Governance arbitrage – a permanent risk?

The purpose of corporate governance is synthesising a company’s abilities to identify, assess and take advantage of opportunities for profitable growth and sustainable development. Long-term shareholder value creation – compared to a vague stakeholder orientation – still seems the most suitable concept to guide corporate governance:

Firstly, it levels out the failures of short-term capitalism by embracing present and future value creation. Secondly, it seems to facilitate the allocation of resources in the case of trade-offs among different stakeholder groups (Goedhart et al. (2015)).[1] The German Corporate Governance Codex combines sustainable creation of value and the conformity requirement with the principles of a social market economy (Regierungs­kommission Deutscher Corporate Governance Kodex (2015)); this includes minority shareholder protection and managing stakeholder concerns.


On the top level, the management, the board of directors and their interaction represent the corporate governance. The parties are obliged to act in the best interest of the shareholders and the company, unbiasedly and performance-oriented. The assignment of management consists of making the required strategic and operational decisions, leading the organizational execution and ensuring financial healthiness. The tasks of the board of directors are to appoint management and ensure ‘next generation’ transitions, to provide oversight by validating the aspiration level and offering strategic counselling, and to control the financial results and protect a company’s assets, which implies approval of any decision with material impact (cf. Barton & Wiseman (2015)).


However, repeatedly value foregone through inadequate corporate governance – i.e. ‘governance arbitrage’ – is immanent with companies. Such governance arbitrage can be measured for example through benchmarking against a company’s best-performing peer or falling short of expectations (of shareholders and analysts) or own business plans. Barton (2011) indicates that fearing “managers could divert corporate resources to serve their own interests rather than the owners’” inspired the idea of shareholder value-maximization in the 1970s and 1980s, with ‘quarterly capitalism’ of investors “who are renters, now owners” (Fink (2015a)) as an undesired outcome.[2] Also the growth of the activist industry in the form of firms that study companies, invest and then publicly advocate change and intervene – which can obstruct managers “from undertaking long term value enhancing actions” (Myners (2007)) – has been only possible “because public boards are often seen as inadequately equipped to meet shareholder interest” (Stephen Murray, quoted by Barton & Wiseman (2015)) and perform poorly (David Beatty, interviewed by Bailey & Koller (2014)). The Washington based Private Equity Council (2007) states that ‘managerial capitalism’[3], i.e. the disconnection between CEOs assuming “the role of representing both management and owners … and shareholders sowed the seeds for the emergence of private equity as a business model based on aligning the interests of shareholders and management”. Schofield (2014) confirms through empirical evidence ineffective governance, e.g. benchmarked against a company’s best-performing peer, as driver for the existence of PE (“buyout governance”), i.e. for a business model obtaining value from “governance arbitrage” (Huth (2007)) by concentrating ownership and correcting corporate inefficiencies.[4] Myners (2007) adds the question how to deal with the fact “that excessive corporate governance regulation wastes valuable board room time on compliance related tasks instead of focusing on running the business”.


Why and when do managers and boards of directors – besides their individual qualities – allow for governance arbitrage? Against the background of ever stricter governance regulations, i.e. legal requirements and fiduciary responsibilities, and an increasingly complex global environment and thus rising expectations, the board of directors faces the challenge to stay in the loop (cf. George (2013)), which requires an “effective, open, transparent, problem-solving, creative interface” (Bailey & Koller (2014)). Hence, misalignment, misinformation and misjudgement and biases could lead to value destroying deficits in corporate governance and perfunctory boards.


  • Misalignment. The ‘principal-agent problem’ occurs when the incentives of managers (the ‘agents’) differ from the interests of their cooperation/shareholders (the ‘principal’) and management does not put the company’s interest first (Lovallo & Sibony (2006)). Such differences could result from particular interests, e.g. career-motivated censorship (building resume or experience for another job), personal vanities (getting caught up and mesmerized in the role) [5] or ‘vested’ incentives which are “insufficiently sensitive to company performance risk” (Schofield 2014) – and members of the board of directors are not immune against this. Particularly deserving of criticism is the craving for immediate, one-off gratification, which creates a greedy gambling culture and myopia (Fink (2015a)).
  • Misinformation. A lack of information – not to be confused with uncertainties of the future – or its misinterpretation can be the result of negligent thoroughness of due diligence and/or inadequate data and decision models. Information asymmetry between management and board of directors make matters worse, a circumstance that is often further aggravated by (i) the high dependence of the board of directors from management upon business and even industry information, (ii) board composition, i.e. insufficient industry or functional expertise of directors, and (iii) size of the board and time that directors spend in that role alongside with a ‘friendly board’ attitude (cf. David Beatty, interviewed by Bailey & Koller (2014)).[6] Inadequate information can relate to the scope of standard reporting (strategy, budget and monthly reports, etc.) as well as to exceptional occurrences (partly to be ‘anticipated’ by risk management). Whether such information is subject to reporting or not is of secondary importance – what ultimately counts for the investor is the (financial) impact on the business and the degree of surprise.
  • Misjudgement and biases. Lovallo & Sibony (2006) count over-optimism and loss aversion as the most likely judgment distortions concerning the likelihood of an outcome and the value placed on it.[7] The prevalence of overoptimistic or overconfident ‘favouritism’ increases with the size of the investment decision and with the infrequency/lack of experience curves. On top of that, ‘big-ticket’ decision making often neglects or under­estimates swing factors, i.e. planning factors of uncertainty, which could really make a difference in performance (success vs. failure) and could lead to the refusal (Birshan et al. (2014)).[8] Besides this misjudgement of own abilities[9], often alongside misreading the environment, a confirmation bias, i.e. attaching more weight to information that is consistent rather than contradictory to the own beliefs, poses an unconscious tendency towards the desired outcome (Meissner et al. (2015)).[10], [11] Loss aversion[12] – due to over-cautiousness in terms of one’s reputation/career prospects of responsible line managers – often is a concern when looking at common, more similar smaller investments as singular events rather than as diversified and thus risk-mitigating portfolio decisions (Lovallo & Sibony (2006)).[13] Reinforced by loss aversion, Hall et al. (2015) reveal that the tendency to use existing budgets as “justifiable” anchor and thus allocating the same levels of resources to business units year after year undermines a company’s strategic direction.[14] Typically this ‘anchoring bias’ intensifies with corporate politics, where business unit executives are competing for resources compared to the previous year (Hall et al. (2015)).


The risk of ‘governance arbitrage’ increases with the moral hazard that an industry faces. Schofield (2014) lists a more diffused ownership structure, organizational complexity, intangible/ ’discretionary’ assets, operating volatility, a lack of competition and substantial free cash flows as aggravating circumstances of the moral hazard variables.


Effective corporate governance should link a business as investment case – alongside with a defined agenda and clear decision making lines for board of directors and management that tackle the described root causes for governance arbitrage – with the levers to exploit the market potential.


Frankfurt, 4 December 2016


[1] Goedhart et al. (2015) cite empirical research evidence showing that those companies with a long strategic horizon create more shareholder value and employment growth (cf. Jiang & Koller (2007), cf. Koller et al. (2010)). For instance in wage negotiations as the probably most typical stakeholder trade-off, a shareholder focus would lead to paying wages “that are just enough to attract quality employees and keep them happy and productive, pairing those with a range of nonmonetary benefits and rewards” (Goedhart et al. (2015)).
[2] Goedhart et al. (2015) point out, that often value-creating opportunities are passed up due to a focus on short-term EPS (earnings per share), even, e.g. in the case of transactions, where “there is no empirical evidence linking increased EPS with the value created by a transaction” (cf. Graham et al. (2006), Dobbs et al. (2005)).
[3] “Sometimes [officials] feel themselves ‘lords of manor’ – superior to everyone and everything. … These and other maladies and temptations are a danger for every Christian and for any administrative organization … and can strike at both the individual and the corporate level” (Pope Francis, quoted by Kirchgaessner (2014)). “A people that value its privileges above its principles soon loses both” (Dwight D. Eisenhower).
[4] Oesterle (2008) concludes that „since publicly-traded companies are unlikely to be free to match the management advantages of private equity funds over their portfolio companies, ‘governance arbitrage’ may always remain an explanatory incentive for successful going private transactions.”
[5] “The name on the front of the jersey is what really matters, not the name on the back” (Joe Paterno).
[6] A McKinsey survey in 2013 of 772 directors revealed, “… just 16% [of the directors themselves] claimed that their boards had a strong understanding of the dynamics of their firms’ industries” (Barton & Wiseman (2105)).
[7] Lovallo & Sibony (2006) divide sources for deficits in strategic decisions in distortions and deceptions. Distortions comprise over optimism (‘hockey stick’ planning) and/or overconfidence respectively vice versa overly high loss aversion. As deceptions they describe misaligned time horizons and/or risk aversion profiles from the perspective of the own career as well as champion bias or ‘sunflower management’, where the proponent is a trusted associate respectively where there is collective consensus around the presumed opinion of a senior person.
[8] For example, stakeholder complexity, ranging from local hearings to the public opinion, or infrastructure links could impede or endanger a project or even render it impossible.
[9] Kahneman takes the general view “that you should not take your intuition at face value. Overconfidence is a powerful source of illusions, primarily determined by the quality and coherence of the story that you can construct, not by its validity” (Kahneman & Klein (2010)).
[10] Bryan (2002) notices that strategy formulation ‘assuming away’ risks and paying lip service “is often an internally driven reflection of what the company wants the world to look like. … As a rule of thumb, a company is familiar with opportunities when it doesn’t have to take any large leaps of faith to understand where it expects to make returns from its investments”.
[11] In order to deliberately break those routines by which people (are endangered to) lose their judgement, companies need to embed safeguards along an escalation hierarchy into their formal decision making processes and corporate culture (cf. Lovallo & Sibony (2006), George et al. (2001)). Such – consistently hardly to override – ‘quality gates’ require to disaggregate the sources of value creation and risk, to qualify these by degree of uncertainty and to quantify them by impact (Birshan et al. (2014)).
[12] “Research shows that if a 50-50 gamble could cost the gambler $1,000, most people, given an objective assessment of the odds, would demand an upside of $2,000 to $2,500” (Lovallo & Sibony (2006), based on Kahneman & Tversky (1979)).
[13] The final agency issues can arise when decisions are taken by subordinates with superior knowledge about a given issues respectively decision-making is taking place in specialist forums, such as R&D committees (Lovallo & Sibony (2006)).
[14] “If corporations don’t approach rebalancing as fiduciaries for long-term corporate value, their life span will decline as creative destruction gets the better of them” (Randy Komisar, quoted by Hall et al. (2015)).