This post comes to us from Camelia Kuhnen
of the Kellogg School of Management.
Business connections can mitigate agency conflicts by facilitating efficient information transfers, but can also be channels for inefficient favoritism. In my forthcoming Journal of Finance paper Business Networks, Corporate Governance, and Contracting in the Mutual Fund Industry, I analyze the extent to which these effects are present in the mutual fund industry, and measure their impact on the welfare of fund investors.
I construct a large and unique data set containing information about advisory contracts for all U.S. mutual funds during 1993 to 2002, as well as information about the identity of the directors of these funds during the same period. This data set tracks business relationships between mutual fund directors and advisory firms, as well as between advisory firms themselves. I identify 257 cases of funds that hired a new subadvisor between 1993 to 2002. These events are used to study which candidates (from a pool of about 1,000 firms each year) win subadvisory contracts from funds. I also study a sample of 216 open-end U.S. mutual funds newly created in 1998 to test whether the connections of potential candidate directors (3,005 individuals) influence the assignment of board seats by the primary advisors of these new funds.
I show that when mutual funds choose among candidate subadvisors, the more connected such a firm is to the directors of these funds through past business relationships, the more likely it is to win the contract. This effect holds even after controlling for the candidate’s reputation, degree of specialization in the investment objective of the fund, cost, and also for the connections between the fund’s primary advisor and the candidate. The preferential selection of connected subadvisors by directors is mirrored by the preferential hiring of connected directors by primary advisory firms when these firms create (sponsor) new funds. In contrast, I find that connections do not have an economically significant impact on investors’ bottom line.
The strong effects of business ties on reciprocal hiring by directors and managers that I document are consistent with both of the possible roles of connections – as means for efficient information exchange, or as channels for favoritism. Overall, my results suggest that the two effects of board-management connections on investor welfare – improved monitoring and increased potential for collusion – balance out in this setting.
The full paper is available for download here.