Are foreign investors locusts? The long-term effects of foreign institutional ownership

Abstract

This paper challenges the view that foreign investors lead firms to adopt a short-term orientation and forgo long-term investment. Using a comprehensive sample of publicly listed firms in 30 countries over the period 2001–2010, we find instead that greater foreign institutional ownership fosters long-term investment in tangible, intangible, and human capital. Foreign institutional ownership also leads to significant increases in innovation output. We identify these effects by exploiting the exogenous variation in foreign institutional ownership that follows the addition of a stock to the MSCI indexes. Our results suggest that foreign institutions exert a disciplinary role on entrenched corporate insiders worldwide.

Introduction

How does financial globalization affect long-term corporate investment and productivity? In recent decades, companies have trended away from the stakeholder capitalism model of concentrated ownership historically predominant in continental Europe and Japan, in which long-term relationships with labor, creditors, and other stakeholders are promoted (Tirole, 2001, Carlin and Mayer, 2003, Allen et al., 2015). Instead, many companies are moving toward the Anglo-Saxon shareholder capitalism model, with its dispersed and globalized shareholder structure. Foreign institutional investors are agents in this change, playing an increasingly prominent monitoring role as shareholders worldwide (Aggarwal et al., 2011).

In this paper, we examine two hypotheses. The first hypothesis is that the presence of foreign institutional investors as shareholders can lead managers to cut long-term investment by reducing capital expenditures, research and development (R&D) expenditures, and employment. This view posits that foreign portfolio flows represent “hot money” in search of short-term profits, with little concern for long-term firm prospects.¹ Regulators and policy makers have expressed concerns that the rising importance of activist investors is leading firms toward short-termist strategies, delivering immediate returns to shareholders at the expense of long-term investment (Organisation for Economic Co-Operation and Development, 2015). In one high-profile case, Franz Müntefering, German Social Democratic Party chairman, compared foreign private equity and activist hedge fund investors targeting German companies to an invasion of “locusts” stripping companies bare.² The “locust” label has since been used to refer to foreign investors more broadly (Benoit, 2007, Economist, 2007). Locust foreign capital, it is proposed, could lead companies to strip assets for short-term profits, delocalize production, and adopt unfriendly labor policies, including layoffs. This attitude is part of a more general phenomenon of protectionist sentiment with regard to foreign capital flows.³

Foreign institutional investors may create market pressure inducing short-termism if they prompt managers to prioritize short-term earnings over long-term growth. Ferreira et al. (2014) argue that the stock market pressures managers to select projects that they can easily communicate to investors; managers forgo innovation in favor of ready-made technologies, which are more transparent to investors. Foreign institutions, moreover, may be less tolerant of failure, which can place executives at greater risk for career concerns, including termination. These factors may steer risk-averse managers away from pursuing opportunities for innovative growth.

The second hypothesis is that foreign institutional investor monitoring promotes long-term investment in fixed capital, innovation, and human capital. This positive impact derives from the disciplinary effect of the presence of institutions on corporate insiders. Institutional investors may persuade managers, who tend to prefer a quiet life (Hart, 1983, Bertrand and Mullainathan, 2003), to innovate via diplomacy, actively voting their shares, or even confrontational proxy fights. In an international context, other corporate insiders, such as blockholders, may extract private benefits through control and may not be diversified, making them averse to risk.⁴

Foreign institutions may be in a better position than domestic institutional investors to monitor corporate insiders and influence strategic decision making. Domestic institutions, because they are more likely to have business ties with local companies, may have a closer relation with the firms they invest in. They may thus be more accommodating to corporate insiders and less effective as external monitors (Gillan and Starks, 2003, Ferreira and Matos, 2008).⁵ In contrast, because they are less encumbered by ties with corporate insiders, foreign institutions can reduce managerial entrenchment and promote investment in riskier opportunities for growth. Foreign institutions may also be better able to tolerate the high-risk/high-return trade-off associated with long-term investment because they can better diversify risks through their international portfolios.⁶

To test our hypotheses, we use a comprehensive data set of portfolio equity holdings by institutional investors covering more than 30,000 publicly listed firms in 30 countries over the period 2001–2010. We find that higher ownership by foreign institutions leads to an increase in long-term investment (proxied by capital and R&D expenditures) and innovation output (proxied by patent counts). We also find that these increases in investment in tangible and intangible capital do not induce unfriendly labor policies. On the contrary, we find that higher foreign institutional ownership leads to increases in employment and measures of human and organization capital.

The endogeneity of foreign institutional ownership makes it difficult to establish a causal effect. In fact, foreign institutions may choose to invest in firms with better long-term growth prospects or in firms for which they anticipate a surge in innovation. We address the omitted variables concern using firm fixed effects that control for time-invariant unobserved firm heterogeneity. Further, we address reverse causality (and omitted variables) concerns using instrumental variables methods that isolate a plausibly exogenous variation in foreign institutional ownership. We exploit the fact that foreign institutions are more likely to invest in Morgan Stanley Capital International (MSCI) indexes’ stocks, because international portfolios are typically benchmarked against these indexes (Cremers et al., 2016). Our instrument for foreign institutional ownership is the stock additions (and deletions) to the MSCI All Country World Index (MSCI ACWI).

The first-stage results indicate that foreign institutions increase their holdings by nearly 3% of market capitalization when a firm's stock is added to the MSCI ACWI. Importantly, we find that domestic institutional ownership does not increase significantly when a firm's stock is added to the MSCI ACWI. This result suggests that stock additions do not affect our outcomes of interest through channels other than foreign institutional ownership (e.g., new information about firms’ future prospects, investor recognition or attention, and changes in capital supply), and thus supports the validity of the exclusion restriction.

The second-stage results indicate that a 3% increase in foreign institutional ownership leads to a 0.3% increase in long-term investment (as a fraction of assets), a 12% increase in employment, and an 11% increase in innovation output. We obtain similar results when we restrict our sample to firms in the 10% bandwidth of the number of stocks around the cutoff that determines the inclusion in the MSCI ACWI.⁷ Results are also consistent when we employ a difference-in-differences estimation around the stock addition events. We conclude that foreign institutional ownership has a positive effect on long-term investment, employment, and innovation, which is consistent with the monitoring hypothesis.

We also examine the impact of stock additions on firms’ financial policies. Using difference-in-differences estimation, we find that the increase in financing needs due to the increase in long-term investment following stock additions to the MSCI ACWI is covered by a decrease in cash holdings and an increase in new debt issuance. Importantly, our results show that firms issue less equity, use less external financing, and use more internal financing after the inclusion of their shares in the MSCI ACWI, which is consistent with the pecking order theory of capital structure. These results mitigate the concern that the increase in long-term investment following the addition of a stock to the index is driven by an increase in the supply of capital, which may enable a firm to raise more external capital at a lower cost.

The evidence from stock additions suggests that indexed money managers play an active governance role and influence corporate policies. Appel et al. (2016) and Crane et al. (2016) use stock additions into the Russell indexes as an identification strategy and find that passive investors (in a portfolio management sense) act as active investors (in a corporate governance sense) in the United States. In fact, Larry Fink, chairman of BlackRock, the world's largest (and mostly indexed) asset manager, sent a high-profile letter to chief executives asking them to “understand that corporate leaders’ duty of care and loyalty is not to every investor or trader who owns their companies’ shares at any moment in time, but to the company and its long-term owners.”

We conduct several tests to examine whether foreign institutions increase long-term investment, employment, and innovation output through the monitoring channel. Using investors’ portfolio turnover as a measure of investment horizon (Gaspar et al., 2005, Harford et al., 2015), we find that long-term foreign institutional ownership has a stronger positive relation with the outcome variables than short-term foreign institutional ownership. To the extent that long-term investors have a greater incentive to monitor, this evidence supports the monitoring hypothesis. We also examine whether the country of origin of foreign institutional investors matters. We find a positive and statistically significant relation between the outcome variables and common law-based foreign institutional ownership. This result is consistent with foreign institutions from common law countries “exporting” good governance practices, providing further support for the monitoring hypothesis.

Next, we find a positive effect of foreign institutional ownership when firms have weaker corporate governance and when country-level investor protection is weaker. Further, we find a positive relation between foreign institutional ownership and innovation output when competition in product markets is less intense (i.e., when managers are more entrenched). If corporate governance standards are weak or there is little competition, managers are not disciplined by such mechanisms as boards and the threat of takeover or bankruptcy, and there is more need for monitoring by foreign institutions. These results again support the monitoring channel. Overall, our findings suggest that foreign institutions act as effective monitors and persuade corporate insiders to pursue long-term projects instead of enjoying a quiet life.⁸

Last, we examine whether the presence of foreign institutions enhances firm value. Indeed, increases in long-term investment and innovation output could be symptoms of overinvestment or “empire building” (Jensen, 1986). To this end, we conduct additional tests using several measures of firm performance. We find that foreign institutional ownership is positively associated with total factor productivity, foreign sales, and shareholder value, suggesting that foreign ownership does not lead to overinvestment.

There is mixed evidence on the impact of institutional investors on long-term U.S. investment. Bushee (1998) finds that firms with larger institutional ownership are less likely to cut R&D expenditures to reverse a decline in earnings. Aghion et al. (2013) find that institutional ownership has a positive effect on innovation by mitigating managers’ career concerns. Harford et al. (2015) show that long-term institutional investors monitor managers and encourage firm policies that increase shareholder value and discourage overinvestment.

Previous research has also examined the effect of private equity and activist hedge funds on firm policies and performance. In a cross-country study, Bernstein et al. (2017) show that industries that receive private equity investments grow faster in terms of output and employment.⁹ The evidence is mixed with respect to activist hedge funds. Brav et al. (2017) show that firms targeted by activists reduce R&D expenditures but increase innovation output, while Cremers et al. (2015) find that activism decreases long-term firm value, especially among more innovative firms. Using a cross-country sample, Becht et al. (2017) find that the returns to hedge fund activism are economically important and that activists are more likely to engage targets with high foreign institutional ownership. We contribute to this literature by showing that foreign portfolio investors who hold minority stakes play an important role in monitoring firms worldwide. Overall, the evidence suggests that there is large heterogeneity in the effect of foreign owners on firm policies and performance.

Our paper is related to the literature on the role of stock markets in promoting or distorting manager incentives to pursue short-term performance at the expense of long-term performance. Stein, 1988, Stein, 1989) discusses investor myopia and optimal managerial decision-making in irrational stock markets. Asker et al. (2015) show that short-termism distorts investment and innovation decisions in U.S. public firms. However, Acharya and Xu (2017) find that public listing is beneficial to the innovation of firms in industries that are more dependent on external finance. Kaplan (2015) names the Internet, the fracking revolution, and the biotech booms of recent decades as evidence against the short-termist view of U.S. corporations that were part of a “failing capital investment system” (Porter, 1992). We contribute to this literature by studying the role of cross-border portfolio flows for long-term investment and innovation output.

Our paper also adds to recent international studies on innovation. Guadalupe et al. (2012) show that foreign direct investment has a positive impact on innovation in local firms through technology and know-how transfers. Hsu et al. (2014) find that equity market development positively affects innovation. In contemporaneous work, Luong et al. (2017) find that foreign institutional investors enhance innovation but do not explore the implications for long-term investment and employment. Others examine the role of different stakeholders in the innovation process, such as blockholders, creditors, and workers. Hsu et al. (2015) show that family ownership promotes innovation. Using country-level data, Acharya et al. (2013) show that employee-friendly laws promote innovation, while Acharya and Subramanian (2009) show that creditor-friendly bankruptcy codes hinder innovation.