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 largely taken over 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 that allow those who wish to do so to capitalize on their experience in senior government administration—particularly within ministerial offices—while also building a very useful network of contacts.

The result is an overrepresentation of graduates from the École Polytechnique and the École Nationale d’Administration (ENA) at the helm of major French companies. This situation is virtually unparalleled anywhere 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—that is, a graduate of one of the eight prestigious universities that make up the Ivy League, including Harvard, Yale, and Princeton.

As a reminder, 13 of the CEOs of CAC 40 companies (one-third) are graduates of just two schools: École Polytechnique and École Nationale d’Administration. Since most board members are also executives, boards of directors 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 true.

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 qualities of each of its members.

Unintended Consequences

The math behind these 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 graduates of the same university—no matter how prestigious it may be—performance is significantly worse. 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 results. 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 at a dead end.

The setbacks experienced 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. The company was then led by Jean-Marie Messier, whose impressive academic background included degrees from the École Polytechnique and the École Nationale d’Administration (ENA). 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 finance 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 of directors’ ability to hold the CEO accountable is inevitably compromised. This reality is acknowledged in the AFEP-MEDEF Corporate Governance Code—in the case of 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 appropriate 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 his or her position—in other words, when he or she does not have to fear losing the 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 CEO’s security in their position.

Two other consequences arise from this situation. The first is that the company tends to be less transparent. It discloses less relevant information. Didn’t Jean-Marie Messier say , “Vivendi is doing better than well,” before announcing staggering 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 thus 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 Solutions

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 of directors. 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 and could permanently tarnish his or her 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 pernicious effects of the personal ties mentioned above are thus better controlled.

Other factors could also play a positive role. It is reasonable to assume that the ongoing internationalization of French companies will promote greater diversity in employee profiles, 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 of 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 operations. For example, it is well known that the presence of female board members significantly reduces the risk of fraud and accounting manipulation.

Finally, increased competition resulting from the opening of markets—such as those for rail transportation or gas and electricity supply—could also impose greater discipline and thus reduce companies’ interest in former senior civil servants and their associated networks.

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