Innovation in Business Groups

Topics: Patent, European Patent Organisation, United States Patent and Trademark Office Pages: 95 (16617 words) Published: November 16, 2008
Using novel data on European firms, this paper examines the effect of business group affiliation on innovation. We find that business groups foster the scale and novelty of corporate innovation. Group affiliation is particularly important in industries that rely more on external finance and have a higher degree of information asymmetry. We also find that the innovation of affiliates is less sensitive to operating cash flows. We interpret our results as supporting the ‘bright side' of business group internal capital markets and explain how legal boundaries between group affiliates mitigate the inefficiencies found in internal capital markets of US conglomerates. Keywords: business groups, innovation, internal capital markets JEL Classifications: G34, L22, L26, and O32

This paper was produced as part of the Centre's Productivity and Innovation Programme. The Centre for Economic Performance is financed by the Economic and Social Research Council. Acknowledgements

We express our special gratitude to Patrick Bolton, Francisco Perez-Gonzalez, Mark Schankerman and John Van Reenen for numerous helpful discussions. We are also grateful for valuable comments from Nick Bloom, Steve Bond, Bjorn Jorgensen, Tarun Khanna, Daniel Paravisini, Tano Santos, Catherine Thomas, Manuel Trajtenberg, Daniel Wolfenzon, Yishay Yafeh and seminar participants at Columbia University (GSB), Hebrew University, London Business School Transatlantic Conference, London School of Economics, NBER, and Oxford University. We thank Liat Oren for invaluable assistance with the programming of the ownership algorithm, Hadar Gafni for excellent research assistance, and the Institute for Fiscal Studies, especially Rachel Griffith and Gareth Macartney, for the EPO patent matching. All remaining errors are our own.

Sharon Belenzon is a Research Economist with the Productivity and Innovation Research Group at the Centre for Economic Performance, London School of Economics. He is also a Postdoctoral Research Fellow at Nuffield College, University of Oxford. Tomer Berkovitz is a Postdoctoral Research Fellow at Columbia University, Graduate School of Business, NY, USA. Published by

Centre for Economic Performance
London School of Economics and Political Science
Houghton Street
London WC2A 2AE
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published. Requests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address.

© S. Belenzon and T. Berkovitz, submitted 2007
Page 3
1. Introduction
Extensive empirical literature over the past three decades has investigated the incen- tives of firms to innovate and the effect of innovation on performance. 1
More recently,
La Porta et al. (1999) showed that outside the US, legally independent firms are commonly tied together through ownership links to form business groups. Yet, little attention has been devoted to the relation between business groups and innovation. This is especially surprising in light of the long debate in the literature on the effect of firm boundaries on the allocation of resources (Coase (1937), Mullainathan and Scharfstein (2001)).

In this paper, we provide a new perspective on how the bound- aries between firms may affect the allocation of internal funds to R&D activity. Using a novel database, we show that while large organizations comprised of a single legal entity have been found to stifle innovation (e.g. Seru (2007) on US conglomerates), business groups foster innovation via a more efficient internal capital market. In a world with asymmetric information, Myers and Majluf (1984) and Greenwald et al. (1984) argue that external financing is more costly than internal...
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