With a little help from your friends
Love it or loathe it, there’s no escaping the impact social networking has on business today. But new research provides evidence that while in-the-vanguard social networking sites like LinkedIn grab all the buzz, some old-school social networks grab corporate power. And in this case ‘old-school’ is not just figurative, in the sense of being off-line and low-tech, it’s also literal; these networks are based on school ties. Far from being left in the dust by virtual networking communities, some academics maintain that the alumni association is still very much in the corporate game.
Studies being conducted by students and faculty at several leading universities indicate a clear, quantifiable difference between business relationships among professionals who attended the same university – even if they were not acquainted during their years on campus – and those who cannot draw on those bonds. The studies further suggest that those relationships have had bearing on a broad range of business scenarios, from how sell-side analysts or mutual fund managers make investment decisions to how likely boards of directors are to reward or punish a CEO based on a company’s performance.
‘Sell-side school ties’ is a study that probes deeply into this phenomenon, investigating ‘the impact of social networks on agents’ ability to gather superior information about firms.’ The study, which was released in February, was co-authored by Lauren Cohen and Christopher Malloy, assistant professors of finance at Harvard University, and Andrea Frazzini, assistant professor of finance at the University of Chicago Graduate School of Business, from which both Cohen and Malloy graduated.
Cohen says their personal experiences with how sharing an alma mater with a professional contact can ‘grease the wheels in terms of information’ sparked the question of how similar connections came into play in the finance world. ‘Information transmission is a critical piece within asset pricing,’ he says. ‘An analyst’s job is to basically find out information, synthesize that and give that information to the financial markets. So if they can even get a small leg up, that would garner huge returns for them in terms of being able to do their jobs better.’
As the authors state in the study’s abstract, ‘Exploiting novel data on the educational backgrounds of sell-side equity analysts and senior officers of firms, we test the hypothesis that analysts’ school ties to senior officers impart comparative information advantages in the production of analyst research. We find evidence that analysts outperform on their stock recommendations when they have an educational link to the company.’ (See ‘Educational edge’, page 37, for an example of a case that was analyzed for this study.)
Cohen explains, ‘What we find is that mutual fund managers, if you look at their entire portfolio, take more concentrated bets on firms to which they have an educational connection and they do significantly better on these educationally connected stocks.’
The authors further calculated, in hard numbers, the impact Regulation FD had on the advantage of that social connection: ‘We find a large effect: pre-Reg FD the return premium from school ties was 8.16 percent per year, while post-Reg FD the return premium is nearly zero and insignificant.’
That particular result is an unplanned by-product of Reg FD’s implementation. Sources at the SEC would not comment on the study’s findings beyond pointing to the language of the regulation. In its announcement of the final rule, the SEC noted that it had received ‘an outpouring of public comment’ in the form of nearly 6,000 letters, the vast majority from ‘individual investors, who … expressed frustration with the practice of selective disclosure, believing that it places them at a severe disadvantage in the market. Many felt that selective disclosure was indistinguishable from insider trading in its effect on the market and investors.’ Reg FD deals directly with selective disclosure and insider trading, not the issues discussed in the professors’ study, and therefore SEC officials declined to respond to questions about the relationship between Reg FD and the study’s findings.
The industry take
Analysts have mixed reactions to the study’s conclusions. Fred Searby, a partner at hedge fund EverKey Global Management and a former sell-side analyst for 16 years at JPMorgan and, earlier, at Salomon Smith Barney, is skeptical. ‘All studies,’ he says, ‘try to exaggerate things to show there’s an effect.’ He does acknowledge that Reg FD ‘made people have to find more innovative and creative ways’ of seeking information.
Conversely, for Theodore O’Neill, an analyst at Kaufman Brothers who specializes in green companies, to a certain degree the study confirms his sneaking suspicion that ‘there was a connection other people had that I didn’t.’ He doesn’t believe the SEC formulated Reg FD with the aim of achieving the results the study details but says, ‘If there was some sort of tit for tat going on where you’d get better information if you went to the same school, I’m not sure eliminating that is a bad thing.’
Both investment pros agree that post-Reg FD, analysts have less access to, in Searby’s words, ‘actionable information’ direct from companies. ‘Sell-side analysts increasingly look to find relevant data points in other sources, whether it’s at parties, whether it’s friends, whether it’s people they knew from school or whether it’s people they didn’t know who they cold-called who just liked to talk,’ he says.
From O’Neill’s perspective, this is a change for the better. He notes that Reg FD restrictions don’t prevent analysts from ‘doing what they’re supposed to do,’ which is contacting customers and doing more legwork. ‘That’s really what the job of the analyst is supposed to be. It’s not supposed to be trading on information that you got from your friends within the company that you cover. You’re supposed to be out there getting information from customers of the company you cover. And that’s a wide-open field. … There’s still plenty of proprietary, original research analysts can do without triggering an FD issue.’
Cohen, Malloy and Frazzini continue to mine the topic of social networks’ impact on analysts’ relationships with the firms they cover. Their follow-up study, ‘Hiring cheerleaders: board appointments of ‘independent’ directors’, examines cases in which former sell-side analysts became board members of companies they once covered. In the abstract, they explain that they set out to ‘test the hypothesis that firms appoint independent directors who are overly sympathetic to management, while still technically independent according to regulatory definitions.’
The study reveals that there is ‘striking evidence that boards appoint overly optimistic analysts who exhibit little skill in evaluating the firm itself, other firms within the firm’s industry or even other firms in general. The magnitude of the optimistic bias is large: 82 percent of appointed recommendations are strong-buy/buy recommendations, compared to 56.9 percent for all other analyst recommendations. … Our results challenge the widely held view that appointments of independent directors necessarily add objectivity to the board of a firm.’
Cohen discusses the findings bluntly. The former analysts most often chosen for board appointments are not those who, when covering the firm, showed themselves to be ‘very keen and smart about the firm’ and who showed a strong ability to accurately predict what was going to happen to the firm. Such former sell-side analysts, he points out, would be shareholders’ picks for board appointments. But they’re not getting them. Those appointments are going to ‘people who have a relationship with the firm or maybe are just super-optimistic about the firm; the kind of people the board of directors would like. … These analysts who get appointed to the board are not the very accurate ones. They’re the ones who are incredibly optimistic about the firm and who are more likely to be socially connected to the firm. These boards are much more connected than you would expect given the legal statutes of what connected is. They’re actually much more socially concentrated than you might think. So independent directors, even though they are independent by legal standards, don’t look like what we would think of as independent directors.’
Cohen also points to evidence cropping up in further studies that suggests these directors should be held to a higher arm’s-length standard.
One of those studies, written by two PhD candidates at Emory University and published in July, supports Cohen’s assertion. ‘It pays to have friends’, say Byoung-Hyoun Hwang and Seoyoung Kim. The report finds that ‘87 percent of boards are conventionally independent, but that only 62 percent are conventionally and socially independent. Furthermore, firms whose boards are conventionally and socially independent award a significantly lower level of compensation, exhibit stronger pay-performance sensitivity and exhibit stronger turnover-performance sensitivity than firms whose boards are only conventionally independent. Our results suggest that social ties do matter and that consequently, a considerable percentage of the conventionally ‘independent’ boards are substantively not.’
Hwang explains that although there is indeed extensive research on the topic of board independence, the pair saw a hole in that research in terms of ‘what actually constitutes an independent board,’ noting that ‘there’s research suggesting that social ties matter a lot.’ That made them question whether social ties should factor into the definition or classification of independent directors.
What’s the upside?
What lessons should corporations take from these findings? According to the authors, unfortunately, it’s still far too early to tell, because much more research has to be done in order to accurately determine what positive impact, if any, these social ties may have on board performance.
‘I don’t think we’ve really thought in terms of policy implications yet, because there could also be some positive aspects of social ties. So far, we’ve only been looking at the monetary and disciplinary aspects of it,’ Kim says.
‘What the net effect is, we don’t really know yet,’ adds Hwang. ‘We don’t, for example, think the SEC should preclude any type of social ties just because it makes [directors] less effective monitors, because they might also be better advisers.’ The two researchers are continuing their studies into the topic and hope to uncover a way to quantify the beneficial and detrimental impact so that they can calculate and quantify the net effect.
Taken as a group, these three papers represent a new area to be mined in academic research. Cohen notes that until now the idea of the importance of social networks wasn’t taken into account in financial literature. ‘I think they’re incredibly important, both on the side of asset pricing – what we look at on the information side with analysts and also mutual fund managers – and on the side of corporate financial policies,’ he says. ‘Social networks can have real effects on firms. … They can change how they pay, or who they hire for their CEO or what firms they merge with. When you start to talk about that you see how powerful these things can be.’