1. Corporate Governance
Corporate governance is
a relationship among stakeholders that is used to
determine and control the strategic direction and
performance of organizations
concerned with identifying ways to ensure that
strategic decisions are made effectively
used in corporations to establish order between the
firm’s owners and its top-level managers
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2. Corporate Governance Mechanisms
Internal Governance Mechanisms
Board of Directors
Managerial Incentive Compensation
Ownership Concentration
External Governance Mechanisms
Market for Corporate Control
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3. Separation of Ownership and Managerial
Control
Basis of the modern corporation
shareholders purchase stock, becoming residual
claimants
shareholders reduce risk by holding diversified
portfolios
professional managers are contracted to provide
decision-making
Modern public corporation form leads to
efficient specialization of tasks
risk bearing by shareholders
strategy development and decision-making by
managers
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6. Agency Relationship: Owners and Managers
Shareholders
(Principals)
• Firm owners
Managers
• Decision makers
(Agents)
• Risk bearing specialist (principal)
pays compensation to a An Agency
managerial decision-making Relationship
specialist (agent)
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7. Agency Theory Problem
The agency problem occurs when:
the desires or goals of the principal and agent
conflict and it is difficult or expensive for the
principal to verify that the agent has behaved
inappropriately
Solution:
principals engage in incentive-based performance
contracts
monitoring mechanisms such as the board of
directors
enforcement mechanisms such as the managerial
labor market to mitigate the agency problem
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8. Manager and Shareholder Risk and
Diversification
Shareholder Managerial
(business) (employment)
S risk profile risk profile M
Risk
A B
Dominant Related Related Unrelated
Business Constrained Linked Businesses
Diversification
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9. Governance Mechanisms
Board of Insiders
• The firm’s CEO and other top-level
Directors managers
Affiliated Outsiders
• Individuals not involved with day-to-
day operations, but who have a
relationship with the company
Independent Outsiders
• Individuals who are independent of the
firm’s day-to-day operations and other
relationships
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10. Governance Mechanisms
Board of Role of the Board of Directors
Directors
• Monitor – Are managers acting in
shareholders best interests
• Evaluate & Influence – examine
proposals, decisions actions, provide
feedback and offer direction
• Initiate & Determine – delineate
corporate mission, specify strategic
options, make decisions
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11. Governance Mechanisms
• Salary, bonuses, long term incentive
Board of compensation
Directors • Executive decisions are complex and
non-routine
Executive • Many factors intervene making it
Compensation difficult to establish how managerial
decisions are directly responsible for
outcomes
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12. Governance Mechanisms
• Stock ownership (long-term
Board of incentive compensation) makes
Directors managers more susceptible to
market changes which are partially
Executive beyond their control
Compensation • Incentive systems do not guarantee
that managers make the “right”
decisions, but do increase the
likelihood that managers will do the
things for which they are rewarded
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13. CEO Pay and Performance
Classic pay for
performance
relationship
Unfortunately, this
CEO Pay
relationship is weak
The stronger
relationship is with
firm size
Firm Performance
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14. CEO Pay and Firm Size
Relationship between
pay and firm size is
curvilinear.
CEO pay increases at
CEO Pay a decreasing rate
Firm Size
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15. Relationship Between Firm performance
and Firm Size
Relationship between
firm performance and
firm size is curvilinear.
Performance
Beyond some point, as
size increases, firm
performance declines
Firm
BUT…
From the graph of CEO
pay vs. firm size, pay
doesn’t decline
Firm Size
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16. Relationship Between Firm performance
and Equity Ownership
Relationship between
firm performance
(Tobin’s Q) and
managerial ownership
is curvilinear.
Firm Value
Beyond some point, as
ownership increases,
firm value declines
Managerial Ownership in %
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17. Governance Mechanisms
• Large block shareholders (often
Board of institutional owners) have a strong
Directors incentive to monitor management
closely
Executive
Compensation • Exit vs. Voice – Cannot costlessly exit
due to equity stake (transaction costs)
so they press for change (exercise
Ownership voice)
Concentration
• They may also obtain Board seats
which enhances their ability to monitor
effectively (although financial
institutions are legally forbidden from
directly holding board seats)
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18. Governance Mechanisms
• Types of institutional investors
Board of - Mutual funds, pension funds,
Directors foundations, churches, universities,
insurance companies
Executive
Compensation • Pressure-resistant versus pressure-
sensitive
Ownership - Mutual and pension funds are
Concentration pressure resistant
• Are Institutional investors the same?
- Short vs. long term
• Components of voice:
- Pension fund hit lists
- Shareholder liability suits
- Investor alliances
- Proxy contests 18
19. Governance Mechanisms
• Firms face the risk of takeover
Board of when they are operated inefficiently
Directors • Many firms begin to operate more
efficiently as a result of the “threat”
Executive of takeover, even though the actual
Compensation incidence of hostile takeovers is
relatively small
Ownership • Changes in regulations have made
Concentration hostile takeovers difficult
• Acts as an important source of
Market for discipline over managerial
Corporate Control incompetence and waste
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20. Managerial Defense Tactics
Designed to fend off the takeover attempt
Increase the costs of making the acquisitions
Causes incumbent management to become
entrenched while reducing the chances of
introducing a new management team
May require asset restructuring
Institutional investors oppose the use of defense
tactics
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How to increase product diversification and how to intensify effort to innovate without increased agency problems? Firms undertake a variety of actions to reduce risk through diversification, including entering diverse lines of business, joining alliances, taking on temporary partners, and outsource risky projects, including R&D. The challenge, as explained in the book, is that shareholders do not directly benefit from risk-reducing diversification strategies when they can replicate this diversification on their own. Diversification, therefore, is often seen as managers’ opportunistic pursuit of their own self-interests at the expense of the shareholders who can, if they so desire, diversify their individual portfolios simply by buying shares in other companies. While this view reflects the influence of agency theory, recently such views have been challenged by stewardship theory (Donaldson, 1990a; Donaldson & Davis, 1991), a framework presuming that managers are actually seeking to maximize organizational performance. For instance, one reason for diversifying would be to enhance company profit and growth prospects by reducing dependence on static or declining products, markets, and even industries. In the parlance of the I/O model discussed in Chapter 1, such motive might lead companies to increase diversification into technologies or industries where profit rates are increasing most and to those where the competitive dynamism is relatively more stable. Managers might also opt to diversify for earnings stability and economies of scale. In short, diversification strategies might represent opportunism, but it might also reflect management rational and genuine response to financial adversity and/or the need for improved financial performance for their company.
Continued from previous page Interestingly, over the past decade the world’s leading private equity firms consistently have delivered internal rates of return twice as large as the S&P 500’s. They’ve achieved this is by adding value to the underlying operations (Rogers, Holland, & Haas, 2002). For example, private equity firms: a) clearly define their investment thesis and its time frame to fruition; b) hire managers who act like owners; c) focus on a few measures of success that all employees understand d) make capital work hard or otherwise re-deploy under-performing assets quickly e) make the center an active shareholder. Can institutional owners understand and act like managers of private equity firms?
Continued from previous page Interestingly, over the past decade the world’s leading private equity firms consistently have delivered internal rates of return twice as large as the S&P 500’s. They’ve achieved this is by adding value to the underlying operations (Rogers, Holland, & Haas, 2002). For example, private equity firms: a) clearly define their investment thesis and its time frame to fruition; b) hire managers who act like owners; c) focus on a few measures of success that all employees understand d) make capital work hard or otherwise re-deploy under-performing assets quickly e) make the center an active shareholder. Can institutional owners understand and act like managers of private equity firms?
Continued from previous page Recently, Phan and his colleagues (2002) explained the relationships between corporate governance and innovation—R&D expenditures, patents, and new products—in 86 publicly listed pharmaceutical firms. Consistent with agency theory, they found that the presence of large block private and institutional shareholders—controlling for firm size and performance—positively influenced innovation. They demonstrated that CEO duality was positively related to R&D expenditures, and that boards with more insiders were positively associated with the number of new products. In short, in the highly turbulent pharmaceutical industry, where risky decisions have to be made under substantial uncertainty, active ownership, unitary command structures, and strategically involved boards provide superior explanatory power for the governance—innovation link. Table 11.3 The Best and Worst Boards of Directors In 2002 http://www.businessweek.com/pdfs/boards.pdf Business Week’s special report on corporate governance: The best and the worst boards http://www.businessweek.com/1997/49/b3556001.htm
