Kerin

How long should a non-executive director sit on a board? Professor Paul Kerin considers the optimum duration and the impact it has on shareholder value.

The nine-year itch

In my September 2015 column, I asked: how long should CEOs stay? Naturally enough, I’ve since been asked how long non-executive directors (NEDs) should stay on board. In contrast to their work on CEO tenure, economists generally haven’t looked at the impact of individual NED tenure on shareholder value. Instead, they have focused on identifying the optimum average NED tenure of boards at a point in time. Why? While it may dent our egos, the fact is that individual NEDs have much less impact on shareholder value than CEOs.

Economists have analysed what investors’ votes – both in the marketplace and at AGMs – say about NED tenure. The weight of evidence suggests that optimum average NED board tenure is about nine years. To be clear, this doesn’t mean that no individual NED should serve more than nine years: a board with a nine-year average NED tenure will generally contain some longer-serving NEDs.

Research generally finds that shareholder value rises with average NED tenure up to nine years and then falls. A typical result is that a one-year increase in a board’s average NED tenure raises shareholder value by 0.5 per cent if the existing average is three years, but reduces it by 0.5 per cent if the existing average is 15 years. These findings imply that investors believe that boards make the best key decisions when average NED tenure is about nine years. Research on specific key decisions supports this belief. For example, market reactions to mergers and acquisitions (M&A) announcements are more negative if a board’s average NED tenure exceeds nine years. Evidence also indicates that such long-tenured boards are less willing to change strategic direction or replace underperforming CEOs.

Underlying these findings is the basic trade-off between the benefits of longer tenure and the potential costs (such as loss of independence and/or enthusiasm and less willingness to re-examine past decisions that NEDs were involved in).

Institutional investors and governance advisers are focusing more closely on average NED tenure. For example, State Street Global Advisors has stated that it may vote against a NED’s re-appointment if the NED’s tenure or the board’s average NED tenure is “excessive” and/or it identifies that the board needs “refreshment”. Likewise, the proportion of NEDs with tenure exceeding nine years now negatively affects proxy adviser ISS’s governance ratings. Australian boards, if anything, err on the short side of NED tenure. Average NED tenure for S&P/ASX 500 companies is 8.4 years. For ASX 200 companies, it’s about six years, although about 20 per cent of NEDs have served more than nine years.

Of course, nine years is just the overall average. Optimum average NED tenure varies with firm-specific, industry-specific and NED-specific factors. For example, it is greater for firms in which the value of accumulated firm-specific and industry-specific knowledge is high and long-lasting – such as firms with high complexity (large, diversified and/or R&D-intensive) that operate in less dynamic environments. In addition, if a board’s average NED tenure exceeds nine years simply because it is lucky enough to have a relatively high proportion of long-serving NEDs who are delivering great value, then of course it should retain them.

As always, the research findings do need to be interpreted carefully. There’s nothing magical about nine years per se. It’s really just the average by-product of well-governed boards. When good boards adopt good governance practices – such as retaining a small core of high-value, long-serving NEDs while regularly introducing high-quality new talent – their average NED tenure will often be about nine years.

Therefore, boards should focus on good board practices, not their by-product (average tenure).

Nevertheless, the nine-year benchmark is a useful check. If average NED tenure is significantly different to nine years, it is worthwhile asking why. Is it because we’ve kept long-tenured NEDs past their use-by dates? Or have we made a sound judgement that the benefits of keeping them on board outweigh the opportunity costs (the forgone opportunities to refresh and diversify board membership, introduce new skills and gain new perspectives)? Revisiting these questions at least once a year is a valuable discipline.