How Board Diversity Affects Firm Performance in Emerging Markets: Evidence on Channels in Controlled Firms

• Author: Ayse Tansel Cetin,Melsa Ararat,Mine Aksu
• Published date: 01 March 2015
• Date: 01 March 2015
• DOI: http://doi.org/10.1111/corg.12103

How Board Diversity Affects Firm Performance in

Emerging Markets: Evidence on Channels in

Controlled Firms

Melsa Ararat*, Mine Aksu and Ayse Tansel Cetin

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Weinvestigate the indirect effectof a board’s demographic diversity on f‌irm performance via board

monitoring in a context where boards are relatively homogeneous with respect to structural diversity, using data from Turkey.

We contextualize our investigation by exploring the inf‌luence of ownership conf‌igurations on the effect of diversity.

Research Findings/Insights: We f‌ind a positiveand non-linear relationship between demographicdiversity and performance,

mediated bythe board’s monitoring efforts.The effect of monitoringis found to be contingent upon (moderated by) the control-

ling shareholders’propensity to expropriate, measured bythe deviation of control rights from cash f‌low rights,i.e. the wedge.

We report that demographic diversity enhances f‌irm performance by mitigating the negative effect of the wedge on board

monitoring.

Theoretical/Academic Implications: Our results provide empirical support for the importance of contextual factors in the re-

lationship between diversity and performance. Our framework and the compound diversity and board-monitoring indices

we construct may prove useful to researchers.

Practitioner/Policy Implications: Regulators can use ourf‌indings in formulating recommendations or regulations relatedto de-

sirable characteristics of boards.Our results are also instructivefor investors and proxy advisors andindicate that the mere ex-

istence of monitoring vehicles may be insuff‌icient to prevent expropriation by dominant shareholders,but diverse boards may

mitigate the propensity to expropriate. Board members and shareholders should also benef‌itfromthef‌indings in creating

boards that are more diligent monitors.

Keywords: Corporate Governance, Board Diversity, Controlled Firms, Firm Performance, Board Monitoring

INTRODUCTION

Initially focusedon top management teams (TMT), attention

on the effect of team diversity has turned to corporate

boards during the past decade, in the aftermath of unprece-

dented governance failures, underscored by the emphasis

placed on the monitoring role of boards by regulators and in-

vestors. Boardsconstitute an important corporate governance

mechanism, especially in markets where external monitoring

is weak (Dahya, Dimitrov, & McConell, 2008).

The “business case”behind board diversity is traditionally

underpinned by two main perspectives resource dependency

(Pfeffer & Salancik, 1978) and agency (Jensen & Meckling,

1976) theories, which relate to the service and control tasks

of boards, respectively (Forbes & Milliken, 1999). Prior re-

search differentiates betweenboards’demographic and struc-

tural diversity (Ben-Amar, Francoeur, Hafsi, & Labelle, 2013).

While the impactof demographic diversityis generally associ-

ated with the service task of the board, structural diversity,

measured by board independence, mostly operationalized as

the percentage of independent board members and/or the

separation of the chairman and the CEO, is associated with

the control task.

Investigations of performance outcomes of single demo-

graphic and structural diversityattributes are equivocal.Meta

studies suggestthat the performance effectof diversity is task-

specif‌ic, nonlinear and contingent upon the context (see Bell,

Villado, Lukasik, Belayu, & Briggs, 2011 and Johnson,

Schnatterly,& Hill, 2013). Several studiesf‌ind a strong connec-

tion between independent directors and market valuations of

f‌irms in some emerging markets (Black, De Carvalho,

Khanna, Kim, & Yurtoglu, 2013). However, structural diver-

sity is generallyweak or ineffective in most emerging markets

(Young, Peng, Ahlstrom, Bruton, & Jiang, 2007). Studies on

the effect of demographic diversity on f‌irm performance in

emerging markets, on the other hand, are very rare and lack

statistical signif‌icance or focus on single diversity dimensions

such as genderor race. Ben-Amar et al. (2013) is oneof the few

*Address for correspondence: Melsa Ararat, Corporate Governance Forum of Turkey,

SabancıUniversity,Turkey,E-mail: melsaararat@sabanciuniv.edu

© 2015 JohnWiley & Sons Ltd

doi:10.1111/corg.12103

83

Corporate Governance: An International Review, 2015, 23(2): 83–103

papers to emphasizethe special role of demographicdiversity,

alongsidestatutory diversity, the nonlinearityof the diversity–

performance relationship in boards, and the effect of owner-

ship on the association between diversity and performance.

We followtheir lead in this study in that, we focus on boards’

demographic diversity and its effect on f‌irm performance,

in the Turkish setting where ownership is concentrated,

structural diversity is weak at best, and external monitoring

is ineffective.

Turkey is an interesting setting to study the effect of

boards’demographic diversity in emerging markets for a

number of reasons. First, boards in Turkey were structurally

homogeneous until recently (Ararat, Black, & Yurtoglu,

2014), allowing us to focus on the effect of demographic di-

versity. Second, Turkey’s societal culture is characterized by

high collectivism according to Hofstede’s typology (Kabasakal

& Dalmachian, 2001), similar to many emerging markets,

suggesting that the positive effect of demographic diversity

on task performance is more likely to emerge than the neg-

ative effect (Chatman, Polzer, Barsade, & Neale, 1998).

Third, family-owned business groups in Turkey are con-

sidered as archetypal examples of large and diversif‌ied

business groups that dominate a broad range of emerging

economies (Yildirim-Oktem & Usdiken, 2010), providing a

suitable setting for us to test the role of such ownership

structures in our investigation. Fourth, Turkey is an impor-

tant middle-income developing market on its own; access

to f‌inance is an important constraint on growth for many

Tur ki sh f‌irms and Turkey’sequitymarketsareunderdevel-

oped compared to its peers, despite the relatively sophisti-

cated market infrastructure and stringent disclosure rules

(World Bank, 2014).

1

We study the effect of a board’s demographic diversity by

developing a compound board diversity index (BDI) and pre-

dict that the channelthrough which demographicdiversity af-

fects performance is the board’s monitoring intensity. We

operationalize the construct of monitoring intensity by com-

bining multipleindicators into a compound boardmonitoring

index (BMI). We f‌ind a positive relationship between BDI and

f‌irm performance, channeled through better monitoring,

when we contextualize our investigation by including owner-

ship variables in ourestimations.We also augment our demo-

graphic diversity measure BDI with structural diversity to

develop a total board diversity index (TBDI), to see the mar-

ginal effect of independent directors on f‌irm performance.

Our resultsshow that independent members enhancethe pos-

itive effect of BDI on the f‌irm’s market value, measured as

market-to-book ratio, although they do not enhance the ac-

counting performance.

Ownership and control structure is the key determinant of

the type of agency problems that affect f‌irms (Villalonga &

Amit, 2006). Inemerging markets like Turkey, the agencycon-

f‌lict between thecontrolling shareholders andminority inves-

tors is augmented by deviations of control rights from cash

f‌low rights, i.e,,the wedge, through the use of dual classshares

and/or pyramidal structures. Wedge is conducive to expro-

priation in many emerging markets (Fan & Wong, 2002) and

in Turkey (Orbay & Yurtoglu, 2006). We predict that the

wedge has a determining effect on the relationship between

board diversity and monitoring, and hence on f‌irm perfor-

mance; the higher thewedge, the weaker would be the board

monitoring,which may limit the owners’freedomin pursuing

self-serving transactions.

Our resultssuggest that boards are lesseffective monitors in

family controlled f‌irms and in f‌irms with a high wedge, while

demographic diversity mitigates the negative effect of the

wedge on monitoring. We conclude that the mediating effect

of BMI is contingent upon (moderated by) the wedge.

Toour knowledge, this study is the f‌irst to combinemultiple

diversity attributes of a board into a compound index using

the Blau (1977) measure of variety. Controlled f‌irms require

different governance mechanisms than widely dispersed

f‌irms (Bebchuk & Hamdani, 2009). Our paper demonstrates

that demographic diversity may be more important in con-

trolled f‌irms, especially when insiders use control-enhancing

mechanismsand dominate the boards. Ourresearch also adds

to the debate on processes throughwhich diversity may affect

performance by operationalizing the board’s monitoring ef-

forts into a novel composite process variable.

The rest of the paper is organized as follows: the next section

reviews the releva nt f‌inance and management literature and

develops our hypotheses using the Turkishcontext. The follow-

ing section describes the data, our variables, and the character-

istics of our sample, followed by a section on research design

and empirical models. We f‌inally present the results of our

analysis, followed by our discussion and conclusion, highlight-

ing the relevance of our f‌indings for various audiences.

PRIOR RESEARCH, THE CONTEXT, AND

DEVELOPMENT OF THE HYPOTHESES

Why Demographic Diversity May Matter More in

Controlled Firms

Board structure and processes matter for f‌irm value (Adams,

Hermalin, & Weisbach, 2009). Fama and Jensen (1983) argue

that independentdirectors are incentivized to scrutinize man-

agement with more diligence because they seek to protect

their reputationas effective monitorsof managerial discretion.

In their multi-country study, Dahya et al. (2008) f‌ind that the

positive effect of board independence on f‌irm valueis greater

in countries with weaker investor protection compared to de-

veloped markets.

The corporate governance landscape in many emerging

markets, Turkey included, is characterized by concentrated

ownership and control, by families and business group struc-

tures, with frequent use of control-enhancing mechanisms

(Young et al., 2007). Concentration of ownership provides in-

centivesfor effective monitoring of management,but also pro-

vides opportunities for self-serving transactions, especially if

legal protectionof shareholder rightsis weak. In such environ-

ments, controlling shareholders have a choice between two

offsetting incentives: a positive incentive effect from share

ownership, and a negative entrenchment effect from dispro-

portionate control, accrued as private benef‌its of control at

the expense of minority investors (Claessens, Djankov, Fan,

& Lang, 2002). In the former case, dominant owners could, if

so inclined, increase f‌irm value by appointing a “strong”

board for assuring investors that they will refrain from diver-

sion of the f‌irm’s resources (Durnev & Kim, 2005). However,

some scholarsargue that the independenceof directors, if they

84 CORPORATE GOVERNANCE

© 2015 JohnWiley & Sons LtdVolume 23 Number 2 March 2015