Wednesday, March 4, 2009

Study Shows Good Corporate Governance Improves Value

A forthcoming paper published this month in The Review of Financial Studies from an academic and agitator for improved corporate governance appears to add some empirical evidence to the intuition that better governance leads to more value. Lucian Bebchuk of Harvard Law School and two colleagues construct a measure of executive entrenchment, and conclude that more entrenched management reduces equity returns by as much as 7% per year. The paper builds on previous work that addresses a critical question: investors have long had a strong hunch that "good governance" makes sense. Yet, these same investors have struggled to connect the range of activist efforts to improve governance to tangible financial results.

Bebchuk and his colleagues start with a laundry list of 24 governance provisions that others have connected to equity returns. They narrow this down to six that appear to have the most impact: classified or staggered boards, golden parachutes, poison pills, and supermajority voting requirements on mergers, charter amendments, and bylaw amendments. While some of the other of the 24 provisions also protect management, these six "appear to provide incumbents at least nominally with protection from removal or the consequences of removal," which they call entrenchment. They construct a simple index of entrenchment, called the "E index", and companies that adopt more of these provisions have a higher score. They are quite proud of the E index, noting that "more than 75 papers have already used our E index in their analysis." Through numerous regression analyses that control for a range of other factors, they conclude that companies with the highest score (most entrenched) deliver equity returns around 7% lower annually than firms with the lowest score.

The authors also have some unflattering comments about others that create and use governance scores, such as ISS and even debt rating agencies like Standard & Poor's and Moody's. These firms uses indexes "based on a massive number of governance attributes." ISS uses a metric based on 61 elements, while Governance Metric International uses one with over 600 elements. The study authors call this appraoch "misguided" and an "attempt to count all the trees in the governance forest."

The paper is available here.

Posted by Michael Levin, Hedge Fund Solutions LLC. Contact Michael at