Inaugural lecture: Governing the corporation
Business administration and finance professor Diane Denis discussed her research on corporate governance in a Nov. 30 provost’s inaugural lecture celebrating her appointment as the Pitt business school’s Katz Alumni Chair in Finance.
Corporate governance encompasses the internal and external mechanisms that induce a company’s “self-interested managers to act in ways to maximize the value of residual cash flows on behalf of its shareholders,” she said, adding that corporate governance research is concerned with understanding conflicts of interest between a firm’s managers and its board members and how to overcome them so that the firm can maximize its resources.
In talking about governing the corporation, the question is “toward what end?” she said. The concept that maximizing shareholder value is the corporation’s goal “is a little bit misunderstood and maybe a little more controversial than it should be,” Denis said.
“When we talk about maximizing shareholder value, the notion isn’t that the shareholders are the only people we care about. The notion is that the shareholders in the hierarchy of the firm are the last people to get paid. And so it’s basically when we talk about maximizing shareholder value we view that as maximizing firm value — because everybody ahead of them has already gotten paid.”
While managers have a fiduciary duty to act in the interest of shareholders, “their interests are potentially in conflict,” Denis said.
“When I teach this to my students, we start from the perspective of things like having corporate jets and nice offices and hiring unqualified family members as employees,” she said.
“All of those are certainly example of conflicts of interest, but they’re kind of small potatoes relative to the sort of conflicts we’re concerned about.”
From a finance perspective, most conflicts can be grouped into three categories: free cash flow, risk aversion and managers’ desire to remain in power, Denis said.
Free cash flow
Free cash flow is all the cash flow that’s produced by the firm in excess of what is needed to fund projects that are expected to provide a return.
Research into leveraged buyouts and recapitalizations found that “debt is an effective mechanism for limiting the free cash flow problems in firms,” Denis said.
There are important differences in risk aversion between shareholders and managers, she said. “Most shareholders in a corporation of any size are very well diversified. They hold shares of lots of firms and so, from a risk standpoint, they would prefer the managers take any risks available as long as they are expected to provide a return that’s commensurate with that amount of risk,” she said.
“Managers, on the other hand, can’t really diversify their human capital in the same way.” Generally, they can only work for one company at a time, “so there are many situations in which a risk that shareholders would think is worth taking, managers are disinclined to do so,” Denis explained.
Some of her research into whether agency problems were responsible for maintaining diversification built on earlier research that found that firms that diversified into a number of different industries seemed to be less valuable than otherwise similar firms that operated in just one segment, she said.
“Shareholders don’t need firms to diversify. Shareholders can go out and buy shares of all these different industries themselves. So it means they don’t give a whit whether the firm does it for them,” she explained.
“Still, it wouldn’t hurt if the firm does it for them — unless diversification leads to some value reduction. And there was some evidence there that already suggests that it does.”
Her research found that higher ownership by insiders and by outside blockholders with large investments leads to less diversification.
“This is consistent with the notion that if a manager has more of a financial stake they are less likely to undertake this value-reducing diversification. However, if they do undertake it, it’s still value reducing,” she found.
Stock prices tended to increase when diversified firms refocused and got rid of side industries, she said.
However, in many cases that refocusing was prompted by external control threats. “It only occurred after another firm came in and threatened a takeover,” she said.
Surprisingly, her team also found that both industrial diversification and global diversification reduced value.
“We were kind of expecting to find global diversification could be very different from industrial diversification. Because you’re not going off into industries you know potentially nothing about, you’re doing your own industry within a different country,” Denis explained.
“The first thing we found: It’s not valuable. It’s value-reducing as well.”
Managers desire to remain in power, even though there will be times when a manager is not performing well or when a manager’s skill set might not be what the firm needs at a given time. “The kind of skills needed to run a growing corporation may be difficult from those needed to run a mature industry,” she said.
Her research has examined management turnover and found that operating performance fell prior to a forced turnover and increased following the ouster. That was not true for voluntary management turnovers such as retirements, she noted.
High inside ownership was found to reduce the level of turnover as well as the sensitivity to turnovers in performance, she said.
Corporate governance mechanisms
Denis said both internal and external corporate governance mechanisms come into play in combating these sorts of conflicts of interest.
The company’s ownership structure and board of directors comprise two broad categories of internal governance mechanisms.
Conflicts of interest are potentially reduced in corporate structures in which the managers also are shareholders, she said. Likewise, a company’s board of directors has the duty to act in the interest of shareholders.
External mechanisms include the capital market, the control market, legal and regulatory systems and the product market, she said.
To the extent that firms need to raise capital to fund projects, “they have some external people taking a look at what they’re doing and needing to, in effect, sign off on it,” she said.
Likewise, if a manager is not running a firm as well as it could be, its value will be reduced, presenting the opportunity for others to create value by taking control through a merger or acquisition.
Or if a firm continues being inefficient long enough, eventually it will go bankrupt. “Of course, there’s plenty of evidence that that can be a really long time,” she said.
Denis is looking more closely at the composition of corporate boards. Earlier research concluded that smaller boards are better than larger ones and that it is more advantageous to have outsiders on the board rather than insiders.
“Having more independent outsiders is better when you’ve got somebody that’s supposed to be keeping an eye on management,” she said.
More recent research has gone beyond the insider vs. outsider question to examine what individual directors bring to a firm’s board.
Preliminary findings in her research on spinoff firms show that industry experience is valued, as are prior ties to a firm’s CEO, she said.
There also is evidence to suggest that well-connected directors are associated with firm quality or high firm performance.
“What we’re still working on is: Do they cause it or is it just a signal?
“Is it the case that having these well-connected directors makes a firm perform better? Or do the well-connected directors only go to work for already well-performing firms?”
—Kimberly K. Barlow