X, ENA… The power of the network: an obstacle to managerial control with harmful effects

[The Conversation] - Published on April 30, 2021 in Science and Society

Everyone knows how important networking is in the business world. The influence of the alumni networks at École Polytechnique (X) and the École Nationale d’Administration (ENA) is well established. Rigorously selected and trained at the taxpayer’s expense to serve the public interest, these graduates have come to dominate the leadership of major private companies.

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

The government’s involvement in key sectors of the economy plays a role in this. It creates opportunities for those who wish to do so to capitalize on their experience in senior government service—particularly within ministerial offices—while also building a highly valuable network of contacts.

The result is that graduates of École Polytechnique and ENA are overrepresented at the helm of major French companies. This situation is virtually unparalleled anywhere else in the world. By way of comparison, only 11 of the 100 largest publicly traded U.S. companies are led by an Ivy League graduate—a group of eight prestigious universities that includes Harvard, Yale, and Princeton among its members.

As a reminder, 13 of the CEOs of CAC 40 companies (or one-third) are graduates of just two schools: École Polytechnique and École Nationale d’Administration. Since most board members are also executives, boards often include members who share the same educational background as the CEO and are therefore part of his or her network.

At first glance, one might think that this concentration of talent is an asset for the company. But on closer reflection, is a team made up of the best players really the best team? In sports, we know that’s not always the case.

Real Madrid proved this in 2004 with a team of world-class stars assembled at great expense, yet one that failed to win a single trophy by the end of the season. Beyond individual talent, it is important not to overlook the importance of teamwork. The quality of the team is not simply the sum of the individual qualities of its members.

Unintended consequences

The math behind investment teams holds another surprise. Researchers at Harvard analyzed the performance of co-investments in venture capital. As might be expected, fund managers who graduated from top universities are associated with better performance. This is rather reassuring for the universities in question.

But what is even more curious is that when both co-managers are alumni of the same university—no matter how prestigious it may be—performance is significantly lower. The authors do not elaborate on the reasons for this underperformance, but it is likely that the lack of a critical perspective toward those who are similar to us plays a key role.

Given this, one might wonder whether having board members with the same background as the CEO might lead to equally damaging outcomes. The risk for the company is that the board of directors may not push the CEO hard enough to question—or even challenge—the validity of his or her strategy. The danger, then, is that the company will go down the wrong path and end up in a dead end.

The setbacks faced by some French companies can be attributed to mistakes that could have been avoided if the board members had been more critical of the decisions made by the CEO. Among the largest losses suffered by French companies, several stem from firms whose boards of directors were composed of members who belonged to the same alumni network as the CEO.

At the top of the list, Vivendi stands out with a loss of 23.3 billion euros in 2002. At the time, the company was led by Jean-Marie Messier, whose impressive academic background included degrees from the École Polytechnique and the École Nationale d’Administration. The only problem is that Vivendi’s board of directors also included three École Polytechnique graduates and four École Nationale d’Administration alumni—all of whom, like Messier himself, were financial inspectors. It is therefore likely that the directors’ leniency toward the most brilliant among them prevented them from detecting the problems early enough and correcting course before it was too late.

Adverse consequences

When directors have close ties to the CEO, the board’s ability to hold the CEO accountable is inevitably compromised. This reality is acknowledged in the AFEP-Medef corporate governance code—specifically regarding financial or family ties—when defining director independence. On the other hand, social ties—such as those resulting from having attended the same school—are completely ignored. Yet these ties affect the directors’ ability to oversee the CEO just as much.

In the absence of adequate oversight, a CEO may simply go about managing the company’s affairs without having to exert too much effort or take too many risks. This conclusion, which might seem exaggerated, has in fact been convincingly demonstrated in the case of U.S. companies. Consequently, one should expect the company to perform less well. Francis Kramarz (Research Director at ENSAE-ENSAI) and David Thesmar (Professor of Economics at MIT) demonstrate this in the French context.

In the longer term, this results in a loss of competitiveness for the firm. One indicator of this vulnerability is the firm’s greater sensitivity to economic fluctuations. Our article, to be published this month in the Revue d’Économie Politique shows more specifically that companies whose boards of directors include members linked to the CEO by their educational background have stock market returns that are more strongly correlated with the market. When the economy slows down, the market declines, and the value of these companies falls even further.

Studies also show that when a CEO is secure in their position—in other words, when they do not have to worry about losing their job—the company tends to invest less in research and development, which is known to have highly uncertain outcomes. As a result, the company is less innovative. Our findings point in the same direction, suggesting that the presence of networks within the board of directors contributes to the leader’s security of tenure.

This situation has two further consequences. The first is that the company tends to be less transparent. It discloses less relevant information. Didn’t Jean-Marie Messier declare that “Vivendi is doing better than well” just before announcing massive losses? Investors therefore have reason to be wary and to demand a higher risk premium.

In an article published this year in the journal *Comptabilité Contrôle Audit*, we were able to demonstrate that social ties between the CEO and the board members 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 the CEO, as is the case when the CEO has been in office for a number of years and holds both the positions of CEO and chairman of the board. A classic example is Carlos Ghosn, whose decisions were never questioned by Renault’s board members until his dramatic arrest by Japanese police.

However, several external governance mechanisms can compensate for the board of directors’ lack of oversight. Major shareholders have the means to make their voices heard and should speak out all the more forcefully given that they have financial interests to defend. They can also threaten to sell their shares, which would constitute a stinging rebuke of the executive capable of permanently tarnishing his reputation.

Monitoring by financial analysts also helps prevent directors who are close to the CEO from providing him with overly complacent support. By highlighting the company’s strategy and emphasizing its financial implications, analysts mitigate the risk of board dysfunction. The harmful effects of the personal ties mentioned above are thus better managed.

Other factors could also play a positive role. It is reasonable to assume that the ongoing internationalization of French companies will lead to a greater diversity of backgrounds, which should reduce the influence of professional networks. Major national companies such as Axa and Air France-KLM are now led by men (Thomas Buberl and Ben Smith) who completed all their education and spent most of their careers abroad.

The increased representation of women since the Copé-Zimmermann Act is another factor that could lead to more effective board performance. For example, it is well established that the presence of female board members significantly reduces the risk of fraud and accounting manipulation.

Finally, increased competition resulting from market liberalization—such as in the rail transport sector or the supply of gas and electricity—could also impose greater discipline and thereby reduce the appeal of former senior civil servants and their associated networks to businesses.

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

This article is republished from The Conversation under a Creative Commons license. Readthe original article.

Keywords: Company, Training, Company, Work