The ‘old school tie’ destroys fund value – new academic study

A shared background between directors on a board could improve communication and facilitate decision making and could improve value, speculates a new paper, The effects of internal board networks: Evidence from closed-end funds by Matthew Souther, an assistant professor of finance at the University of Missouri.
Or, it could reduce the “likelihood of dissent as a result of fewer opposing viewpoints”.
It turns out that the latter is the correct hypothesis.
The study looked at three types of connections: education, employment and family; based on attending the same university, working for the same employer or being related. Educational connections were the most frequent, being found at about 40% of the boards studied, and more than 7% of directors within the same boards shared those connections. Adding together all the connections, just over half of boards in the sample of 622 closed-end fund boards had at least one connection between directors. “A more closely connected board is associated with lower firm values and higher costs, both direct and indirect, borne by shareholders,” said the study. Direct costs, in the form of the expense ratios, were higher for funds with connected boards. Indirect costs, including poor monitoring and oversight, were seen in “an increased likelihood of rights offerings and more frequent cases of deceptive disclosure practices”.
“While independent directors had a positive effect on fund values, connected directors had an almost equal effect in the opposite direction,” Souther said in a press release. “Each additional connection between directors was associated with a 0.88% decline in the value of the fund.
“Financial misrepresentations were also more frequent when connected directors were present, along with higher compensation for the board and higher expenses charged to shareholders.”Each additional connected director relates to a 7% increase in director compensation, adds the report. There is also lower turnover and an increased likelihood of a connected director being appointed to a ‘connected’ board. Not only do ‘connected’ boards have more frequent rights offerings, they also have fewer share repurchases; a double whammy for performance.

Each additional connection between directors was associated with a 0.88% decline in the value of the fund.

While the study is limited to boards of closed-end funds, it is likely, it posits, that “similar governance problems would exist in connected boardrooms of other public firms” because the same governance standards and regulations apply to both sets of directors, indeed, investment funds have additional regulations. The author also notes that internal connections are likely to be even higher in family firms – about 40% of the Fortune 500 – and similar problems are likely to be found there.
But most studies have found that family firms outperform others in the same industry. What is crucial here, and missing from the directors of closed-end funds who are paid in cash, is share ownership of the family firm.
The report’s conclusion is that, while the directors on these boards fell within independence requirements, they still exerted a negative influence on fund value and this indicates “that perhaps current laws do not adequately protect shareholder interests”.