Does relative strength in corporate governance improve corporate performance? Empirical evidence using MCDA approach

Abstract

Academics and practitioners have developed different constructs to quantify corporate governance quality. Despite the limitations of the existing measures, they are still being commonly used. The literature finds that the relationship between performance and corporate governance quality can be positive, non-existing or even negative. To resolve this puzzle, we introduce a multi-criteria decision analysis (MCDA) approach to construct an alternative corporate governance quality synthesising companies’ practices and mechanisms through an exhaustive pair comparison procedures based on outranking relationships analysis. Our approach compares the aggregate quality with a well-known corporate governance index, ASSET4 ESG in Thomson Reuters Datastream, using data for the US firms. Using this MCDA approach based on PROMETHEE methods and econometric analysis, we obtain consistently a negative and strong link between firm performance and corporate governance quality. The findings are of particular interest to both scholars and decision makers including providers of corporate governance indices and rating agencies.

Keywords:

• Multiple criteria analysis
• decision analysis
• corporate governance
• financial performance
• outranking relationships

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 The MCDA approach is extended and applied to other fields for further dissemination of knowledge in the operations research literature. For example, Oliveira, Ferreira, Ilander, and Jalali (2017) examine the propensity of firms becoming insolvent; Poplawska, Labib, and Reed (2017) focus on the quantification of corporate social responsibility decisions; Doukas et al. (2007) use the linguistic variables on innovative energy technologies; Ferreira, Santos, and Rodrigues (2011) evaluate bank branch performance; Hayashida et al. (2010) examine effective policies for financing activities to preserve forests; Cohen, Doumpos, Neofytou, and Zopounidis (2012) evaluate the financial viability and distress of municipalities; Galariotis et al. (2016) introduce a multi-attribute financial evaluation to analyse municipalities; Fukuyama and Matousek (2017) evaluate banks’ network revenue efficiency on non-performing loans, and Walczak and Rutkowska (2017) propose automated comparisons of participatory budget projects.

2 PROMETHEE output is a set of values based on which it is possible to rank alternatives and show the resulting rank. Yet, we ought to note that the motivation and priority of our paper is the general behaviour of the system rather than a single company (see e.g., Hernandez-Perdomo et al., 2019).

3 The outranking relationship, denoted as S, does not determine if the relationship between two alternatives a and b is a strong preference (aPb), weak preference (aQb), or indifferent (aIb), but instead it establishes if “the alternative a is at least as good as the alternative b” (Brans & Mareschal, 2005).

4 Other GC types too might be used. However, they require additional information either from decision makers or from the data such as information about the parameters to model the threshold of indifference among objects or strict preference. We thus consider the GC “type I” since no additional information is required. Besides, our choice allows considering small differences for the corporate governance evaluations among the incumbent companies. Further research regarding other types of GC needs to be developed considering that preference and indifference values among the companies is going to be relaxed, and the statistical significance and explanatory power of the regression models might be affected.

5 As for the corporate governance index in ASSET 4 ESG, there is no additional information for differentiated weights of criteria (perspectives). However, the MCDA approach can also consider different weights if they are justified either theoretically or empirically, and results might change. As Cohen et al. (2012) state, if the MCDA approach requires subjective judgments about the parameters of the evaluation process and these factors should reflect the judgment policy of decision makers. However, this approach into our research is not appropriate due to the lack of access to decision makers or actual users of the aggregate quality of corporate governance indices. Nevertheless, in order to mitigate the concern associated with the lack of grey area we changed the definition of constructs in Table 2 that are based on the comparison between firm average and industry average figures. This robustness check (results are not reported here but available on request) confirms that our findings remain qualitatively the same.

6 The MCDA index yields relatively highly negative figures in years 2002 and 2003. The reason could be: the Sarbanes-Oxley Act-enacted in 2002-stipulated very strict corporate governance practices to improve accountability, responsibility and transparency and the contention is that its financial costs and regulatory burden decelerated the speed of adjustment of firms to comply with this Act (see e.g., Engel, Hayes, & Wang, 2007; Zhang, 2007). Such negative figures are observed for energy and telecommunication industries. One possible explanation for this is that these industries are highly regulated by strict compliance processes regarding the environment and social responsibility, and shareholder protection, which could constrain their aggregate quality. The other explanation could be that it is less costly for regulated companies if they do not fully comply with the corporate governance codes at least because such firms do not suffer that much from information asymmetry between insiders and outsiders, compared to the firms in other industries.

7 To conserve space, we do not report the correlation matrix but it is available on request. We use pairwise correlations with Bonferroni-adjusted significance levels. The variance inflation factors (VIFs) are far less than 10 with the mean value of 2.24, indicating the absence of the multicollinearity problem.

8 The corporate finance literature (e.g., Hutchinson & Gul, 2004) states that growth options determine financial performance due to the issues related to agency conflicts, asymmetric information and control mechanisms. For instance, corporate performance would decrease if growth firms face underinvestment or overinvestment inefficiencies. Similarly, the resource-based view contends that firms with good growth opportunities are likely to yield superior financial performance (see e.g., Barney, 1991). As an additional check, we followed the procedure proposed by Dumitrescu and Hurlin (2012) to test for the Granger causality in panel datasets; i.e., whether growth options influences financial performance or vice-versa. As our p-value strongly rejects the null hypothesis that growth opportunities do not Granger-cause firm performance as opposed to the hypothesis that they do, one can deduce from this test that the causality is likely to run from growth options to performance.

9 In unreported results, the p-value (<0.01) for the Breusch-Pagan LM test confirms the presence of panel effects and the p-value (<0.01) for the Hausman test favours fixed effects over random effects estimations.

10 These additional variables for performance are labelled as netincroa, ebitroa, roic, nroe and salesgrowth; they are defined in the Appendix. It appears that the effect of ROE on corporate governance quality is positive and significant for both quality constructs. The reason for this finding is that ROE is not an overall performance measure and may not explain enough about the multi-dimensional aspects. In fact, ROE is the outcome of the interaction between efficiency and financial indebtedness of the firms and its focus is on shareholders’ rate of return. Hence it would not be straightforward to figure out whether a change in performance is attributed to change in operational efficiency or in capital structure or even pay-out policy, noting that repurchasing shares mechanistically improves ROE. Chaudhuri et al. (2016) too refer to ROE as a problematic performance measure, and we recommend a further research of its usage as key performance proxy. Moreover, these additional estimates reveal that the impact of the traditional governance index on firm performance is quite sensitive to the definition of the latter.

11 We use the Durbin-Wu-Hausman (DWH) test to examine the presence of endogeneity. Our significant p-value rejects the null hypothesis of the exogeneity of the regressor. In this two-stage estimation setting, we use firm size and growth options as the external exogenous leverage determinants in the first stage. Our results are insensitive to choosing lagged values of leverage as internal instruments. The validity of the instruments has been confirmed by the Sargan test.

12 Wintoki et al. (2012), among others, suggest the use of lagging all explanatory variables for partial control of the endogeneity concerns. Following this suggestion, we regress the current firm performance (ROA_t) on all explanatory variables lagged by one period. In untabulated results, we again notice that our main results are qualitatively the same.