A paper recently presented at the annual meeting of the American Accounting Association in Anaheim, California investigates the tenures of outside directors of more than 2,000 corporate boards during a 13-year period and finds them to be, on average, close to the level that yields the optimum in company market value.
The study, by Sterling Huang of the INSEAD Business School, finds the relationship between board tenure and firm value to be in the shape of an inverted U that reaches a peak at about nine years. In other words, other relevant factors being equal, the value of companies rises as the average tenure of their outside board members increases to nine years after which it falls off by as much as 10%. The pattern holds whether average tenures of boards are primarily the result of director turnover or simply the passage of time and whether the tenures of board colleagues are relatively diverse or similar.
As it turns out, this high point at nine years is not far from the actual corporate mean for outsider board tenure, which the study finds to be 8.35 years.
But there is still plenty of opportunity for investor grumbling, given that board-tenure averages among the more than 2,000 companies making up the study sample ranged all the way up to 31 years, almost four times the optimal level.
To gauge corporate value, Huang used a standard measure called Tobin’s Q, which is a ratio of two variables – roughly, the company’s market value (that is, its stock price multiplied by the number of stocks issued) divided by an amount equal to what it would cost to replace the firm’s assets. Since market value reflects investors’ assessment of the company, a high value for Tobin’s Q reflects investor approval of a firm and optimism about its prospects.
After attaining a peak when average board tenure reaches nine years, Tobin’s Q goes into decline as tenure increases, falling by about 10% by the time the average reaches 24 years, assuming other major financial, structural, and governance factors affecting firms’ market value are held constant.
Huang sees the inverted-U shape his research uncovers as reflecting a tradeoff between two factors — knowledge accumulation and independence. As directors acquire firm-specific knowledge early in their tenure, the result is better firm performance, but this continues, he finds, only up to some threshold level of board tenure beyond which learning gains are less than independence losses. In the words of the study, “for firms with short-tenured boards, the marginal effect of board learning dominates entrenchment effects, whereas for firms that have long-tenured boards, the opposite is true.” Eventually, “as tenure continues to advance, boards become ‘zombie boards’ as their oversight declines and firms engage in more value-destroying activity.”
In addition to investigating how the tradeoff between knowledge and entrenchment affects overall firm value, as measured by Tobin’s Q, the study probes whether a similar inverted-U pattern prevails in specific corporate policies and decisions. Huang finds this to be the case with respect to merger-and-acquisition performance, financial-reporting quality, readiness to replace CEOs, and strategic persistence and innovation but not in preventing opportunistic backdating of CEO option grants.
For example, “firms with very short- or very long-tenured board make suboptimal acquisition decisions, though for different reasons. For a short-tenured board, a lack of knowledge about the business makes it less effective in selecting an acquisition target. As tenure advances, learning allows the board to make better acquisition decisions, as suggested by the market’s reaction to acquisition announcements, but only up to some threshold level of tenure, beyond which familiarity with management weakens the monitoring capacity of the board, leading to inefficient investments that are less well-received by the market.”