Synthetic Governance

Steven Davidoff Solomon is Professor of Law at the UC Berkeley School of Law. This post is based on a recent paper by Professor Davidoff Solomon; Byung Hyun Ahn, a doctoral student at the Haas School of Business at UC Berkeley; Jill Fisch, the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Law School; and Panos N. Patatoukas, associate professor at the Haas School of Business at UC Berkeley. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here) and The Perils of Small-Minority Controllers by Lucian Bebchuk and Kobi Kastiel (discussed on the Forum here).

Scholars, practitioners and policymakers continue to debate what constitutes “good” corporate governance. Investors threaten to vote against directors of issuers with defective governance practices while, at the same time, call for regulators to ban particularly controversial practices such as fee-shifting bylaws and dual class voting structures. Although empirical studies have failed to develop conclusive evidence linking specific governance provisions to firm value, the debate has become increasingly heated and political.

In Synthetic Governance, we provide a possible solution to the debate. As we explain, the rise of index investing offers a low-cost market-based tool by which asset managers can give investors the opportunity to vote with their feet by selecting a rules-based investment strategy that screens portfolio companies according to specified governance criteria. Investors with particular corporate governance preferences could, by selecting a bespoke governance index, and mechanism, invest according to those preferences. At the same time, governance-based indexes can provide valuable data on the relationship between corporate governance and firm value.

We highlight the potential value of synthetic governance through the creation of the Dual Index—an index that selects portfolio companies on the basis of a dual class voting structure. Specifically, the Dual Index creates and evaluates the performance of an index of dual-class companies. We examine the performance of this Index over a period of time. We find that over a back-testing period from June 2009 to December 2019 the Dual Index earned an annual return of 19.23% with standard deviation of 14.39%, while the market index earned an annual return of 14.98% with standard deviation of 12.98%. The Dual Index performance corresponds to a monthly multi-factor alpha of 31 basis points, which is economically important.

We further demonstrate the flexibility of the Dual Index by excluding companies a designated number of years after their IPO—in effect imposing a synthetic time-based sunset. The Dual Index thus enables investors to reap the potential value of dual-class stock in an issuer’s early years, but to use their investment decisions to impose a time-based sunset. Our results highlight that value creation in the Dual Index occurs to a greater extent in the immediate years after the firm’s IPO.

We also expand our analysis of synthetic governance with a second index—the Split Index—which tests the effect of separating the positions of CEO and Chairman of the Board. Institutional investors increasingly cite the separation of these positions as good governance characteristic. We find that the Split Index outperforms the market. Our results further support the potential value of synthetic governance in generating excess returns.

Our paper highlights three potential benefits to synthetic governance. First, it provides a market-based mechanism to test the economic value of controversial governance provisions. If critics of such governance provisions are correct, governance-based index funds should outperform their broad-based competitors. Second, synthetic governance may lead to more efficient allocation of capital by drawing inflows into funds that properly evaluate the economic value of governance. Third, synthetic governance provides a mechanism to enhance management accountability by providing passive investors a mechanism for subjecting the governance choices of their portfolio companies to capital market discipline. There are also systemic effects—if bespoke governance indexes are successful in attracting investor assets, firms may adopt specific governance practices to qualify for inclusion. Notably, because synthetic governance relies on rules-based modifications to standard market indexes, it can be implemented at a far lower cost than an actively-managed investment strategy.

Our examples demonstrate the broad potential that synthetic governance, through the use of governance-based indexes, offers for investor choice. An investor that believes dual class voting structures are value-decreasing can invest in a mutual fund based on an index of S&P 500 firms that excludes dual-class stocks. Another investor might not want to exclude all dual-class firms from its portfolio, but could instead invest in a fund which disinvests from companies with dual-class stock if that the dual class does not sunset after a pre-specified period of time, creating, in effect, a synthetic sunset. The results of the Dual Index and Split Index reveal the potential for these investment strategies to generate economically significant differences in investment performance.

Our evidence highlights that the choice between private ordering and public intervention has historically been artificially constrained. The new technology of using bespoke indexes to develop low-cost governance-based strategies offers investors greater potential to direct their capital in accordance with their governance preferences. Moreover, these allocation choices highlight the economic value of governance as it fits within each investor’s lens, further focusing the capital markets. Our application of the Dual Index illustrates the wider potential value of bespoke portfolios to enable investors to incorporate “bad” and “good” governance attributes systematically into their investment decisions. Ultimately, synthetic governance offers a new mechanism to mediate the ongoing struggles between institutional investors and publicly traded firms over the appropriate mechanisms for corporate governance and enables a market-based resolution of the corporate governance wars.

The complete paper is available for download here.

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