Naveen D. Daniel

Boards: Does One Size Fit All?

This paper reexamines the relation between firm value and board structure. We find that complex firms, which have greater advising requirements than simple firms, have larger boards with more outside directors. The relation between Tobin’s Q and board size is U-shaped, which, at face value, suggests that either very small or very large boards are optimal. This relation, however, arises from differences between complex and simple firms. Tobin’s Q increases (decreases) in board size for complex (simple) firms, and this relation is driven by the number of outside directors. We find some evidence that R&D-intensive firms, for which the firm-specific knowledge of insiders is relatively important, have a higher fraction of insiders on the board and that, for these firms, Q increases with the fraction of insiders on the board. Our findings challenge the notion that restrictions on board size and management representation on the board necessarily enhance firm value. r 2007 Published by Elsevier B.V. JEL classification: G32; G34; K22

Co-opted Boards

We develop two measures of board composition to investigate whether directors appointed by the CEO have allegiance to the CEO and decrease their monitoring. Co-option is the fraction of the board comprised of directors appointed after the CEO assumed office. As Co-option increases, board monitoring decreases: turnover-performance sensitivity diminishes, pay increases (without commensurate increase in pay-performance sensitivity), and investment increases. Non-Co-opted Independence—the fraction of directors who are independent and were appointed before the CEO—has more explanatory power for monitoring effectiveness than the conventional measure of board independence. Our results suggest that not all independent directors are effective monitors.

The Hidden Cost of Managerial Incentives: Evidence from the Bond and Stock Markets

We examine how incentives embedded in managerial compensation contracts are priced by the bond and stock markets. Specifically, the incentives we consider are the sensitivity of CEO wealth to stock price (delta) and the sensitivity of CEO wealth to stock-return volatility (vega). Controlling for other determinants, we find that higher levels of both vega and delta are associated with higher bond credit spreads and higher expected stock returns. In addition to having a direct effect on credit spreads and expected stock returns, higher incentives are also associated with lower average cash flows, higher volatility of cash flows, and higher volatility of stock returns (all of which increase credit spreads), and higher systematic risk (which increases expected stock return). Thus, higher incentives have a cascading effect on credit spreads and expected stock returns. Also, a portfolio of high-incentive firms significantly underperforms a portfolio of low-incentive firms on a risk-adjusted basis; thus, on average shareholders appear to be harmed ex post as a result of incentive provision.

Does the Choice of Model or Benchmark Affect Inference in Measuring Mutual Fund Performance

We address the practical question of whether investors and researchers are likely to make invalid inferences about fund manager performance when using the wrong model and/or benchmark. We consider three well-known models, those of Jensen (1968), Treynor and Mazuy (1966), and Henriksson and Merton (1981), and two commonly used timing benchmarks, the SP (2) but biases in measures of overall performance are economically insignificant; (3) benchmark misspecification results in qualitatively similar difficulties, with the addition that overall performance as well can be biased; and (4) model and benchmark misspecification do not appreciably alter the power to detect ability and distinguish a good fund from a bad fund. These results are robust to alternative asset pricing specifications, alternative simulation schemes, varying length of the return series, and periodicity of the simulated series. The use of daily fund returns amplifies our conclusions about the biases induced by model misspecifications. Moreover, the biases we identify appear to be difficult to correct by using standard model selection criteria and misspecification tests. If the benchmark is known but the timing model is not, investors should use measures of overall performance to evaluate funds and managers.

The Advisory Role of Foreign Directors in U.S. Firms

We study the role of foreign directors in U.S. firms. We conclude that foreign directors, especially those from countries that are dissimilar to the U.S. in terms of business environment (i.e., dissimilar directors), are chosen by multinational corporations (MNCs) to provide advice, and this advice is valuable. We measure director dissimilarity along the dimensions of legal regime, language, trust, and religion. Our conclusion is supported by two findings. (i) Firms with operations in countries that are dissimilar to the U.S. in terms of business environment are more likely to choose dissimilar directors. (ii) The average announcement period return to the appointment of foreign directors is significantly positive, and is due to appointments by MNCs, and within MNCs, to dissimilar directors. Analysis using Tobin’s q leads to similar inferences.

Dividends, Investment, and Financial Flexibility

Faced with cash flows that fall short of the sum of expected dividend and investment levels, firms must do one of the following: cut dividends, cut investment, or raise funds through security sales, asset sales or reductions in cash reserves. Our analysis indicates that while very few firms (6%) cut dividends, the majority (68%) make significant cuts in investment relative to expected levels. Investment cuts make up for approximately half of the shortfall, with the other half being covered primarily by debt financing. Net equity issues, reductions in cash balances and asset sales account for a trivial percentage of the shortfall. Our findings challenge several widely-held views in the corporate finance literature.

Do Model and Benchmark Specification Error Affect Inference in Measuring Mutual Fund Performance

This paper examines the implications for mutual fund performance measurement of two likely sources of specification error. We compare three well-known models, those of Jensen (1968), Treynor and Mazuy (1966), and Henriksson and Merton (1981), and two commonly-used timing benchmarks, the SP (2) benchmark misspecification results in qualitatively similar inferences, although statistical significance is not as strong; and (3) the power of detecting ability for an individual fund or for distinguishing between a good fund from a bad fund is typically quite low and such power is not appreciably altered by model and benchmark misspecification. These results are robust to alternative asset pricing specifications (CAPM versus Carhart 4-factor) and the periodicity of the simulation (calibrated to daily versus monthly data).

Asymmetry in Pay for Luck: A Size Effect?

Garvey and Milbourn (2006) document an asymmetry in pay for luck. Their methodology involves decomposing stock returns into luck and skill. Theoretically, the estimates of luck and skill should have zero correlation; empirically, the correlation is –44%. We find that this correlation arises due to lack of control for firm size. We find no asymmetry once we control for size. Specifically, we find no asymmetry (i) if we exclude the largest 0.4% of firms; (ii) using estimates of luck and skill from return-decomposition models that account for size; and (iii) using estimates of luck and skill where correlation is zero.

Co-opted Boards: Causes and Consequences

We develop a measure of board co-option - the proportion of directors who joined the board after the CEO assumed office - and analyze whether this measure captures the extent to which the CEO can exert control over the board. We find that the sensitivity of CEO turnover to performance decreases in board co-option. CEO pay and pay hikes increase with co-option but there is no offsetting increase in pay-performance sensitivity. On the other hand, R&D intensity increases in co-option. Observed co-option increases in the importance of firm-specific human capital and measures of CEO power. Finally, Tobins q increases in co-option for firms that benefit from CEO investment in firm-specific human capital while for other firms there is no relation between q and co-option. All results are robust to controlling for the proportion of independent directors on the board, CEO tenure, and alternative measures of co-option. We conclude that independent directors who join the board after the CEO assumes office are at least partially aligned with the CEO. In contrast, independent directors who joined before the CEO appear effective at monitoring the CEO.