Board structure and role of outside directors in private firms

• Author: Zhongda He,Huasheng Gao
• DOI: http://doi.org/10.1111/eufm.12191
• Date: 01 September 2019
• Published date: 01 September 2019

DOI: 10.1111/eufm.12191

ORIGINAL ARTICLE

Board structure and role of outside directors

in private firms

Huasheng Gao

1

|

Zhongda He

2

1

Fanhai International School of Finance,

Fudan University, Shanghai, China

Email: huashenggao@fudan.edu.cn

2

Chinese Academy of Finance and

Development, Central University of

Finance and Economics, Beijing 100081,

China

Email: hezhongda@cufe.edu.cn

Abstract

We examine the board composition and the role of outside

directors in US private firms. We find that compared with

public firms, private firms have a higher proportion of

outside directors on the boards and select their outside

directors in a more responsive way to their advisory and

monitoring needs. We also find that private firms’CEO

turnover–performance sensitivity, earnings quality, going-

publiclikelihood, and IPO value increase with the proportion

of outside directors. These results are consistent with the

view that lack of external governance in private firmsleads

to a greater demand for board monitoring for private firms.

KEYWORDS

advisory role, earnings quality,external governance, information

environment, monitoringrole, outside director, private firms, public firms

JEL CLASSIFICATION

G32, G34, L22

1

|

INTRODUCTION

While examining the effect of board composition on firm value and the role of outside directors

has been the central theme in the literature on boards of directors (e.g., Adams & Ferreira, 2007;

We are grateful for the helpful comments from John Doukas (the editor), an anonymous referee, Jun-koo Kang, Qiang

Cheng, Xia Chen, Lixiong Guo, Emdadul Islam, Bin Ke, Tomislav Ladika, Angie Low, and seminar participants at the

Chinese University of Hong Kong, Nanyang Technological University, Singapore Management University, the 2012 China

International Conference in Finance, and the 26th Australian Finance and Banking conference. We thank Yong Bao Kwang

and Zheng Qiao for excellent research assistance. Gao acknowledges that this paper is sponsored by Shanghai Pujiang

Program. All errors are ours. For any questions regarding the proofs and reprint order forms, please contact Huasheng Gao

(Room 413, Think Tank Building, No. 220 Handan Road, Shanghai, China).

Eur Financ Manag. 2018;1–47. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

|

1

861Eur Financ Manag. 2019;25:861–907. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

Fama & Jensen, 1983; Hermalin & Weisbach, 2003; Knyazeva, Knyazeva, & Masulis, 2013), the

evidence on these issues is extremely thin for private firms relative to public firms. This lack of

evidence on private firms makes it difficult to fully understand how corporate boards in the United

States are structured and function, given that private firms account for over 60% of US production and

comprise over 70% of US firms with more than 500 employees (Farre-Mensa, 2014).

In this paper we attempt to fill this gap by analyzing how the board composition (i.e., proportion of

outside directors on the board) of private firms is different from that of public firms and whether outside

directors in private firms perform a value-enhancing role in monitoring and advising the managers.

Given the unique contracting environments of private firms compared with public firms (e.g., poor

stock liquidity, high information opacity, little stock market regulation, etc.), our analysis is expected

to shed new light on how firms design their optimal board structure in response to their different

environment and governance systems.

Theories on board compositions have two competing predictions on private firms’board structure

as opposed to public firms, which also has an important implication for the role of outside directors in

private firms. On the one hand, Fama (1980) and Fama and Jensen (1983) argue that board structure is

determined by the effectiveness of external governance mechanisms (e.g., hostile takeovers and stock

market monitoring). Thus, firms facing weaker external governance need to have more outside

directors on the boards to take greater responsibility in monitoring managerial discretion.

The influence of external governance is arguably weaker in private firms than in public firms

because private firms in which their shares are not publicly traded face little threat of hostile takeover or

stock market monitoring. This argument predicts that private firms have more outside directors on their

boards than public firms (‘external governance’hypothesis) and outside directors in private firms play

an important role in enhancing firm performance.

On the other hand, Adams and Ferreira (2007), Raheja (2005), and Maug (1998) argue that it is not

optimal for firms with high information asymmetry to invite monitoring from outside directors because

of high costs associated with transferring firm-specific information to outsiders. Previous studies show

that, compared with public firms, private firms face a lower level of accounting information scrutiny by

regulatory agencies and capital market participants and they are also less likely to be covered by news

media and analysts, suggesting that private firms face greater information asymmetry and enjoy

considerable latitude in setting accounting policy (Ball & Shivakumar, 2005; Burgstahler, Hail, &

Leuz, 2006; De Franco, Gavious, Jin, & Richardson, 2011). Thus, this argument suggests that outside

directors in private firms incur higher costs in collecting firm-specific information and performing their

roles as monitors and advisors than those in public firms, predicting that private firms have fewer

outside directors on the boards than public firms. The lack of information and high costs associated

with collecting firm-specific soft information also suggest that outside directors in private firms are not

active in performing value-enhancing roles. Moreover, due to the separation between ownership and

control, public firms could be subject to more serious agency problems and thus demand a higher level

of governance than private firms. This would also predict a larger proportion of outside directors in

public firms than private firms (‘information environment and ownership separation’hypothesis).

Using a large sample of 7,563 private and 23,790 public firm-year observations (4,099 matching

private and public firm pairs) from 1999 to 2008, we find that consistent with the external governance

hypothesis, private firms have a higher proportion of outside directors on their board than public firms.

This finding is robust to controlling for various firm and CEO characteristics, including ownership

structure and other internal governance mechanisms, and holds for the subsample of nonfamily firms.

To address the potential endogeneity of firms being publicly listed, we conduct several additional

tests. First, to take into account the possibility that some unobservable firm characteristics drive our

results, we examine within-firm variation in listing status. Using a sample of more than 300 IPO firms,

2

|

GAO AND HE

w

d

i

o

T

c

n

f

t

p

t

i

p

p

h

p

s

v

e

h

2

f

i

p

g

d

f

m

o

u

s

e

r

e

p

e

2

F

f

F

m

G

G

2

|

GAO AND HE

862

e

f

d

d

f

e

.

r

d

t

e

n

s

k

e

.

s

r

r

y

t

e

w

y

s

y

&

e

r

r

d

t

d

l

n

g

e

.

p

.

l

r

,

E

we find that after being listed on stock exchanges, firms significantly decrease the proportion of outside

directors on the boards. Second, we apply a two-stage least squares (2SLS) regression approach using

industry IPO volume as an instrumental variable. We find that the differences in the proportion of

outside directors between public and private firms remain statistically and economically significant.

Third, we use a propensity score matching approach to control for observable firm and CEO

characteristics that may affect both a firm's listing status and board structure decisions. Our result does

not change.

Next, to examine whether a higher proportion of outside directors in private firms than in public

firms is related to their greater responsibility in advising and monitoring managers, we perform several

tests. First, we examine the association between a firm's advisory and monitoring needs and the

proportion of outside directors on the board and find that this association is stronger in private firms

than in public firms. Second, we examine CEO turnover–performance sensitivity and earnings quality

in private firms, going-public likelihood, and IPO valuation, and find that they increase with the

proportion of outside directors on the board. These results suggest that outside directors in private firms

perform important value-enhancing functions for shareholders, supporting the external governance

hypothesis. Finally, we compare the personal backgrounds of outside directors between public and

private firms. We find that outside directors in private firms are more likely to have MBA and elite

school degrees than those in public firms. They also have greater financial expertise in banking and

venture capital businesses. To the extent that directors’educational qualification is an important

element of effective boards (Carpenter & Westphal, 2001) and their accounting and financial expertise

helps them perform effective monitoring and advisory functions (Cohen, Krishnamoorthy, & Wright,

2010), these results suggest that directors’better qualification and greater financial expertise in private

firms could be one potential source of private firms’better board functioning.

Our study contributes to the literature on boards of directors by examining how board composition

in private firms is different from that in public firms. We find that private firms have a higher

proportion of outside directors on the board than public firms, suggesting that lack of external

governance in private firms, such as hostile takeovers and stock market monitoring, leads to a greater

demand for board monitoring for private firms. We also examine whether outside directors in private

firms perform important value-enhancing functions and show that they take greater responsibility in

monitoring and advising managers than those in public firms. These findings suggest that firms set the

optimal board structure on the basis of their governance-specific environment, and help improve our

understanding of how corporate boards (in both private and public firms) in the United States are

structured and function.

The paper is organized as follows. In section 2 we review the literature and develop our main

empirical predictions. In section 3 we describe the data and sample characteristics. Section 4 presents

results from the tests of our main hypotheses. In section 5 we present results from controlling for

endogeneity bias of being publicly listed. In section 6 we examine the monitoring and advisory roles

performed by outside directors in private firms, using CEO turnovers and IPOs as the events for our

experiments. Finally, we present summary and concluding remarks in section 7.

2

|

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Fama and Jensen (1983) argue that the unrestricted alienability of public firms’shares makes public

firms subject to external discipline, such as stock market monitoring and the threat of hostile takeover.

For example, the stock market that specializes in pricing can exert influence on management to

maximize shareholder wealth by making the stock prices a visible signal that summarizes the

GAO AND HE

|

3GAO AND HE

|

3

E

863