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The conversation starts to pick up on
the cart ride between the 8th and 9th
holes. The CEO of a small but growing
business casually mentions that
he’s thinking about expanding the
company’s operations, investing in
new facilities, and hiring a larger staff.
His golf partner, a board member at
another firm, asks questions and offers
advice based on his own experience.
A productive discussion ensues and, by the end of the back
nine, the two part ways feeling more informed about their anticipated
investments.
This common scenario represents more than just a chance networking
opportunity. It could also yield measurable benefits for
each company’s economic performance.
Executives’ influence on company performance extends well
beyond the corporate boardroom. When they’re not at the office,
they serve on boards at nonprofit organizations and social clubs.
They play golf with former colleagues and get drinks with old
classmates. Often these associates are other executives who are
knowledgeable about the current business climate; when the
small talk winds down, the shop talk begins.
Just as someone would recommend a restaurant or movie to his
or her group of friends, executives who share social circles tend to
give each other advice: whether it’s a good time to make corporate
investments, open a new plant, or hire employees. In most cases
there is nothing underhanded about these conversations, provided
no inside financial information is being exchanged.
Cesare Fracassi, an assistant professor at McCombs who studies
executives’ social networks, says these interactions can equip
corporate leaders to make more educated decisions and improve
their companies’ financial performance.
“Social networks help to create more informed decisions,” Fracassi
says. “When I have more friends, I can decide what restaurant
I want to eat at, what movie I want to watch, and how to invest.”
Go with the Flow
In a recent study, Fracassi traced the social ties between 30,860
executives at 2,059 companies over the course of nine years,
identifying connections between those who overlapped at school,
held management positions in the same company, or had memberships
in common social clubs or nonprofit organizations. Next
he looked at company decisions, especially investment patterns.
Fracassi observed that companies led by socially connected
directors increased their investments at similar rates, while companies
with less-connected executives tended to follow more distinct
strategies. This occurs because when one member of a social circle
decides to ramp up his or her investments, the CEOs and directors
of other firms in the group are inclined to follow suit, Fracassi says.
“The more social connections two companies share with each
other, the more similar their investment policies are,” the study
reports. “In addition, two connected companies change their
investment policies over time more similarly than two companies
that are less socially connected.”
This tendency is known as informational cascade. And Fracassi
says it’s often a good thing.
It Pays to be Social
Being in the loop gives a firm access to a large volume of information
to guide financial decisions—but does all that insight
translate into good decisions Fracassi found evidence that when
a group of knowledgeable executives starts talking, it pays to be
part of the conversation.
“There is evidence that suggests that where the CEO and directors
are more socially involved, the company is more profitable,”
Fracassi says. “The information they receive helps the company
to make the right decisions.”
Specifically, companies that are positioned more centrally
in the web of social networks tend to have better economic
results—including greater firm value and a higher return on
assets—than those on the social fringes, the study reports. That
bump could result in a jump in performance of 5 to 15 percent.
Because the word-of-mouth information passed through social
networks flows freely and at a low cost, it’s advantageous for
companies to collect as much of it as possible.
“A strategic position in the network gives a player a competitive
informational advantage relative to other players that are
less connected,” Fracassi writes.
Keep Your Friends Close …
But Not Too Close
While the research indicates that staying connected to outside
social networks can benefit a company’s financial performance,
Fracassi says the opposite may be true for close social relationships
among directors within the same company—specifically
between the CEO and the board of directors.
In a 2012 paper, Fracassi and co-author Geoffrey Tate of the
University of North Carolina detailed the risks associated with
that type of scenario.
At most companies, board members are charged with monitoring
the CEO and holding him or her accountable for poor investment
decisions. But if the CEO and directors are connected through outside
social ties— say, they worked together in the past, went to the
same school, or are members of the same nonprofit organization
or club—the monitoring tends to be weaker.
In this scenario, the board tends to be more lenient toward the
CEO, even if he or she starts growing the company too rapidly by
making unwise acquisitions or unproductive investments. This,
in turn, can lead to a dip in the company’s share price, especially
for firms that have weaker shareholder rights.
The study also indicates that firms with powerful CEOs are the
most likely to add new directors who have pre-existing connections
to the executive, strengthening those social bonds
Fracassi says this outcome isn’t always the result of a conscious
distortion by directors who want to cut a friend some
slack. Rather, it’s that people are naturally more trusting of
someone they know.
“But this trust leads to CEOs making decisions that harm
shareholders’ value” in the form of unwise merger deals, he says.
Some argue that close ties can help improve the exchange
of information between executives at the same firm. But overall,
Fracassi’s research suggests that on balance, the negative
effects from these internal social ties often outweigh the
potential advantages.
“A well-functioning board of directors provides both valuable
advice to management and a check on its policies,” the study’s
authors write. “An effective director should not just ‘rubber
stamp’ management’s actions, but should take a contrarian opinion
when management’s proposals are not in the interest of the
firm’s shareholders.”
A series of legislative measures, including the Sarbanes–Oxley
Act of 2002, have taken aim at boardroom corruption, but Fracassi
and Tate have found little evidence that those policies
have significantly discouraged the practice of stocking boards
with familiar faces. The researchers identify internal networks
of CEOs and board members as “an effective target for future
governance reform.” O
Additional reporting by Jeremy Simon
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