Does good governance prevent bad strategy?


A new study published in the Strategic Management Journal provides evidence that corporate governance devices for deterring firms from financial diversification are moderated in their impact by the level of free cash flow (FCF) in the company.

Financial diversification is a strategy used by firms to smooth revenue across business lines and reduce risk but that – according to theory – frequently destroys shareholder value. A popular line of enquiry in agency theory, most current research prescribes corporate governance devices including that of alignment and ownership control as effective preventative measures against diversification.

Researchers from the University of Lausanne, Switzerland, and Erasmus University analysed a sample of 59 publicly-traded French corporations from 2000-2006 to test the effectiveness of these strategies specifically in relation to financial diversification.

According to their findings only one corporate governance device – the separation of CEO and chairman roles – proved effective, and only when CEOs had FCF at their disposal and thus the opportunity to pursue financial diversification. FCF creates a situation of potential conflict between CEOs and shareholders, because CEOs can return FCF to shareholders through dividends or share repurchases, but can also use it to fund new projects that increase their own utility, such as financial diversification.

Additionally and contrary to agency theory, the corporate governance device of providing CEOs with variable compensation schemes that are aligned with shareholder objectives increased financial diversification when the firm had substantial FCF. Alignment devices increased CEOs perceived risk and thus inclination to reduce this risk through financial diversification.

Researchers thus argue for a contingent model in which corporate governance devices are understood to have a significant effect on financial diversification depending on the FCF level.

Results also confirmed what have thus far been only assumptions, that financial diversification negatively impacts firm value and shareholder value.

Castañer, X. & Kavadis, N. (2013). Does good governance prevent bad strategy? A study of corporate governance, financial diversification, and value creation by French corporations, 2000-2006. Strategic Management Journal, Volume 34, Issue 7, p 863–876.