Month: June 2018

Internal Governance Does Matter to Equity Returns but Much More So During “Flights to Quality”

Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns

In our fifth article of the Winter 30.1 issue our authors discuss how good internal governance helps firms perform better.

Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns

Although few doubt that good internal governance helps firms perform better, the statistical evidence is actually mixed because the positive effects of good corporate governance matters much more so at some times than others. The statistical link is strongest during “flights to quality,” when market sentiment turns bearish and pessimistic but weakens for long periods of time during bull markets and low market volatility. Using more than ten years’ evidence from Australian firms, the authors show that internal governance is related to both firm value and performance and that firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns. When risk aversion is high, demand for well-governed firms increases and investors discount the value of firms with potential agency conflicts. This time-varying relationship between internal governance and returns may explain both the limited explanatory power of governance on firm value and the mixed empirical evidence reported in previous studies.

Firms with strong internal governance do earn significantly higher stock returns compared with firms with weak governance; but that also means that the value of governance is not fully incorporated into prices, thereby explaining the limited explanatory power of governance on firm value.

Authored by Peter Brooke, Platypus Asset Management, Paul Docherty, Monash University,
Jim Psaros, The University of Newcastle and Michael Seamer, The University of Newcastle

Say on Pay: Is It Needed? Does It Work?

The fourth article in our Winter 30.1 issue deals with “Say on Pay” rules, those corporate practices giving shareholders the right to vote on executive compensation. The assumption behind “Say on Pay” is that managers may be overpaid because directors fail to provide adequate oversight. Stephen O’Byrne questions this underlying assumption.

O’Byrne provides substantial evidence that directors do a poor job overseeing executive pay and that directors have weak incentives to pursue shareholder interests in executive pay.

“Say on Pay voting is sensitive to differences in pay for performance, but so forgiving that extraordinary pay premiums are required to elicit a majority ‘no’ vote.”

The common corporate practice of providing competitive target compensation regardless of past performance leads to low alignment of pay and performance. Unfortunately, directors have little incentive to protect shareholder interests “because they are paid labor providers, just like management, not stewards of substantial personal capital.”

Authored by Stephen O’Byrne, Shareholder Value Advisors

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy

In our third article of the Winter 30.1 issue we look at whether logically, the practice of corporate finance and corporate strategy should be closely coordinated, but in reality there remains a massive gap between the two. This can lead strategically oriented firms to de-emphasize or even discard NPV. Neither financial theory nor competitive strategy has been very open to the economic value of investment opportunity capture. Strategy must recognize that financial flexibility provides powerful advantages and financial theory must evaluate entire strategic programs rather than discrete, stand-alone projects.

Necessarily, the financial discussion of cost of capital and capital structure has to change. The authors offer two specific concepts to bridge the Gap between Finance and Strategy:

1) Reserve Financial Capacity is the annual sum of Free Cash Flow, Financing Flexibility and Cash Reserves over the period envisioned for strategy execution. Individual projects must belong to strategic programs in the sense that they either: 1) keep the base business running; 2) preserve an existing competitive position; or 3) form part of a program to enhance advantage or fashion a strategic breakout.

2) Strategically Sustainable Cost of Capital is the true, blended cost of capital required to complete an entire capital program.

These concepts provide financial rigor to firms with well-defined strategies and allow managements to wield Financial Flexibility as a strategic weapon, creating options on unique buying opportunities, such as at the bottom of industry cycles. The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.

Authored by Stephen V. Arbogast, Kenan-Flagler Business School, University of North Carolina at Chapel Hill and Dr. Praveen Kumar, C.T. Bauer College of Business, University of Houston.

Fiduciary Duties of Corporate Directors in Uncertain Times – Have These Roles Changed?

The second article of our Winter 30.1 issue of the Journal of Applied Finance deals with whether directors may wonder if their fiduciary duties have changed. The authors synthesize the latest decisions of the Delaware courts on the standards of conduct for directors and the standards by which their conduct is reviewed. While directors should expect uncertainty in corporate life, neither the fiduciary duties of directors nor the protections afforded them have changed. Disinterested and independent directors, acting in good faith to make decisions they deem in the best interests of the corporation, continue to have broad protections under the business judgment rule. This legal framework enables and encourages active directors to make hard choices when they need to do so.

The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.

Written by Ira M. Millstein, Ellen J. Odoner, and Aabha Sharma, of Weil, Gotshal & Manges.

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