Managerial response to institutional investor distraction

When institutional investors become distracted due to extreme returns in other portfolio firms, managers face less pressure to pursue and actively oversee risk-taking innovation that creates long-term shareholder value. We document that firms significantly reduce innovation output following increases in investor distraction, measured by both patent filings and patent citations and after controlling for firm and industry characteristics. We further show that managers respond by decreasing firm idiosyncratic risk as predicted by agency theory. However, our results examining executive compensation do not suggest that firm boards quickly alter executive compensation to adjust for changing incentives resulting from institutional distraction. Rather, executives increase their insider sale percentage.