Mixing it up

Diversifying board composition can help organisations improve performance. Professor Paul Kerin explains how boards can achieve the perfect balance.

We would probably all agree that diversity makes boards better. But diversity has many dimensions: degree of independence, skills, experience, gender, age and ethnicity, to name just some. Given that board size is limited, how can boards determine the optimum mix of diversity across these dimensions?

Economists’ research provides some guidance, but the clearest conclusion from the available evidence is that the optimum mix depends on organisation-specific circumstances and should change as circumstances change.

In the wake of the global financial crisis (GFC), regulators and/or exchange operators in many countries (including Australia) required that boards of listed companies contain a majority of independent directors (or, at least, explain why not), although the definition of independence varies around the world. Some experts go further: more than a decade before the GFC, Harvard Business School’s Jay Lorsch argued that at least two-thirds of a board’s directors should be independent.

The two principal roles of directors are monitoring and advising/decision-making. The main rationale for independent directors is that they improve the monitoring of performance. However, the evidence on whether director independence improves overall firm performance is mixed. Some studies find that a higher proportion of independent directors improves firm performance, some that it worsens it, others that it doesn’t matter at all.

Nevertheless, there is some evidence that greater board independence reduces shareholders’ perceived risks and therefore the cost of equity. The evidence does show that markets react negatively to resignations of independent directors. However, that may be because the market interprets such resignations as signals that something is wrong, rather than because the market values independent directors more highly than non-dependent directors.

The evidence also shows that the value of independence is firm-specific. For example, greater board independence tends to improve the performance of firms with high growth options more than that of other firms. Economists argue that this is because information asymmetries (between management and shareholders) are greater for high growth firms; as a result, the value of monitoring by independent directors is greater for those firms.

While independent directors may provide better monitoring, a director’s value to a board is substantially driven by other personal characteristics – particularly those that enable them to add value on the advising/decision-making front.

The bad news for directors is that, according to a recent Australian study, less than 20 per cent of all director appointments are welcomed by a significant positive market reaction.

The appointments that are welcomed tend to be of directors with both depth (previous director experience) and breadth (multiple other directorships), particularly when those appointments are made to relatively inexperienced boards.

Interestingly, the depth and breadth of director experience seems to matter more than professional expertise or qualifications, although some studies show that appointees with chief executive officer experience are more likely to garner positive market reactions. The market rarely reacts positively to appointments of academics, while appointments of former politicians receive the most negative reactions.

Women now hold 20 per cent of S&P/ASX 200 board seats – slightly more than in the US S&P 500 (19.2 per cent), but below that in the UK FTSE 100 (22.8 per cent) and well below that in Australian Federal Government boards (38.5 per cent).

The evidence on the effect of board gender composition on firm performance is also mixed. However, that mixed evidence is consistent with the view that it is not gender per se that matters, but other director characteristics (such as independence and experience). Economists’ research has also produced evidence of the existence of a “glass cliff”: women are more likely to be appointed to a firm’s board the more precarious is the firm’s position.

The kindest interpretation of this finding is that women may be perceived as superior crisis managers. The less kind interpretation is that it reflects ongoing discrimination against women on the boards of well-performing firms.