Does Corporate Governance Impact Performance?

July 24th, 2009
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Contributed by: Eric Jackson, Ironfire Capital
After the collapse of Bear Stearns, Countrywide, Lehman Brothers, GM and AIG last year, and with Citigroup (C) and Bank of America (BAC) greatly diminished in stature, corporate governance has once again become a popular topic in government, the mainstream business press and on corporate boards.

Although most people intuitively think that it's a good thing for the performance of a company and its own risk management to have a strong and independent board of directors overseeing it, last year a group of Stanford professors published a working paper in which they questioned this basic assumption.

The professors examined the three largest firms that assign governance ratings each year for American public companies: RiskMetrics (RMG), GovernanceMetrics International and The Corporate Library -- and concluded that none was correlated with better current performance, and few of the ratings predicted better future company performance.

Some corporate governance critics pointed to the paper's results as demonstrating their deeply held view that corporate governance is a crock and has no bearing on whether a company will have better or worse financial performance in the future.

Before we collectively toss aside the notion that the quality of corporate governance impacts a company's performance and risk management, let's examine the facts around the professors' research:

-This is still a "working paper" and is not yet published in a peer-reviewed journal, suggesting there are still kinks being worked out in the research.

-They found that none of the governance ratings firms' ratings was linked to how a company was currently performing. Yet, if you're thinking of making an investment in a company or writing a D&O insurance policy or making a commercial loan, you have no interest in this type of correlation; you only want to know if there's a link between today's governance structure and future performance.

-They found that The Corporate Library's governance scores predicted a company's future operating performance and future earnings' multiples. Unfortunately, the metrics they used to find this relationship are common in the academic world (e.g., Tobin's Q) but almost never used by investors, banks, or insurance companies.

So, even with several problems, the study did still find that better corporate governance led to better future financial and stock performance. However, the study still raises the question of, if this link exists, why hasn't corporate governance become more widely used by investors as a variable to consider when making investment decisions?

I was puzzled by this and recently asked this question of several institutional investors. The most common response I heard back is that "there's no link that's been established between corporate governance and performance." Although there have been different studies that have found such a link, clearly the mountain of evidence to date hasn't been compelling enough to most investors to get them to pay attention to it.

And, if it's not compelling to investors, it shouldn't really be surprising that CEOs, senior managers and boards (all usually large shareholders themselves) haven't paid attention to implementing every purported "good governance" practice that is suggested.

The truth is that not every corporate governance improvement has been shown to improve performance over time. In my own research (going back 10 years now), I remember being surprised, for example, to find no link between a company separating the chairman and CEO roles and subsequent stock performance.

Yet, we did find a whopping relationship between outside directors' stock holdings (which they purchased themselves rather than being given stock or stock options) and future performance.

Sometimes the problems in finding a link between good governance and performance come down to defining what you mean and making sure you're actually measuring it correctly. For example, what is an "independent" board? Ask 10 people and you'll likely get 10 different answers.

So, the bottom line is that even though I (a corporate governance advocate) can quibble with the academics on the merits of their research, it is true that proponents of better corporate governance often assume their prescriptions will lead to better performance and lower risk without the empirical evidence to back up their claims.

Therefore, if you are going to build a composite score for a public company's "governance rating," the devil is in the details. If a ratings agency assigns an equal weighting in a composite score for how a company splits the chairman and CEO roles with equity ownership on the board, the result is going to be a flawed rating system.

Ratings agencies need to do a better job at ensuring each variable that goes into their scores actually predicts future performance. It all comes down to what you measure and how you measure it.

There are likely many contingency factors (such as industry or size of the public company) that strengthen or weaken the impact on performance of corporate governance factors. It's not likely that you'll find one type of board fits all types of companies.

Governance ratings firms are at a disadvantage though (as are legislators with something like Sarbanes-Oxley or regulators such as the SEC). They're on the outside to what goes on in board meetings. Third parties can only measure, rate and regulate information that's publicly available. Board "independence" defined whatever way you choose is just a proxy measure for the quality of debate and decision-making that goes on inside the boardroom. You'll never get companies disclosing the quality of their boardroom discussions in their 10-Ks to the SEC.
The investors (or insurance companies or banks) which "crack the code" to effectively track effective and ineffective governance factors that strongly predict performance will have an enormous advantage in modeling an element of risk that most investors disregard -- even after the last 18 months. That smells like a great opportunity to me.

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Ironfire Capital
Related People: Eric Jackson; Jackson Leadership Systems, Inc
Related Entities: Ironfire Capital US Fund LP
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