Are Internal Capital Markets Good for Innovation?

Abstract

Which type of firm is more innovative: the decentralized, diversified corporation or the smaller, more narrowly focused “entrepreneurial” firm? According to one argument, diversified corporations can do more R&D because their operating units have access to an internal capital market. Other writers argue that decentralized, diversified firms over-rely on financial accounting criteria to evaluate the performance of their operating units, discouraging divisional managers from investing in projects like R&D with long-term, uncertain payoffs. This paper uses a comprehensive sample of diversified and nondiversified firms from 1980 to 1999 to study the relationship between diversification and innovation. I find a robust negative correlation between diversification and R&D intensity, even when controlling for firm scale, cash flow, and investment opportunities. Industry-adjusted R&D—the difference between the R&D intensity of a diversified firm and the R&D intensity it would most likely have if its divisions were standalone firms—is negative, consistent with the hypothesis that diversification reduces innovation by discouraging R&D investment. However, other evidence suggests that internal-capital-market inefficiencies, rather than managerial myopia, are driving the negative relationship between diversification and innovation.