1 University of Exeter Business School Corporate Governance: Applying Social Network Theory and Analysis Professor Joanne Horton

2 SNA as a research methodology If we ask all the teenage girls in a school-year about their romantic partners in the last year, we may get the following result Each respondent had the same number of partners. The data does not tell us an interesting story

3 SNA as a research methodology However, if we connect all of the data into a network… We regain the context in which the romantic ties took place Can show differences between the ties (visibility, power, reputation, etc.)

4 Uses of network analysis Tracing the connections between the Al Quaeda cells that committed the 9/11 terrorist acts shows who are the possible leaders.

5 Uses of network analysis Visualisation of Wall Street ‘players’ exposes the high degree of connectivity

6 Connectedness: Applying Social Capital Theory Social Capital –Social capital is a metaphor about advantage -people who do better are somehow better connected –Certain people (or groups of people) do better in the sense of receiving higher returns to their efforts Research shows that social ties help individuals gain access to: –information about job opportunities, –new innovations, –provide a finer grained information set.

7 Social Capital: Better connected? Differing views, different context – what does it mean to be better connected? Holding a certain position in the structure of these exchanges can be an asset in its own right. –The asset is social capital, in essence a concept of location effects in differentiated markets –LOCATION LOCATION LOCATION!

8 Location, Location, Location Holding a certain position –The asset is social capital, in essence a concept of location effects in differentiated markets Location of actor will determine: –The timeliness of information –Type of information, e.g. private information –Quality of the information e.g. credibility –Amount of information available –How much control over the information flow –The ability to create information arbitrage Location of actor captures: –Status, prestige, power, influence –Entrepreneurial opportunities

Location Measures Centrality –Degree, Closeness, Bonacich centrality, Betweenness Brokerage –Dyadic constraint (Burt) –Betweenness Closure –Dyadic constraint 9

10 Degree, Closeness Degree –Number of direct ties –Actors who have more ties to other actors may be advantaged positions –They may have alternative ways to satisfy needs, and hence are less dependent on other individuals –Access to, and be able to call on more of the resources of the network as a whole –Effective measure of an actor's centrality and power potential is their degree. Closeness –Captures the centrality of an individual and reflects how near that individual is to all others in the social network –More access:- Resources from these others Use communication effectively Monitor the information flow Better view of the activity in the network Reflect status, power and influence of the actor

11 Closeness G A B C H E D F I K L J ClosenessDegree – A – B – C – D – E – F – I – K – G – H – J – L1

Bonacich, Brokerage Bonacich: –proposed that both centrality and power were a function of the connections of the actors in one's neighbourhood. –The more connections the actors in your neighbourhood have, the more central you are. –So being connected to neighbours with more connections makes one powerful. This is a straight-forward extension of the degree centrality idea. Brokerage (Bridging the Gap!) –Burt by bridging disparate unconnected groups of individuals in a network gain benefits Access to a wider diversity of information Early access to that information More control over information diffusion, can easily lie –The information arbitrage provides them with the opportunity to create new innovations and access to economic opportunities 12

13 Brokerage = entrepreneur Where did the M-16 come from? Eugene Stoner –An American armament expert describes Eugene, the engineer who developed the M- 16 assault rifle as ‘an engineering genius of the first order’ –Another described him as ‘the most gifted small-arm designer since Browning” –Eugene had a high level of brokerage Moving from Airline industry to armoury

14 Google 20% of an individuals working time spent outside of the corporation From that 20% - 50% of the Google best ideas generated Moving outside of immediate network: –Creating structural holes –Obtaining new information sets

My Research Not reinventing wheel re: apply social capital theory and network measures Create network of corporations through board interlocks (observable ties) Focus on the gatekeepers (Coffee, 2001) –Directors (executive and non-executive) –Analysts –Auditors 15

16 Directors Resources or Power?: Social Networks, Executive and Outside Director Compensation (2012) Horton, Serafeim and Millo Findings: –Network comprises 4,278 firms, 31,495 directors and 111,114 directorship-years –An increase in one standard deviation in closeness increases CEO compensation by approximately £20,500 –A move from the 10 th percentile to the 90 th percentile (closeness) increases executives compensation by approx 9% –A move from the 10 th percentile to the 90 th percentile (brokerage) increases executives compensation by approx 12% –An increase of one standard deviation in closeness increases outside director’s compensation by 6%. –A move from the 10th percentile to the 90th percentile based on the brokerage position increases compensation by approximately 10%.

17 Directors: Resource or Power? An increase of one standard deviation in the firm’s connectedness increases the firms’ two- year average future stock return by 4%, an estimate that is economically significant. One standard deviation increase in the firm’s connectedness increases this three-year average MTB by approximately 19 points. An increase of one standard deviation in the firm’s connectedness variable increases ROA by approximately 0.22 points.

18 Analysts Security Analyst Networks, Performance and Career Outcomes (2012) Horton and Serafeim. Create network of both directors and analysts (US data) Find: –An analyst with an excellent brokerage position and therefore in the 90 th percentile has 4.65% lower forecast errors compared to an analyst at 10 th percentile –For example, Meredith Whitney, one of the most influential banking analysts in Wall Street after predicting the collapse of the banking sector scores at the 90 th percentile. –Better connected = leaders in terms of forecast timeliness (4 days earlier than other analysts) –Less likely to lose their job –More valuable to brokerage houses

Auditors Network analysis: Audit partner independence and audit quality (2013), Horton, Serafeim and Wood Create network of both directors and audit partners (French and German data) Using network measures of power, the paper identifies which audit partners occupy the most powerful positions Determines whether these network positions, enable the audit partner to deliver better quality audits (greater independence leads to better quality audits). ‘‘power’’ reflects the capacity to influence others and the ability to resist others’ influence Find: AP in powerful positions are positively associated with higher quality audits but not higher audit fees –abnormal working capital accruals –frequency of firms reporting small earnings increase –accounting conservatism 19

Other Applications Creating a workable definition of director independence using network theory Influence of networks on banking crisis –Understanding: group think, herding, group polarization etc. –PhD student investigating Irish banking crisis Implications of creating social networks: –PhD student – retail FX trading following the creation of social networking sites 20