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 the rest of 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 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 non-profit 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.”
About the Author
This article was written by Rob Hendrick of Texas Enterprise, a business blog that shares the business and public policy knowledge created at The University of Texas with the world. Rob was born and raised in Austin, writer Rob Heidrick has spent several years as a contributor and editor at local magazines and community newspapers. He earned an English degree from Davidson College in 2006 and a Master’s in Journalism from the Medill School of Journalism at Northwestern University in 2008. Before joining the Texas Enterprise staff in November 2010, he was a senior editor at Community Impact Newspaper, overseeing three publications in Williamson County. see more.