is stronger when firms

are more innovativeand innovation efficiency is more crucial for success. Specifically, this occurs

when firms are subject to greater f inancial constraints (e.g., smaller free cash flow and higher

leverage) and increasing innovation efficiency rather than input is more important and relevant

(Almeida et al., 2013); when managerial myopia is more severe in undervalued (lower Q) firms

(Aghion et al., 2013); and when firms operate in more competitive industries where productivity

and efficiency are critical (Brav, Jiang, and Kim, 2013). Taken together, hedge fund ownership

appears to benefit innovation by increasing efficiency and reducing excessive investments in un-

productive R&D. Consequently, hedge fund ownership increases firm value via a positive effect

on innovation, suggesting an additional channel through which hedge funds can add firm value.

Our paper adds to the literature regarding hedge funds and their effect on corporate decision-

making in that we find a positive effect of hedge fund ownership on corporate innovation. The

heightened financial incentives, sophistication, light regulation, concentrated ownership, and

unique structure (e.g., lock-up provisions) of hedge funds allow them to effectively monitor

corporate managers and promote innovation. Indeed, recent work indicates that hedge funds are

effective monitors who bring about operational, financial, and governance improvement in target

firms (Clifford, 2008; Brav, Jiang, and Kim, 2009; Klein and Zur, 2009; Huang, 2010; Brav

et al., 2013). We also contribute to a nascent literature on patent innovation by providing the

Wang & Zhao rHedge Funds and Corporate Innovation 355

first empirical evidence that hedge fund ownership enhances innovation quantity, quality, and

efficiency, and subsequently increases firm value.1

The remainder of the paper proceeds as follows.Section I describes the data. Section II examines

the effect of hedge fund ownership on patent quantity and quality. Section III investigates the

mechanism through which hedge fund ownership affects innovation. Section IV explores the

relationship between innovation,hedge fund holdings, and f irm value. We present our conclusions

in Section V.

I. Data

We obtain patents and patent citations data from the NBER patent database compiled by

Hall, Jaffe, and Trajtenberg (2002), and hedge fund ownership data from the Thomson Reuters

Institutional Holdings (13F) database. Firm financial information is obtained from Compustat

and stock return data from the Center for Research in Security Prices (CRSP). The sample

period begins in 1998, when hedge fund holdings data are available, and ends in 2006 when the

NBER patent data end.2Our sample contains all firm-year observations in Compustat during our

sample period that have nonmissing hedge fund holdings data. Tomitigate sample selection bias,

we follow Atanassov (2013) and He and Tian (2013) and assign zero value to firm-years with

missing patent or R&D data and include them in our regressions.

A. Patent Measures

To measure corporate innovation, we follow Trajtenberg, Henderson, and Jaffe (1997), Hall

et al. (2002), and Hall (2005) and employ a variety of metrics including the number of patents

filed per year (PA T ), the number of citations received per patent (Cite), patent generality (GEN)

that captures how broadly the patent impacts future descendants, and patent originality (ORG)

that measures how original the patent is relative to its predecessors. To control for industry trend

and truncation bias in patent data, we also use bias-adjusted measures of patent quantity (PAT_tn

and PAT_tc), citations (Cite_tn,Cite_tc, and Cite_h), generality (GEN_tn and GEN_tc), and

originality (ORG_tn and ORG_tc). Appendix A provides details regarding these patent measures.

The definitions of these measures are also summarized in Panel A of Appendix B.

B. Hedge Fund Ownership

Since 1978, all institutions with more than $100 million under management are required to

file 13F forms quarterly for all US equity positions worth over $200,000 or consisting of more

than 10,000 shares. These reporting requirements apply regardless as to whether an institution

is regulated by the Securities and Exchange Commission (SEC) or not. Thus, they also apply to

1Prior research has examinedthe relation between innovation and various other factors, including stock returns (Hsu, 2009;

Li, 2011; Hirshleifer, Hsu, and Li, 2013; Almeida et al., 2013), market liquidity (Fang, Tian,and Tice, 2013), leverage

buyouts (Lerner, Sorensen, and Stromberg, 2011), state anti-takeover laws (Atanassov, 2013), corporate governance

(Chemmanur and Tian, 2013), analyst coverage(He and Tian, 2013), institutional ownership (Aghion et al., 2013), bank

loan contracting (Francis, Hasan, Huang, and Sharma, 2012), bank competition (Cornaggia, Mao, Tian, and Wolfe,2015),

chief executive officer (CEO) overconfidence (Hirshleifer, Low, and Teoh,2012), non-executive employee stock options

(Chang, Fu, Low,and Zhang, 2015), labor unions (Bradley, Kim, and Tian,2013), and board interlocks (Helmers, Patnam,

and Rau, 2013), among others.

2Since we estimate lead-lag regressions in our main tests, our dependent (independent) variables coverthe period from

1999 to 2006 (1998-2005).