The Latest Research in Corporate Governance: Finance

1. The Latest Research inCorporate Governance:Finance Nikhil P. Varaiya Professor of Finance

2. Top-Tier Finance Journals • Journal of Finance • Journal of Financial Economics • Journal of Financial and Quantitative Analysis • Review of Financial Studies • Journal of Business • American Economic Review • Journal of Applied Corporate Finance

3. Topics • Corporate Governance and Corporate Performance: Review of Current Finance Research 2. Corporate Governance and Corporate Performance: Implications 3. Shareholder Value Creation Drivers 4. Key Tasks of Management and Board 5. Summary

4. 1. Corporate Governance and Corporate Performance: Review of Current Finance Research • Bhagat and Bolton (2008) examine the relationship between seven Corporate Governance (CG) metrics and two Corporate Performance (CP) metrics. • CG metrics Gompers-Ishii-Metrick (GIM) index; Bebchuk-Cohen-Ferrell (BCF) Index; Brown-Caylor (BC) Index; The Corporate Library (TCL) Index; Board Ownership; CEO-Board Chair Separation; and Board Independence; GIM, BCF are constructed from IRRC data; BC constructed from ISS data • CP metrics Operating Rate of Return and Risk-adjusted Share-holder Return

5. Summary of Bhagat & Bolton Results • GIM; BCF, Board Ownership, and CEO-BOD Chair Separation improves contemporaneous and subsequent operating performance. • Board Independence is not associated with better contemporaneous or subsequent operating performance. • None of the governance metrics is associated with stock market performance. • Given poor firm performance, the likelihood of disciplinary management turnover increases with Board Ownership and with Board Independence.

6. Corporate Governance and Corporate Performance: Review of Current Finance Research (cont.) • Wruck (2008) surveys literature on private equity to infer key operating tasks and likely success factors • Operating Tasks • Which assets to keep and which to divest? • Organization Design Issues • Who makes what decisions? • How is success defined? • What is the performance measurement and reward system? • High leverage ensures that post-buyout shareholder equity is highly concentrated • Highlights disciplining role of recent regulatory developments coupled with active market for corporate control on corporate governance and performance of public corporations

7. Corporate Governance and Corporate Performance: Review of Current Finance Research (cont.) • Jonathan Macey (2008) • Effective corporate governance is about ensuring that firms meet investor expectations of maximizing shareholder value; the role of corporate governance is to minimize ‘corporate deviance’ from meeting shareholder expectations • Boards, shareholder voting, outside accountants, credit-rating agencies, and stock market analysts have not been very effective in meeting shareholder expectations • Market for corporate control, hedge funds, private equity funds, dissident directors have been more effective in meeting shareholder expectations

8. Corporate Governance and Corporate Performance: Review of Current Finance Research (cont.) • Ralph Walkling (2008) reports on discussion with Robert Monks and Michael Jensen on the current state of corporate governance • Robert Monks: • “I see governance as concerned primarily with internal processes and accountability rather than performance.” • “What does the board of an American corporation actually do and what is it supposed to be doing… In America a board does pretty much what the CEO wants it to do.” • Michael Jensen: “The function of a board member in the U.S. is basically to counsel and support the CEO.” • Both have stressed that the boards get active only when there is a crisis of corporate performance.

9. Corporate Governance and Corporate Performance: Review of Current Finance Research (cont.) Conundrum: • The benefits of private equity—concentrated share ownership and significant board involvement—serve to align shareholder and management interests. • However, private equity needs an active public market for equity, so the public corporation must endure as an organization form.

10. 2. Corporate Governance and Corporate Performance: Implications • Corporate Governance is a complex combination of: contract, law, and societal norms and customs. Measurement of this complex combination and its link to Corporate Performance is problematic • Yet, effective Corporate Governance requires that the Board embrace the following linkage: Corporate Governance Corporate Strategy Corporate Performance

11. 3. Drivers of Shareholder Value Creation: Profitability & Growth MBV = 0.166x[Profitability] + 0.173x[Growth]; Adj. R2 = 71%

12. The Growth-Profitability Imperative • AlliedSignal Corp. Larry Bossidy, CEO, sets rugged growth targets and provides the resources to get there but requires that [business] units earn their cost of capital. FORTUNE, August 21, 1995 • Microsoft Corp. “It’s a very large company, and it almost can’t grow at the rates it was growing.” WALL STREET JOURNAL, January 28, 2003 • Intel Corp. “I have been chartered with growing the earnings of this company. Figuring out where the opportunities are over the next five years and refining our bets. President & COO, Paul Otellini Intel Beyond 2003, Stanford B-School Case, 2003 • Emerson Electric Chuck Knight, CEO, Emerson Electric wants to push revenue growth to as high as 10% per year, from under 5% in recent years, while keeping profit margins and return on equity steady. FORBES, August 1, 1994 • Qualcomm “The company can return some of its cash to shareholders without impacting future revenue and earnings growth or restricting strategic opportunities.” Chairman & CEO Irwin Jacobs. SAN DIEGO UNION TRIBUNE, Feb. 12, 2003

13. Key Tasks of Management and Board • Which Markets Should We Serve? Participation & Operating Strategy • Determine Our Competitive Position: Cost-Offering-Price in served markets • Estimate Financing Needs to Sustain Our Growth Strategy. Financing Strategy • Determine Sources and Composition of Financing. • Select the Organizational Design: • People, Architecture, Routines and Culture to Best Identify & Implement the Strategies Above. Implementation Strategy

14. Key Tasks of Management and Board Strategy – People – Architecture – Routines – Culture • Right Strategy • Right Markets • Right Competitive Positions in Served Markets • Right Financing Mix • Right Implementation • Right People • Right Organization Architecture • Right Communication Routines • Right Corporate Culture

15. 5. Summary • The impact of corporate governance on corporate performance is complex and poses measurement challenges. • Studies have shown that effective corporate governance (board ownership, CEO-Chair separation) can enhance firm performance. • The board will be effective in its governance role when it is knowledgeable about: (i) the firm’s markets and competitive positions, and (ii) decision-making drivers within the firm.

16. The Latest Research inCorporate Governance:Finance

17. The Latest Research inCorporate Governance:Finance Nikhil P. Varaiya Professor of Finance