Boardroom gender diversity and investment inefficiency: New evidence from the United Kingdom

• Published date: 01 January 2023
• Author: Sanaullah Farooq,Christopher Gan,Muhammad Nadeem
• Date: 01 January 2023
• DOI: http://doi.org/10.1111/corg.12443

ORIGINAL ARTICLE

Boardroom gender diversity and investment inefficiency: New

evidence from the United Kingdom

Sanaullah Farooq

1

| Christopher Gan

1

| Muhammad Nadeem

2

1

Department of Financial and Business

Systems, Lincoln University, Lincoln,

New Zealand

2

Department of Accountancy and Finance,

University of Otago, Dunedin, New Zealand

Correspondence

Sanaullah Farooq, Department of Financial and

Business Systems, Lincoln University, Lincoln,

New Zealand,

Email: sanaullah.farooq@lincolnuni.ac.nz

Abstract

Research Question/Issue: Motivated by the recent regulatory reforms, in the forms

of the UK Corporate Governance Code (UK CGC) in 2011 and the enaction of

section 414C of the Companies Act 2006, to increase female representation on cor-

porate boards, this study investigates the effect of boardroom gender diversity

(BGD) on investment inefficiency (IE). These reforms were aimed at enhancing corpo-

rate governance by allowing a pool of female directors into directorship positions

and bringing fresher and independent perspective of female directors, thus strength-

ening board monitoring and its internal control systems. This study therefore seeks

to understand whether and how female directors align managers' and shareholders'

interests by improving investment efficiency.

Findings: Using a sample of UK listed firms from 2005 to 2018, this study provides

the first empirical evidence on the impact of BGD on IE. Consistent with our theoret-

ical predictions, we find a negative and statistically significant association between

BGD and IE. Furthermore, in a difference-in-differences analysis, we find a significant

impact of UK CGC on the BGD-IE relationship. We also identify three possible chan-

nels (board dynamics, stewardship effect, and information environment) through

which BGD is likely to affect IE. Finally, we also document that the said relationship

is more pronounced in firms with three or more female directors, which is consistent

with critical mass theory, and that BGD mitigates concerns surrounding both the

underinvestment and overinvestment decisions. Our main results are robust to endo-

geneity bias, alternative measures of BGD and IE, and controlling for potential bias

with a two-step investment estimation method.

Policy Implications: Our findings have important implications for regulators, policy-

makers, and other corporate stakeholders. Most importantly, the recent policy

initiatives on improving representation of female directors can strengthen board

monitoring and could reduce inefficient investments.

KEYWORDS

corporate governance, boardroom gender diversity, investment inefficiency, boarddynamics,

stewardship

1|INTRODUCTION

This study empirically examines the association between boardroom

gender diversity (BGD) and investment inefficiency (IE) based on a

sample of UK listed firms. According to the neo-classical framework,

investments must only be driven through their marginal Q-ratio

(Abel, 1983; Hayashi, 1982; Yoshikawa, 1980).

1

However, as a result

of low firm transparency (FT), managerial investments may deviate

Received: 18 November 2020 Revised: 23 January 2022 Accepted: 7 March 2022

DOI: 10.1111/corg.12443

2© 2022 John Wiley & Sons Ltd Corp Govern Int Rev. 2023;31:2–32.wileyonlinelibrary.com/journal/corg

from optimal levels because of moral hazard, such as managers pursu-

ing their own interests (Jensen & Meckling, 1976) or adverse selection

associated with managerial reluctance to raise capital at a discount

(Myers & Majluf, 1984). Proponents of the moral hazard theory pro-

vide several arguments on the divergence of managerial behavior

leading to poor investment decisions, such as investing excessively for

managerial empire building (Jensen, 1986; Stulz, 1990), enhancing

their professional reputation and future employment prospects

(Aggarwal & Samwick, 2003), and growing their salary (Conyon &

Murphy, 2000; Jensen & Murphy, 1990; Lei et al., 2014). Several stud-

ies discuss managerial career concerns leading to poor investment

choices, such as managers investing in investment projects related to

their skills and expertise (Shleifer & Vishny, 1989), thus diversifying

their employment risk (Amihud & Lev, 1981). Models of adverse selec-

tion suggest that low FT may prevent managers from raising funds at

low cost of capital resulting in subsequent underinvestment (Biddle

et al., 2009; Myers & Majluf, 1984). Regardless of the specific cause

of managerial poor investment choices, the literature suggests that

poor investment decisions can have adverse consequences on firm

performance. The literature investigating the impact of inefficient

investments on firm performance shows that high investments in

firms prone to overinvestment lead to negative subsequent stock

returns (Cooper et al., 2008; Titman et al., 2004) and poor future

operating performance (Fu, 2010; Li, 2004).

A board of directors appointed by shareholders is meant to act as

an effective control system to supervise managerial decisions. It

involves overseeing and scrutinizing strategic corporate decisions

undertaken by the managers (Liu et al., 2014; Zaman, Atawnah,

Baghdadi, et al., 2021). Most importantly, corporate boards are autho-

rized to make vital decisions such as appointing and firing senior exec-

utives (Fama & Jensen, 1983) and improving the overall information

environment (Armstrong et al., 2014). However, during recent

decades, the failure of corporate boards to provide effective supervi-

sory oversight is evident in a series of corporate scandals and bank-

ruptcies around the globe. This resulted in regulatory calls to overhaul

corporate boards such as restructuring them, to establish efficient

boards with superior governance. In 2011, the UK Financial Reporting

Council (FRC) included recommendations in the UK Corporate Gover-

nance Code (UK CGC), requiring UK listed firms to report in their

annual reports on the board's gender policy, measurable objectives on

gender diversity, and the progress in achieving these objectives

(FRC, 2011). In 2013, the UK Government further tightened the rules

by requiring UK firms to disclose the proportion of females in their

boardroom (Companies-Act, 2006). Overall, these reforms were to

boost board monitoring and reduce agency conflicts by breaking the

old boys' network (Adams et al., 2010) and improving the availability

and appointment of a better qualified pool of females for directorships

(Eagly & Carli, 2003; Hillman et al., 2007). These women would bring

a fresher, independent perspective (Capezio & Mavisakalyan, 2016)as

they are less likely to adhere to the prevailing board culture (Konrad

et al., 2008). However, evidence on the efficacy of these reforms and

whether these reforms make a business case, or a case for gender

equality, are still under investigation in recent literature.

Literature on BGD indicates that firms with female directors are

better governed (Adams & Ferreira, 2009; Schwartz-Ziv, 2017) and

have superior internal controls (Abbott et al., 2012; Chen,

Eshleman, et al., 2016). Female directors tend to reduce agency costs

through reducing excess free cash flows through dividends (Byoun

et al., 2016; Chen et al., 2017), and these firms have lower information

asymmetry (Gul et al., 2011; Gul et al., 2013; Nadeem, 2020). How-

ever, empirical evidence on the efficacy of female directors on direct

measures of inefficient investments is still unclear. Those few BGD

studies investigating the association between BGD and investments

have mainly focussed on acquisitions (Chen, Crossland, et al., 2016;

Dowling & Aribi, 2013; Levi et al., 2014), efficiency of R&D invest-

ments (Chen, Leung, et al., 2018; Chen, Ni, et al., 2016), or asset turn-

over ratio (Bennouri et al., 2018).

Therefore, motivated by the recent regulatory upsurges and the

gap in the current body of literature, we explore the association of

female directors with IE. More specifically, we explore the impact of

BGD on direct measures of IE using the optimal investment models of

Chen et al. (2011) and Biddle et al. (2009). As the purpose of the 2011

UK CGC was to encourage firms to appoint female directors on cor-

porate boards, we also examine the impact of this legislation on the

relationship between BGD and IE. Furthermore, we identify and

empirically test the possible channels through which BGD is likely to

affect IE. Finally, given the nature of UK's disclosure-based BGD, reg-

ulations can lead to “tick-box”compliance and the predictions of

token status and critical mass theory (CMT) that only the higher repre-

sentation of female directors may bring the desired monitoring out-

come. We therefore also investigate whether a greater number of

female directors have a more pronounced effect in mitigating IE.

Our findings reveal that female directors have a negative and sta-

tistically significant impact on IE, meaning that BGD significantly

improves investment efficiency. This finding is in line with our theo-

retical predictions that female directors indeed improve corporate

governance and influence strategic corporate decision-making,

thereby increasing firm value by reducing inefficient investments. We

then perform a difference-in-differences analysis based on the 2011

UK CGC and find that the code has a significant impact on the

BGD-IE relationship, meaning that the BGD-IE relationship is stronger

post UK CGC. This finding endorses the gender legislation in the

United Kingdom in particular and around the world in general that

increased female representation on boards to improve firm value. We

then explore the diverse mechanisms through which BGD may be

associated with IE. More specifically, we find that BGD improves the

board dynamics, stewardship effect, and information environment, all

of which have positive impacts on investment efficiency. Finally, we

show that firms with three or more female directors have a more pro-

nounced effect on IE, which is consistent with CMT. Finally, we also

show that BGD-induced improvement in investment efficiency is

driven by reduction in both overinvestment and underinvestment.

Our findings are robust to multiple proxies of BGD and IE. We also

address endogeneity concerns in a battery of addition analyses and

correct for possible bias with the two-step investment method based

on Chen, Hribar, et al. (2018).

FAROOQ ET AL.3