Shareholder coordination and corporate innovation

• Author: Ani Manakyan Mathers,Xiaohong (Sara) Wang,Bin Wang
• DOI: http://doi.org/10.1111/jbfa.12433
• Date: 01 May 2020
• Published date: 01 May 2020

DOI: 10.1111/jbfa.12433

Shareholder coordination and corporate

innovation

Ani Manakyan Mathers1Bin Wang2Xiaohong (Sara) Wang3

1Department of Economics and Finance, Perdue

School of Business, Salisbury University,

Salisbury, MD, 21801, USA

2Department of Finance, College of Business

Administration,Marquette University,

Milwaukee,WI, 53210, USA

3Department of Accounting, Business Law and

Finance, College of Business and Management,

Northeastern Illinois University, Chicago, IL,

60625, USA

Correspondence

BinWang, Department of Finance, College of

BusinessAdministration, Marquette University,

Milwaukee,WI 53210, USA.

Email:bin.wang@marquette.edu

Fundinginformation

FranklinP.Perdue School of Business

[Correctionadded on 4 March 2020, after first

onlinepublication: The acknowledgements

sectionhas been updated to include funding

details.]

Abstract

We show that greater shareholder coordination, as proxied by the

geographic proximity between institutional investors, is positively

related to corporateinnovation outcomes. This relationship is driven

by coordination among dedicated and independent institutions who

have strong monitoring incentives and is more pronounced among

firms with lower blockholder ownership and greater information

asymmetry where there is greater benefit to monitoring. We pro-

pose that shareholder coordination promotes corporate innovation

through a reduction in managerial agency problems. Overall, our

results are consistent with the notion that greater shareholder coor-

dination enables diffuse shareholders to monitor managers more

effectively and enhances corporate innovation.

KEYWORDS

agency problem, Innovation, monitoring, shareholder coordination

JEL CLASSIFICATION

O30, G34

1INTRODUCTION

Innovation is a key driverof economic growth. However, market frictions may hinder innovation. A fear of being fired

due to bad luck under uncertain investment outcomes (Holmstrom, 1999), the private benefits of effort shirking and

avoiding difficult tasks (Hart, 1983), and a focus on short-term stock price (Stein, 1988, 1989) may hinder managers

from innovating. Several studies suggest that the presence of institutional investors helps to alleviate this underin-

vestment problem. For example, Aghion, Van Reenen, and Zingales (2013) find that greateri nstitutional ownership

increases innovation productivity. Edmans (2009) contends that equity blockholders can gather private information

about firms’ fundamental value and utilize their exit option to pressure managers to make optimal innovation deci-

sions. Bushee (1998) provides evidence that firm managers are less likely to cut investmentin research and develop-

ment (R&D) to makeup for an earnings decline when there is greater institutional ownership.

Nonetheless, the literature has largely ignored the fact that institutional ownership is often diffuse in prac-

tice. Huang (2014) documents that between 1980 and 2011 the median institution’s equity holding accounts

for only 0.06% of the firm’s total outstanding shares, and the dispersion of ownership has increased over time.

730 c

2020 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:730–759.

MATHERSET AL.731

The diffusion of ownership gives rise to the classical free rider problem (Grossman & Hart, 1980) and potentially

weakens the monitoring efforts of institutional investors. This free rider problem may be more acute in the case

of monitoring innovation productivity, where monitoring costs are greater due to the high uncertainty of innova-

tion outcomes and the hard-to-verify private information and actions of managers (e.g., Fuente & Marin, 1996).1

However, if diffuse institutions are able to coordinate their monitoring efforts and share the gains of monitor-

ing, then they may act like a large blockholder and exert greater pressure on management, resulting in improved

corporate governance and better innovation outcomes.2For example, institutional investors may collaborate

to improve managers’ incentive to innovate by monitoring the managers collectively and protecting them from

being fired due to purely bad luck in innovation outcomes. Coordinated institutional investors may also force

managers to exert costly effort to innovate and to focus less on short-term stock prices but more on value-

increasing long-term innovation projects through enhanced monitoring, such as the threat of collectively selling their

shares.

We empirically examine whether firms with a greater presence of coordinated shareholders have greater inno-

vation productivity. Following the literature(e.g., Coval & Moskowitz, 2001; Huang, 2014), we measure shareholder

coordination based on the geographic proximity of a firm’s institutional investors. Our proxy for shareholder coor-

dination builds upon the social network literature, which suggests that social networks are more likely to develop

when individuals are able to associate and bond with others due to familiarity, often driven by geographicproximity

(e.g., Marsden, 1988; McPherson, Smith-Lovin, & Cook, 2001). Institutional investors who work in the same region

are more likely to share similar cultural values and to have repeated social interactions, for example at local invest-

ment conferences, which foster familiarity and mutual trust for cooperation and information sharing. The existing

literature also suggests that geographic proximity is influential in building close personal and business relationships.

For example, Hong, Kubik, and Stein (2005) show that geographic proximity promotes word-of-mouth communica-

tions between mutual fund managers and leads to similar trading decisions among managers in the same city.3There-

fore, we contend that shareholders with closer geographic proximity are more likely to coordinate their monitoring

efforts.

We find that firms with more coordinated institutional investorshave greater innovation productivity, as measured

by patent counts and patent citations. These findings are driven by coordination between institutional investors with

stronger monitoring incentives. Specifically, we find that innovation is only positively associated with coordination

among dedicated institutions with a long-term investment horizon (Bushee, 1998) and independent investors with

no business relationship with the firm (Chen, Harford, & Li, 2007) and unrelated to the presence of geographically

proximate institutions with short-term investment horizons or potential business relationships with the firm. To

address potential endogeneity concerns, we conduct a series of tests. We implement a two-stage residual analysis to

alleviate concerns that shareholder coordination may simply be an aggregate measure of other firm characteristics,

such as institutional ownership or analyst coverage.We find that the unexplained portion of shareholder coordination

is significantly and positively associated with patent counts and citations, suggesting that shareholder coordination

is an important incremental factor beyond determinants of innovation previously documented in the literature.

Reverse causality may also be a concern if institutional investors with a preference to invest in innovative firms

are clustered in certain geographic areas. To address this issue, we use a generalized method of moments (GMM)

1Studiesshow that investments in innovation have a failure rate between 50%–80% (Asplund & Sandin, 1999; Cozjinsen, Vrakking, & IJerzloo, 2000).

2Anecdotalevidence suggests that institutional investors often engage in collaborative actions. Forinstance, the California S tate Teacher’sRetirement System

(CALSTRS) partnered with California-based Relational Investors LLCto force Occidental Petroleum to improve its corporate governance practices and to

push the TimkenCompany to spin off its steel division (CALSTRS, 2010, 2013). Research also shows that institutional investors can work together to initiate

shareholderproposals to influence corporate decisions (e.g., Gillan & Starks, 2000).

3Specifically, Hong et al. (2005) show that mutual fund managers are more likelyto buy (or sell) a particular stock if other managers in the same city are

buying(or selling) that same stock. Geographic proximity has also been shown to be an important determinant of friendship and marriage (Bossard, 1932), the

formation of interlocked corporateboards (Kono, Palmer, Friedland, & Zafonte, 1998), the development of relationships among floor traders (Baker,1984),

andventure capital firms’ investment decisions (Sorenson & Stuart, 2001).