Effects of Institutional Ownership

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Institutional investors, who currently control almost 60% of the outstanding common shares of stock in the United States, are a potent force. Hewlett-Packard Co. could easily have failed in its landmark $19 billion merger with Compaq Computer Corp. had many institutional investors elected to block that deal. Indeed, such shareholders can greatly influence a company's corporate strategy by exerting subtle (or not so subtle) pressures on executives. But recent research has shown that not all institutional investors are alike. In fact, different groups often have contradictory views regarding, for example, whether a corporation should fund internal efforts to develop a technology or instead acquire it from the outside. Another crucial factor is whether a company's board is composed mainly of outside directors or inside executives.

Prior research has found links between institutional investors and corporate strategy, but the results have been inconclusive. One theory asserts that pressures from institutional investors tend to make company executives focus on short-term results, and so those organizations become risk-averse. For example, institutional investors might shy away from companies pursuing entrepreneurial activities, such as research and development to generate revolutionary new products, which then discourages those businesses from pursuing similar projects in the future. But another theory contends that institutional investors favor companies that take risks, such as allocating considerable R&D funds for focused, opportunistic projects. According to that argument, institutional shareholders typically manage broadly diversified portfolios, which allow them to spread and balance risks, so they are more willing to invest in companies that pursue riskier ventures with potentially high payoffs.

There's a reason for the apparent discrepancy regarding what institutional investors truly want. According to “Conflicting Voices: The Effects of Institutional Ownership Heterogeneity and Internal Governance on Corporate Innovation Strategies,” published in the August–September 2002 Academy of Management Journal, the simple fact is that institutional investors are not homogeneous. The authors are Robert E. Hoskisson, professor of management at the University of Oklahoma; Michael A. Hitt, distinguished professor of management at Texas A&M University; Richard A. Johnson, professor of management at the University of Oklahoma; and Wayne Grossman, assistant professor of management, entrepreneurship and general business at Hofstra University. They contend that managers of pension funds behave quite differently from their counterparts who oversee investment funds. The former prefer companies that develop technologies internally, while the latter favor businesses that acquire innovations from external sources.

One explanation the authors offer is that pension fund managers, who often hold stocks for a decade or more, are more interested in yields over longer time horizons, so they are likely to have the patience to wait for internal R&D to pay off. In contrast, professional managers of investment funds are typically under tremendous pressure for results, so they will likely prefer approaches that promise quick returns, such as the acquisition of outside technology. Investment fund managers, for example, are interested in companies that acquire businesses with promising new patents.

The makeup of an organization's board also plays an important role. Inside directors with equity positions in their companies tend to concentrate on internal innovation, while outside directors often focus on acquiring external innovation. Not surprisingly, the authors found that pension fund managers and those who oversee investment funds tend to prefer different types of boards. The former are more amenable to having boards composed of inside directors with equity along with independent outside directors. In contrast, the latter have a stronger preference for greater representation by outside directors.

Three members of the research team (Hoskisson, Hitt and Johnson) along with Laszlo Tihanyi, an assistant professor of management at the University of Oklahoma, have conducted a follow-up study that provides further support for their findings. In particular, they found that managers of both pension funds and professional investment funds generally favor companies with strategies for expanding internationally. But managers of investment funds tend to avoid such companies if those organizations compete in the high-tech industry. In striking contrast, managers of pension funds have a positive bias toward high tech. One explanation is that investment fund managers do not have the patience for companies that must wait for their investments in both technology and foreign markets to pay off. On a separate note, the researchers also confirmed that the governance structure of companies (for example, board membership) is indeed an important factor that institutional investors consider.

For further information about the research, contact the lead author at rhoskiss@ou.edu.

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