Do Directors from Related Industries Help Bridge the Information Gap?

The following post comes to us from Nishant Dass of the Finance Area at Georgia Institute of Technology; Omesh Kini, Professor of Finance at Georgia State University; Vikram Nanda, Professor of Finance at Rutgers University; Bünyamin Önal of the Department of Finance at Aalto University; and Jun Wang of the Department of Economics and Finance at Baruch College.

Directors have two complementary functions in a firm: that of monitoring and offering strategic advice. Directors with current expertise in the firm’s own industry have the requisite information and therefore are clearly suited to perform these functions effectively. However, antitrust laws prohibit firms from having directors from other firms that compete in the same product market. Given these constraints, “directors from related industries” (DRIs) are well-positioned to perform these critical functions, particularly when firms face a severe information gap vis-à-vis their related upstream and downstream industries. For instance, DRIs can improve a firm’s ability to respond to demand/supply shocks or forecast trends in related upstream/downstream industries. They can also help shrink the information gap between the firm’s board and its managers regarding conditions in related industries, thereby enhancing the board’s ability to monitor managerial performance.

In our paper, Board Expertise: Do Directors from Related Industries Help Bridge the Information Gap?, forthcoming in the Review of Financial Studies, we study why firms choose directors from related industries, whether there is value in having these directors, and some specific channels through which these directors affect firm value. We develop hypotheses in which the rationale for having DRIs on the board depends on information, market structure, and conflicts of interest considerations. Overall, our empirical results support these hypotheses for the use of DRIs. We find that attributes such as firm and industry innovativeness, average correlation between stock returns of the firm’s industry and its related industries, firm’s market share, industry concentration, degree of vertical integration in the firm’s industry, and CEO duality increase the likelihood of DRIs on the board, whereas stock price informativeness and, to a lesser extent, industry homogeneity decrease this likelihood.

After endogeneity corrections, we find that directors from related industries have an economically significant positive impact on firm value (Tobin’s Q) and performance (ROA). The benefits are substantially larger in firms that face more severe information problems. Also, DRIs appear to enhance the ability of firms to handle industry shocks, help shorten the firm’s cash conversion cycle, and alleviate financial constraints. Finally, announcements of DRI appointments are associated with significant positive abnormal returns. Overall, our results suggest that the documented positive relation between firm value/performance and DRIs is likely to be a director effect rather than an industry or firm effect.

In light of the above findings, a natural question that arises is why does every firm not have DRIs on the board? We argue that there may be more than one explanation. First, when DRIs are from actual or potential suppliers and customers, the firm has reason to be concerned about conflicts of interest. DRIs can also be a potential source of proprietary information leakage to rival firms. Additionally, bringing in DRIs has opportunity costs. A firm, presumably, arrives at its board size by trading off the benefits of an additional director with the difficulty of decision making in a larger board. Hence, bringing in a DRI may well imply not having another director who can add value—say, one with valuable political connections or financial expertise. Thus, consistent with the view in Adams, Hermalin, and Weisbach (2010), we believe that DRIs are endogenously chosen as the “solution to the constrained optimization problem the organization faces” (59); that is, DRIs will be present when the benefits of having them outweigh the costs to both the firm and the managers.

The full paper is available for download here.

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