Does good governance lead to better performance? The answer is not as clear-cut as previous studies would suggest.
Good governance is a team activity with its primary process being one of collective sense-making. That was the view expressed by Dr Robert Kay, executive director and co-founder of Incept Labs, when addressing delegates at the Australian Institute of Company Directors’ (AICD’s) annual conference in Kuala Lumpur in May.
Discussing the findings of a recent report backed by the AICD titled, When does good governance lead to better performance? Kay outlined the key findings of the study which he said represented a significant departure from the way in which the topic of good governance has been researched in the past.
Highlighting limitations to the way the topic has previously been approached, Kay said because the study of governance requires complexity and a vast number of variables, “the use of traditional research methods may often be a key limiting factor in getting to the heart of what good governance is and how it can be improved”. Therefore, the study aimed to explore what constituted “good governance” using the findings from interviews with 100 chairs in the listed, private, not-for-profit and public sector space as well as the introduction of heuristics that encouraged a different perspective.
The report begins by examining the way in which the topic of good governance has been explored previously and highlighted some of the assumptions that have limited the way the topic has been discussed. Key to this, said Kay, is that despite the plethora of academic articles that have claimed to examine the relationship between good governance and better performance, very few researchers appear to have actually spoken to anyone on a board in their studies. This leads to what Kay described as a “black box” approach to understanding how governance takes place within the boardroom, i.e. examining the functionality of an application without peering into its internal structures or workings.
Another critical factor is that previous studies have been limited to the board as a unit but should be conceived of the board and the executive leadership team. “Whilst this may appear to conflict with the structural notions of independence, independence was overwhelmingly viewed as a mindset and characteristic of the individual by the chairs,” he said.
Kay told delegates that these two points have to date, influenced our understanding of the relationship between good governance and performance, however, they present three major challenges to our ability to understand what good governance might actually be. The first is that there is a disproportionate focus in previous studies on listed companies. This, he said, limits our understanding of other sectors. The second is that there is extensive use of proxy measures to assess the presence of good governance and to define performance without first examining the nature of causality between the two. And finally, there is an assumption that the relationship between good governance and performance looks the same regardless of factors such as sector, economic conditions and the stage of the organisational life cycle.
“Based on this research, my view would be that the relationship between governance and performance is a little bit more complex,” he said. As a result, Kay said the purpose of his study was to reposition the question of whether good governance leads to better performance as it fails to deal with the organisational realities that board members experience and assumes a one size fits all approach.
Instead, the study’s aim was to ask the question: “Under what circumstances does good governance lead to better performance?” while examining what constitutes “good” in different contexts and how governance is conceived in different contexts. “This reframing highlighted the considerable complexity involved in understanding the drivers of good governance,” he said.
The Holling Cycle
In order to make sense of the data captured in the research, Kay said the research collated would need to be viewed in a way that emulates the changing dynamics of the workplace.
“If the world was constant, if circumstances never changed and everything remained the same, we probably wouldn’t need governance. We wouldn’t need a guiding hand to take us through the eddies of the future, every day would be the same as the next. But the world does change and so if we are to understand the causal relationship between governance and performance, we are going to need a conceptual lens, a way of looking at the problem that accounts for those circumstances that we might find ourselves in,” he said.
To provide this “conceptual lens”, Kay used the Holling Cycle as a framework to categorise the different circumstances boards faced as well as illustrate the characteristics associated with different circumstances. The Holling Cycle is a model of cyclical change that was developed by Canadian ecologist C.S. Holling. It is used to help guide the choice of strategic stance appropriate to different environmental circumstances and is divided into four phases or states through which a system is continuously travelling. The phases are:
- Conservation – The most stable phase during which the focus is on consolidating the organisation’s position in the market and aligning organisational investments and processes to service it in an increasingly efficient manner.
- Release – This phase follows a market disruption that may be due to a change in consumer preferences; a technical innovation rendering existing products or services obsolete; or just simply the result of poor management.
- Reorganisation – The release phase is followed by the need for reorganisation, during which time existing assets and systems are abandoned or sold thereby freeing up capital for re-investment. This phase is associated with high levels of innovation, uncertainty and instability with old business models that were destroyed during the release phase, and have yet to be replaced by a new dominance approach.
- Exploitation – The fourth and final phase. Here, a multitude of small activities that characterised the reorganisation phase are reduced to a few dominant models that prove most effective at capturing the available resources and maximising value from the environment. Innovation is also prevalent in this phase but is more focused on finding increasingly effective and efficient production processes to underpin the new business models.
“All the phases of the cycle are inevitable, necessary and, most importantly, unavoidable,” said Kay. “ The question in terms of what constitutes ‘good’ governance is whether the decision-making body of the organisation has the capacity to effectively manage the different challenges inherent to each of the phases.”
Theory and experience
Kay explained that in order to try to make sense of the data captured during the interview process, the Holling Cycle was used to categorise the different circumstances boards faced as well as illustrate the characteristics associated with these different circumstances.
He explained that the highest proportion of stories (40 per cent) described instances of governance characteristic of a conservation phase. Kay added that he would have expected more conservation stories in the sample because for the vast majority of the time, boards will be dealing with decisions involving the conservation of business as usual.
Kay added that when the sample was split in terms of those stories that chairs considered to be positive and those that were negative, the release phase was associated with a significantly higher percentage of negative stories (55 per cent) compared with the others. This breakdown, Kay added, presents an interesting paradox and the first distinguishing characteristic of good governance.
“The release phase of the Holling Cycle is inevitable in all natural systems, as such, while it may be within the power of the board to influence the timing and extent of the ‘release’, it is not something that can be avoided altogether. Therefore it seems logical that the board’s capacity to pre-emptively and successfully read the environment and guide the organisation through a release phase is critical to the notion of good governance,” he said.
However, as with all theories, the answer to seeking good governance is not that straightforward, Kay added. He said that while a crisis may expose the quality of governance in an organisation to the outside world, the experiences of those involved would suggest that the more frustrating governance problems were experienced when things were going well, such as introducing new things when there is no particularly compelling reason to change what was being done.
“It is from these observations that three critical factors emerge that are crucial to the ability of the board and executive team to deliver a superior outcome,” Kay said. They are:
- Perspective – The ability to ensure an accurate assessment of the organisational situation given its complexity and ambiguity.
- Scale – The ability to appropriately frame or understand the implications of decisions taken at one level of the organisation on activities and performance at a different level of the organisation.
- Prediction – The ability of the team to adequately predict changes in the environment of the organisation at a future point in time.
“These factors represent human failings,” Kay said. “The limitations of human psychology, in the form of personal bias, hubris and the simple fact that one cannot be good at everything requires a team to overcome these difficulties.
“The notion that good governance is a team activity arises because, through an effective team, we can to some extent overcome these limitations, or at least minimise their impact,” he added.
Defining the team
In order to define what a team might be, Kay was keen to stress that the chairs interviewed were very clear about the qualities that were required. “It is not just a group of people thrown together,” he said. “Without an effective team, the ability to align the decision-making approach to circumstance will be reduced, with the quality of governance suffering as a result.”
The research feedback found that there were certain qualities that must be held in combination in order to be effective. They were:
- A diversity of skill and experience.
- An independent mindset and willingness to question and challenge respectfully.
- Openness to alternatives.
However, while these factors were considered to be crucial to effective corporate governance, they tend to be viewed in a piecemeal fashion. “Most commonly, they are reduced to structural proxies that, while easy to measure, in the view of the chairs are too loosely related to ‘good’ governance.” Kay added that while these features of the team were critical to their capacity to make sense of the complexity and challenges of uncertainty, it is more accurate to view good governance as a collective cognitive process that is dependent on the effective functioning of the team.
The research also showed that building and maintaining the right type of team is difficult and many chairs indicated a “sweet spot” where the many variables involved came together to produce an effective decision-making unit. Many also recognised that this was difficult to maintain over time and that while the need for skilled, experienced directors and increased diversity on boards is well documented, it was no guarantee of good governance.
In fact, good governance is more than just different skills and diversity of perspective, it involves the creation of trust between members of the board and the executive, Kay said. “Independence of mindset was key, but often seen as inaccessible without trust.”
Governance and performance
Drawing the presentation to a close, Kay said the concept of team and trust and the relationship between them presented significant measurement issues to understanding the relationship between good governance and performance.
He added that attempting to quantify the relationship between good governance and performance was difficult due to the vast range of variables involved.
He stressed that the research merely “scratched the surface” in trying to identify the answer as to whether good governance leads to better performance. Instead it was directed towards trying to identify the factors that contribute to the relationship between governance and performance.
As a result, the findings dealt with what directors actually think about governance and the concerns they have to deal with and led the research in a different direction, particularly in terms of defining the concept of “good”.
Ultimately, the research shows that chairs consider good governance to be a team activity, with that team being inclusive of both the board and executive. This in itself contrasts with agency-based models about governance to date, the research states.
“Good governance is more than risk management. It involves accepting, dealing with and capturing value from uncertainty. It also changes, depending on the context,” Kay said.
“It is also clear that governance is a quintessentially human activity and subject to all the imperfections and frailties that it engenders. Good governance then provides a pathway to dealing with these limitations,” the research concludes.
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