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Corporate capital flows to CEO cronies, but that’s not always a bad thing

Most Americans decry workplace cronyism—the practice of favoring friends—as unethical, unfair and unproductive.

In fact, it can be quite productive, according to new research by Ran Duchin, an associate professor of finance and Reimers Endowed Faculty Fellow at the University of Washington Foster School of Business.

Duchin’s study of capital allocation within large corporations confirms that more money flows to divisional managers who are socially connected to the CEO. It also finds that this is not necessarily bad for the bottom line.

CEO favoritism does lead to poorer performance at firms characterized by weak corporate governance. But in more complex firms that engage in a diverse range of industries, this same favoritism actually improves financial performance by speeding the flow of information to the top.

“In such companies,” Duchin notes, “connectedness facilitates information exchange and can foster trust between divisional managers and the CEO, resulting in greater investment efficiency and greater value in the end.”

Playing favorites

While the capital budgeting process is one of the most fundamental of corporate decisions, relatively little is known about this aspect of a firm’s inner workings.

To better understand the effect of managerial influence on investment decisions and firm value, Duchin and co-author Denis Sosyura of the University of Michigan constructed a database of divisional managers at more than 200 firms listed in the S&P 500. They then established each manager’s degree of social connection to the firm’s CEO, considering past education, former employment, and social connections such as club membership and service on non-profit boards.

This unique set of data introduced some revealing human context to the relationship between capital allocation and firm performance.

Duchin and Sosyura documented that managers with social connections to the CEO are allocated significantly more capital, controlling for division size, performance, investment opportunities, managerial ability and other characteristics. How much more capital? A divisional manager with a social connection to the CEO receives 9.2 percent more capital—which translates into approximately $5.3 million in additional annual resources at the average firm in the study.

The researchers established two primary ways in which connected divisional managers received extra capital. One-third of the extra capital results from CEOs appointing their connections to divisions that already commanded a lion’s share of capital. The other two-thirds results from the CEO increasing capital allocation after appointing his or her connections to lead a division.

Finally, Duchin and Sosyura determined that crony capital allocations in firms with weak corporate governance and captured boards of directors result in inefficient investment and reduce firm value. On the other hand, social connections are linked to greater investment efficiency and firm value at complex firms that operate in many different industries and have to navigate what academics call “information asymmetry.”

Networking pays

From a study that offers variable findings depending on the organizational context, one conclusion is universal: networking pays off, in every case.

It’s not exactly a new notion. But Duchin’s findings provide even more reason to connect with classmates while in school, to broaden personal networks at work, and to cultivate friendships—or at least healthy acquaintances—in social and organizational settings.

For stakeholders of organizations that suffer from lax corporate governance and weak boards of directors, Duchin advises challenging senior management on the preferential allocation of resources. Otherwise, this favoritism is likely to serve individual benefactors at the expense of the organization overall.

On the other hand, Duchin also suggests that we consider our societal opinion of cronyism within a bit of context. In the kind of large organizations that operate in a diversity of industries and locations, a CEO’s social connections appear to produce more efficient use of corporate capital.

“As a society, we believe that equal opportunity is a virtue. We view social connections driving capital allocations as a bad thing,” Duchin says. “But the essence of connectedness is not all bad. While it can breed inefficiencies, it can also facilitate information exchange and give rise to greater trust.”

Divisional Managers and Internal Capital Markets” is published in the October 2013 Journal of Finance.