Tuesday, September 21, 2004

Does size matter? An examination of board composition and size by Coles, Daniel, and Naveen

Our trip through the FMA annual meeting at New Orleans continues with a look at a paper on Board Size and Makeup by Jeffrey L. Coles, Naveen D. Daniel, and Lalitha Naveen.

Short Version:

Optimal board composition and board size are a function of firm makeup.

Long Version:

They examine two questions: 1) Is there such a thing as an optimal Board of Directors? and 2) Is board composition firm dependent?

In other words, is this there such a simple formula that will yield a "good" board of directors? Or is this question too complex for a simple answer and what is optimal for one firm may be horrible for another firm?

One way to motivate this paper is to consider that while "several studies have documented that an outsider-dominated, or more independent, board makes better decisions from the shareholder's perspective," many firms do not have this type of board. Why? Is it an agency-cost problem? Or is does the optimal board vary from firm to firm?

Coles, Daniel, and Naveen investigate this topic in their new paper "Boards: Does One Size Fit All?"

To understand this we must remember that boards serve several functions. Chief among the function are monitoring management and providing expertise and aid in strategic planning. While small boards may be better at monitoring, larger and more diverse boards may be better at the providing assistance in planning.

Recently, most evidence on governance suggests that smaller is better. For instance, as the authors write: "Lipton and Lorsch (1992) and Jensen (1993) suggest that larger boards may be less effective than smaller boards due to co-ordination problems in larger boards and problems such as director free-riding. Yermack (1996) and Eisenberg, Sundgren, and Wells (1998) provide evidence that firms with smaller boards have higher Tobin's Q."

This view is not universal however as "Klein (1998) argues that the CEO's need for advice will increase with the complexity of the organization. " Moreover, there is a strand of literature that finds that diversified firms are more complex (Rose and Shephard, 1997). Additionally "Hermalin and Weisbach (1988) and Yermack (1996), suggest that CEOs of diversified firms have greater need for advice as they operate in multiple segments, and therefore require larger boards. " Thus, the authors "expect,..., that board size will be higher for diversified firms."

Additional hypotheses include that insider board members may have more value at firms with higher levels of R&D (insider information is more valuable) and that firms with higher levels of debt may need larger boards to protect the firm from stakeholder conflicts.

Using a sample of 2740 firm-years from 1992 to 1998, the authors use regression analysis (Dependent variable is the firm's Tobin Q value) to show that there is not single optimal board make-up.

True to theory, they find "that Q is increasing in board size in diversified firms and in firms with higher leverage." Q is also "increasing in [the] fraction of inside directors as R&D-intensive firms."

This all fits the view that there is no single optimal board composition that fits all firms. Rather each firm must select its board size makeup based on its specific problems and opportunities.


Boards:Does one size fit all?

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