An Empirical Investigation of Internal Governance
50 Pages Posted: 15 Mar 2012
Date Written: March 14, 2012
Acharya, Myers, and Rajan (2011) theorize that self-serving actions and rent extraction by CEOs can be constrained by subordinate managers when the managers' efforts are needed in production. This force, which they call internal governance, works best when the CEO and the managers are both important to firm output, in the sense that their relative contributions to firm value are balanced. We empirically examine the effects of internal governance on firm investment and performance. We develop a measure of internal governance that captures the relative contribution of the CEO compared to non-CEO executives in firm value creation. Consistent with the theory, we find that there is a hump-shaped relation between relative contributions and corporate investment measured as either capital expenditures or R&D spending. We also find a hump-shaped relation between relative contributions and several measures of firm performance such as Tobin's Q and free cash flow. The hump-shaped relations between investment and relative contributions and between firm performance and relative contributions are more evident for firms with a greater age difference between the CEO and the managers, firms in growing industries, firms with non-founder CEOs or CEOs without substantial equity ownership, firms with weaker external monitoring, and firms in which internal managers are more likely to become CEO in the future. Further, neither external governance nor board governance diminishes the importance of internal governance. Overall, our results are strongly supportive of the theory.
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