In an article with N. Kavadis forthcoming in the Strategic Management Journal, we examine whether what agency theory proposes as good corporate governance and which has diffused as law and appropriate practice across the world prevents firms from engaging in financial diversification – that is defined as being present in different businesses which have less than perfectly correlated cash-flows (also known as revenue smoothing). Financial diversification is generally considered as a value destroying corporate strategy, because investors can more cheaply diversify their own investment portfolio than corporations (e.g. Amihud & Lev, 1981). According to agency theory (e.g. Jensen & Meckling, 1976), good corporate governance consists in using two devices: first, to provide variable compensation to executives so their interests are aligned with shareholders’ interests and, second, to have an independent board which can critically monitor the CEO. To be independent, boards are usually thought to require a majority of outsiders (not current or past employees of the firm) and that the Chairman of the board and CEO are not the same person. According to agency theory, interest alignment and board monitoring should prevent firms from being led by their CEOs to take bad, value-destroying decisions which further CEOs’ interests but not shareholders’ interests.
Drawing on Jensen (1986), we argue that free cash flow (FCF) – excess cash beyond what is needed to fund current projects in the future – provides CEOs with the possibility to envision and push for poor strategies. Thus, we claim that corporate governance devices are more necessary and thus might be more effective when FCF exists. However, we also posit that, because variable compensation increases CEO perceived risk and agency theory assumes that managers are risk averse, variable compensation is likely to increase rather than to decrease financial diversification, given that it reduces firm’s risk and thus it indirectly diminishes CEO’s remuneration and unemployment risks.
We test our hypotheses in a sample of 59 French publicly-traded corporations in the 2000–2006 period. We first show that financial diversification was value-destroying in our context: it negatively impacts shareholder return and firm value. Moreover, we obtain support for several of our hypotheses: at high levels of FCF, CEO variable compensation increases financial diversification whereas Chairman/CEO non-duality reduces it. In contrast, a greater proportion of independent directors (measured as outsiders with no CEO role in other French firms) increases financial diversification at low levels of FCF (although weakly). We also find that ownership concentration – which is supposed to facilitate shareholders’ control – only reduces financial diversification when FCF is low.
Our results therefore suggest some limits to the arguments in favor of agency theory-based corporate governance devices, at least in the context of French publicly-traded corporations in the 2000-2006 period. Only the separation of the CEO and Chairman roles appear to be an effective governance device in terms of preventing financial diversification when FCF is available. In contrast, instead of leading to less financial diversification, variable compensation is associated with greater financial diversification. We believe these findings should trigger a reflection on the effectiveness of what is currently assumed as ‘good’ corporate governance.