A new look at the impact of firms’ governance on investor returns

Corporate governance is the “system of rules, practices, and processes by which a firm is directed and controlled” (Investopedia). This includes the processes through which a company’s objectives are set and pursued in the context of the social, regulatory and market environment, such that stakeholders can have confidence in the company.

Telfer professor Adelphe Ekponon has received an SMRG grant for a project titled “Governance Risk and the Cross-Section of Stock Returns: Can Business Cycles Help Solve the Puzzle?” He’ll investigate the link between corporate governance and equity prices, asking whether governance quality can explain differences in equity returns.

Puzzling findings

According to Ekponon, the first attempts (in the early 2000s) to answer this question found a positive relationship between good governance and equity risk premiums (the additional cost that a company must bear to get the financing it needs). This finding has been puzzling — finance theory predicts that more governance risk, not less, should lead to greater equity risk.

Ekponon will attempt to show that factoring in shifts in economic conditions between expansion and recession periods helps explain why good governance translates into higher risk premiums. Additionally, he will redefine the term “governance risk” and show that bad governance is in fact a source of risk. He will corroborate this by showing that firms with higher governance risk during recessionary periods have higher average risk premiums.

An original contribution

Ekponon says that understanding the implications of corporate governance for the price of assets (like a company’s shares) has been a challenge. As shown by the literature, the balance of power between insiders (officers, directors, shareholders, etc.) and investors should play a significant role in shedding light on this challenge.

Ekponon focuses on the relationship between insiders and investors, and environmental, social and governance (ESG) scores. And unlike others, he considers varying economic conditions.

As most papers that have studied the impact of governance policy on corporate debt decisions have shown, Ekponon predicts that higher governance risk (bad governance) will translate into less debt. However, no other model has successfully linked governance quality to equity premiums. His research project may not only contribute to linking governance risk and corporate debt, but also debt and equity premiums.