Posted by Renée B. Adams (University of Oxford), Ali C. Akyol (University of Melbourne), and Patrick Verwijmeren (Erasmus University & University of Melbourne)
Editor’s Note: Renée B. Adams is Professor of Finance at the University of Oxford’s Saïd Business School; Ali C. Akyol is Senior Lecturer at the University of Melbourne; and Patrick Verwijmeren is Professor of Corporate Finance at the Erasmus School of Economics and the University of Melbourne. This post is based on a recent paper by Professor Adams, Dr. Akyol, and Professor Verwijmeren.
Boards of directors are multi-dimensional and the optimal board combines monitoring and advisory roles to varying degrees. We examine how individual director skills map into these roles. Do directors specialize as “advisors” or “monitors,” or, like boards, do they combine roles? And how do directors’ skills aggregate to the board level—are individual skills independent of each other or do they complement/substitute each other? The answers to these questions are important for understanding what boards do, why they are structured the way they are, and how they can be improved.
In our paper, we answer these questions by exploiting an amendment to Regulation S-K in 2009, which requires public U.S. firms to describe their reasons for nominating directors. According to this rule, firms have to disclose the skills they believe each director brings to the table. A particular strength of these data is that the descriptions represent the firm’s perspective rather than a perspective chosen by researchers. The data allow us to document the skills that directors have and allow us to test how these skills cluster at the board level. We then examine whether some boards have skill sets that lead them to systematically outperform other boards.
We distinguish between 20 skills: Academic, Company business, Compensation, Entrepreneurial, Finance and accounting, Governance, Government and policy, International, Leadership, Legal, Management, Manufacturing, Marketing, Outside board, Outside executive, Risk management, Scientific, Strategic planning, Sustainability, and Technology. We show that directors are not one-dimensional. In a sample of 3,218 firm-year observations (1,031 unique firms) between 2010 and 2013, firms report that outside directors have on average 3.02 skills and inside directors have 3.33 skills.
Boards are also not one-dimensional. All boards have a director with finance and accounting skills. Boards also tend to have management skills (89.5% of boards) and leadership skills (74.7%) in common. But some boards will also have legal skills (34%) or risk management skills (27.6%), while others have manufacturing skills (37.3%) or entrepreneurial skills (16%).
We use factor analysis to extract the main dimensions along which boards vary with respect to the skills of their directors. We find that boards vary primarily along one dimension: the diversity of skills that are available on a board. Some firms assign directors with many different skills to their board, while other firms focus on a few particular skills. As such, we conclude that there is an important distinction between diverse boards and boards with a substantial concentration of skills.
Since there may be advantages and disadvantages to having more diversity of skills on a team, it is an empirical question how director skill diversity relates to performance on average. We examine whether diversity of skills is related to firm performance as measured by Tobin’s Q. Boards with greater skill diversity do not perform better. Using Blau (1977) measures of concentration of types, we find evidence that this result is plausibly driven by a lack of common ground in skill sets that arises with greater diversity. We view this evidence as consistent with the argument that having common ground among group members can facilitate effective decision making.
Overall, our paper moves away from a one-dimensional treatment of directors and boards and focuses on skill sets. Our finding that directors are multi-dimensional suggests that it may be difficult for outsiders to understand which skills of a particular director are the most valuable for a firm. The value of individual director’s skills also depend in part on the other skills that are represented on the board. If a CEO sits on a board with a lawyer then the CEO’s skills may complement the lawyer’s skills. But the CEO may not always understand the lawyer’s viewpoint (and vice versa) because they approach problem-solving in a different way. If a CEO sits on a board with other executives, there may be no communication problems because the directors share common ground. However, a board with only executives may lack diversity in skills. In this regard, we complement prior studies focusing on one particular skill of directors at a time, such as industry experience, professional skills, leadership skills, or financial skills.
The multi-dimensionality of director skill sets may also help explain outcomes in the director labor market. Studies relating individual director characteristics to firm value often face the challenge of explaining why firms do not optimize. If industry experience is positively related to firm performance, for example, then firms would do better by having more industry experts. The question is why they do not. If we view directors as one-dimensional, this question is difficult to answer. But if we view directors as multi-dimensional, it becomes easier. When firms appoint directors, they face a multi-dimensional search problem. In the presence of frictions, e.g., search costs, firms may not be able to optimize along every dimension. Similarly, in trying to fulfill governance regulations focusing on one characteristic, e.g., independence, or one objective, e.g., diversity, firms may not achieve the best match between new directors and the board. Thus, governance regulations may not always lead to better firm outcomes.
Incorporating a multi-dimensional perspective into governance theory and empirical work is challenging. But future governance research and policy may still benefit from recognizing that the governance problems firms face are more complex than we typically imagine.
The complete paper is available here.