It may seem obvious that shareholders stand to benefit when outside directors on a company’s board have experience in the industry the company operates in.
However, a forthcoming research paper contends, that doesn’t hold true in the case of highly diversified companies, where directors tend to “play favorites” by influencing over-investment in the industries they’re most familiar with.
Several studies have in fact documented that companies make better investment decisions when that scenario is in play. However, there are two important caveats to the conclusions of those papers, according to the new study’s authors.
First, the authors say they were not able to determine from the prior papers whether directors influence companies to invest in industries they know well or, alternatively, whether companies choose to appoint directors with experience in an industry in which they plan to invest heavily.
Second, many companies operate in several different industries. Prior studies were silent on the degree to which conglomerates should match outside directors’ industry experience with the industry composition of the companies’ business units, say the authors, Jesse Ellis of North Carolina State University, C. Edward Fee of Tulane University, and Shawn Thomas of the University of Pittsburgh.
Not surprisingly, the authors find that having industry expert representation on the board causes increased investment in divisions operating in that industry. However, the results of further analysis indicate that in the case of diversified firms, such greater investment acts, on average, to reduce both profit and business value. And the effect is not small. For example, the presence of an outside director on the board with experience in a division’s industry is associated with an 8.3 percentage point reduction in the division’s industry-adjusted return on assets.
That finding is “somewhat counterintuitive and unanticipated,” says Thomas.
The study has potentially important implications in light of the Securities and Exchange Commission’s recent proxy disclosure reforms, according to Thomas. Specifically, under the new rules registrants must now disclose for each director and any nominee for director “the particular experience, qualifications, attributes, or skills that qualify that person to serve as director … in light of the company’s business.”
“At the margin, the requirement to justify appointments of directors will likely increase the incentive to select people with related industry experience, as their prior experience is a defensible basis for their selection,” says Thomas. “However, our results suggest that increased incentive to add outside directors with related experience may come, all else equal, with a cost of decreased investment efficiency and, hence, reduced company values for conglomerates.”
The paper is scheduled to be published in a forthcoming issue of the Journal of Financial and Quantitative Analysis.
Separately, compensation and governance research firm Equilar reports that annual pay for directors at the largest U.S. companies has risen almost 20% in the past five years.
In fiscal-year 2016, the median annual retainer — or base pay in cash and equity — was $245,000 at the 500 largest U.S. publicly held companies. That was 19.5% more than the median of $205,000 recorded in fiscal 2012.
A majority of the increase was driven by greater equity awards to directors. Among companies that awarded equity, median value was $150,000 in 2016, up from $125,000 in 2012. Cash awards — which were provided at 98% of the companies studied by Equilar — increased in median value from $75,000 to $90,000 at the median.
Some elements of director pay, such as meeting fees, have declined and are falling out of favor. For example, just 14.5% of companies awarded meeting fees to directors in fiscal 2016, down from 29.5% in 2012.