X, ENA... The power of the network, an obstacle to executive control with deleterious effects

Everyone knows the importance of networks in the business world. The power of alumni from the École Polytechnique (X) and the École Nationale d'Administration (ENA) is well established. Rigorously selected and trained at taxpayers' expense to serve the public interest, these graduates have largely invaded the management of major private companies.

Pascal Nguyen, University of Montpellier and Cédric Van Appelghem, University of Evry - Paris-Saclay University

A third of CAC 40 CEOs today come from just two schools, X and ENA (photo). J. Barande/École Polytechnique, CC BY-SA

Government involvement in key sectors of the economy is no stranger to this. It creates gateways that enable those who wish to do so to gain experience in the upper echelons of the administration, particularly in ministerial cabinets, as well as a highly useful address book.

The result is an over-representation of X or ENA graduates at the head of major French companies. This situation is virtually unrivalled anywhere else in the world. By way of comparison, only 11 of the 100 largest listed American companies are headed by a graduate of the Ivy League, the group of eight prestigious universities that includes Harvard, Yale and Princeton.

As a reminder, 13 of the CAC 40 bosses (i.e. a third) are graduates of just two schools: X and ENA. As most directors are also executives, boards of directors often include members who share the same educational background as the executive, and are therefore part of his or her network.

On the face of it, you'd think that this concentration of talent would be an asset for the company. But if you think about it, is the best team really the best team? In sport, we know this isn't always true.

Real Madrid proved this in 2004, when a team of world stars assembled at great expense failed to win a single trophy at the end of the season. Individual talent aside, it's important not to overlook the importance of the collective. The quality of a group is not simply the sum of the qualities of each of its members.

Perverse effects

Team arithmetic holds another surprise. Harvard researchers have analyzed the performance of venture capital co-investments. As might be expected, managers with degrees from the best universities are associated with better performance. This is rather reassuring for the universities in question.

What's even more curious is that when both co-managers come from the same university, however prestigious, performance is much poorer. The authors don't elaborate on the reasons for this underperformance, but it's likely that the absence of a critical eye towards the one who looks like us plays a key role.

This raises the question of whether the presence of directors with the same educational background as the manager might not lead to equally damaging results. The risk for the company is that the board of directors does not push the manager enough to question, or even challenge, the validity of his strategy. The danger is that the company will go off course and end up in a dead end.

The misfortunes of some French companies can be blamed on mistakes that could have been avoided if the directors had been more critical of the decisions made by the CEO. Some of the biggest losses suffered by French companies have come from boards whose members were part of the same alumni network as the CEO.

Directors who come from the same school as their manager seem to be less able to control the latter.
Shutterstock

Top of the list was Vivendi, with a loss of 23.3 billion euros in 2002. At the time, the company was headed by Jean-Marie Messier, whose brilliant educational background includes X and ENA. The only problem is that Vivendi's Board of Directors also included 3 X graduates and 4 ENA alumni, who were also finance inspectors like Messier himself. It is therefore likely that the directors' indulgence of the most brilliant of them failed to detect the problems early enough and correct them before it was too late.

Harmful consequences

When directors have close ties with the executive, the Board's ability to hold the executive to account is necessarily compromised. The Afep-Medef corporate governance code recognizes this in the case of financial or family ties, to define the independence of directors. On the other hand, social ties, such as those resulting from attending the same school, are totally ignored. And yet these ties have just as much of an impact on the ability of directors to control their executives.

In the absence of appropriate control, the executive can simply manage the company's affairs without having to exert too much effort or take too many risks. This conclusion, which one might think exaggerated, has in fact been convincingly demonstrated in the case of American companies. As a result, we can expect the company to perform less well. Francis Kramarz (Director of Research at ENSAE-ENSAI) and David Thesmar (Professor of Economics at MIT) prove this in the French context.

In the longer term, this results in a loss of competitiveness for the company. One indicator of this fragility is the company's greater sensitivity to economic fluctuations. Our article to appear this month in the Revue d'Économie Politique shows more precisely that companies whose board of directors includes members with ties to the executive through their training have stock market returns that are more strongly correlated with the market. When the economy goes down, the market goes down, and the value of these companies falls even further.

Studies also show that when managers are entrenched - in other words, when they don't have to worry about losing their position - companies tend to invest less in research and development, the outcome of which is known to be highly uncertain. As a result, they are less innovative. The results we obtained point in the same direction, suggesting that the presence of networks within the board of directors contributes to the entrenchment of the executive.

When directors come from the same school as the executive, the latter tends to take root in this position.
Shutterstock

Two other consequences flow from this situation. The first is that the company tends to be less transparent. It discloses less relevant information. Didn't Jean-Marie Messier declare "Vivendi is doing better than well" before announcing shattering losses? This gives investors reason to be wary, and to demand a higher risk premium.

In an article published this year in the journal Comptabilité Contrôle Audit, we have shown that the social ties between the manager and the directors result in a higher cost of equity. The company's growth rate is also lower.

Aggravating factors and possible remedies

All these problems are exacerbated by the concentration of power in the hands of a single executive, as is the case when the latter has been in office for a number of years and combines the functions of CEO and Chairman of the Board of Directors. A typical example is Carlos Ghosn, whose decisions were never questioned by Renault's directors until his spectacular arrest by the Japanese police.

Carlos Ghosn's lecture as Chairman and CEO of the Renault-Nissan Alliance at the Ecole Polytechnique.
Wikimedia, CC BY-SA

There are, however, a number of external governance mechanisms that can compensate for the lack of control exercised by the Board of Directors. Holders of blocks of shares can make their voices heard, and should do so all the more loudly if they have financial interests to defend. They can also threaten to sell their shares, which would be a stinging disavowal of the executive and could tarnish his or her reputation for a long time to come.

Monitoring by financial analysts also helps prevent directors who are close to the executive from becoming too complacent in their support of the latter. By highlighting the company's strategy and emphasizing its financial implications, analysts mitigate the risk of board dysfunction. The pernicious effects of social ties mentioned above are thus better controlled.

Other factors could also play a beneficial role. We can assume that the continued internationalization of French companies will encourage a greater mix of profiles, which should reduce the influence of networks. Major national companies such as Axa and Air France-KLM are now headed by men (Thomas Buberl and Ben Smith) who did all their studies and most of their careers abroad.

The higher proportion of women directors since the Copé-Zimmermann law is another factor likely to lead to better boardroom performance. We know, for example, that the presence of female directors significantly reduces the risk of fraud and accounting manipulation.

Finally, the intensification of competition with the opening up of markets such as rail transport or gas and electricity supply, could also impose greater discipline and thus lessen the attractiveness of companies for former senior civil servants and the network associated with them.The Conversation

Pascal Nguyen, Professor of Finance, University of Montpellier and Cédric Van Appelghem, Senior Lecturer in Management Sciences - Researcher at LITEM, University of Evry - Paris-Saclay University

This article is republished from The Conversation under a Creative Commons license. Read theoriginal article.