How good corporate governance reduces equity volatility

New research explores how corporate governance reforms can reduce equity volatility and improve the risk-return profile of companies for shareholders

Organisations and their boards of directors around the world are subject to increased regulation. Improved corporate governance is often the goal of such regulation, which imposes additional burdens of compliance upon directors regarding the sound and ethical operation of business affairs within their respective organisations.

One important goal of corporate governance regulation is to reduce conflicts of interest between a firm’s controlling shareholders and minority shareholders. As controlling shareholders usually hold a majority of a company’s voting stock, they can exercise stronger corporate controls over a company. This can lead to potential conflicts of interest, wherein such shareholders may divert some of a firm’s profits for their own personal gain or benefit, such as the use of private jets, for example. This was recently highlighted by the IRS, which announced an audit of corporate jet usage and potential misuse by certain parties, including shareholders. These conflicts of interest can leave minority shareholders worse off, thereby reducing their valuation of the firm in the process.

While extensive evidence shows that corporate governance that regulates such conflicts of interest actually increases firm and equity valuation, the impact on shareholder risk (as measured by equity volatility, for example) remains largely underexplored – despite its critical role in financial economics, according to Alexandre Jeanneret, a Professor in the School of Banking and Finance at UNSW Business School.

UNSW Business School's Professor Alexandre Jeanneret said that when corporate governance is strengthened, this leads to a stabilising of a firm’s financial performance. Photo: supplied

“In particular, does higher equity valuation come at the cost of more volatile returns? The answer is not straightforward, as governance can influence the equity volatility of individual firms through various distinct channels,” says Professor Jeanneret, who recently co-authored How Does Corporate Governance Affect Equity Volatility? Worldwide Evidence and Theory together with Professor Louis Gagnon from the Smith School of Business at Queen’s University in Canada.

How corporate governance reduces equity volatility

The research paper, which is based on a study of 33,831 firms from 48 countries over the past 25 years, revealed some critical insights, according to Professors Jeanneret and Gagnon. Firstly, they observed a significant decline in equity return volatility following the implementation of corporate governance reforms, particularly those aimed at increasing board independence. More specifically, equity volatility dropped by almost one-fifth (to just over 10 per cent compared to the average firm’s equity volatility of 44.6 per cent) following the passage of corporate board independence reforms. “This finding underscores the direct impact of governance improvements on reducing the risk borne by shareholders,” said Professor Gagnon.

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Interestingly, this effect cannot be attributed to changes in the firms’ investment policies, profitability, asset risk, or capital structure. The research found that the key driver of this decline in equity return volatility is a drop in fixed operating costs, which Professors Jeanneret and Gagnon attribute to a reduction in the degree of “rent extraction” on the part of controlling shareholders following the passage of the reforms.

To illustrate, the authors provided an example of how controlling shareholder expropriation can impact equity volatility. “A firm has a cash flow equal to $10 this year, which either increases to $12 or decreases to $8 next year,” the authors explained in the paper. In both years, a majority shareholder might divert a constant amount of $2 for their own perks, which can be viewed as fixed operating costs (eg. maintenance of the firm’s private jet). The minority shareholders receive the balance, that is, $8 this year and either $10 or $6 next year. Next year’s cash flow received by minority shareholders thus varies by ±25 per cent, which corresponds to a volatility of 35 per cent.

“Now consider that a corporate governance reform is enacted and that managerial expropriation drops to zero in both years,” the authors explained. “Minority shareholders receive $10 this year and either $12 or $8 next year, so their cash flow will vary by ±20 per cent next year, which corresponds to a volatility of 28 per cent.” As a result, volatility of free cash flows to minority shareholders falls from 35 per cent to 28 per cent (or about one-fifth). When managers tend to divert a fixed dollar amount, the authors noted the reduction in expropriation following the reforms effectively levers down equity volatility.

Controlling shareholders may feel inclined to leverage profits for their own personal benefit, such as the use of private jets.jpg
Controlling shareholders may feel inclined to leverage profits for their own personal benefit, such as the use of private jets. Photo: Getty Images

Determining corporate governance effectiveness

The research paper also found that the impact of governance reforms is notably more significant among firms with characteristics that facilitate resource diversion, such as lower debt levels, higher cash reserves, smaller size, and a greater proportion of intangible assets. Professor Jeanneret said this suggests that the reforms are particularly effective in contexts where the potential for and severity of managerial misappropriation are higher.

The research employed a simple model in which “managerial rents” (the benefits extracted from a corporate by majority shareholders) are composed of two parts: a persistent component and a component that varies in proportion to the firm’s profits. “This framework demonstrates that the presence of a constant element in rent extraction has significant implications,” said Professor Jeanneret.

Specifically, he said it indicates that enhanced corporate governance leads to both an increase in equity valuation and a decrease in equity volatility. “This is consistent with our worldwide evidence,” he said. “When corporate governance is strengthened, it effectively curbs the constant aspect of managerial rent-seeking, thereby stabilising the firm’s financial performance and reducing the level of equity volatility.”

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Implications for organisations, boards and directors

The research has important implications for organisations, boards, directors and shareholders, particularly with regard to the practical implementation of robust corporate governance (such as board independence) in reducing equity volatility.

“Importantly, this risk reduction is not achieved at the expense of lower equity valuation; instead, it complements it by enhancing firms’ risk-return profile, as measured by their Sharpe ratio,” said Professor Jeanneret. For boards and directors, he said this translates into a dual responsibility: safeguarding not only firm value, but also the firm’s risk profile, thereby aligning with both shareholder value maximisation and risk mitigation.

He also observed that shareholders (especially minority ones) stand to benefit significantly from strengthened corporate governance, enhanced board independence and less volatile equity markets. “This stability is beneficial for minority shareholders who often face the brunt of managerial excesses and suboptimal risk-taking,” he said.

“For shareholders at large, the findings suggest a more predictable and less risky investment environment, which is more closely aligned with their long-term wealth maximisation objectives.”


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