EFA

Eastern The
Financial
Finance
Association Review
The Financial Review 33 (1998) 1-16

Board Composition, Managerial

Ownership, and Firm Performance: An
Empirical Analysis
Scott W. Barnhart
Florida Atlantic University

Stuart Rosenstein"
University of Colorado at Denver

Abstract

Our objective is to examine the sensitivity of simultaneous equations techniques in

corporate governance research. We model Tobin's Q, board composition, and managerial
ownership using a three-equation instrumental variables approach, with two specifications
and four instruments. We find that the variables are jointly determined. However, results
depend strongly on the specification of the model and the instruments. We conclude that
results using simultaneous equations methods must be interpreted cautiously, OLS estimates
should not be casually dismissed, and that sensitivity analysis is essential when estimating
an empirical model whose structure is uncertain.

Keywords: simultaneous equation models, cross-sectional methods, corporate governance

JEL classifications:C31lG34

1. Introduction
Corporate governance research has identified a variety of mechanisms that are
intended to ensure that management teams act in the best interests of shareholders.
These include internal mechanisms, such as the board of directors, ownership by
managers, and executive compensation;and external mechanisms such as the market

*Corresponding author: College of Business Administration, Campus Box 165, P.O. Box 173364,
Denver, CO 80217; Phone: (303) 556-6518, Fax: (303) 556-5899, E-mail: srosenstein@castle.cudenv-
er.edu

1
2 S. W. Bamhart, S. Rosenstein/The Financial Review 33 (1998) 1-16

for corporate control, institutional ownership, and the level of debt financing. Re-
searchers have also recognized that governance mechanisms may be affected by
the firm’s financial success ( e g , Gilson, 1990; Hermalin and Weisbach, 1988;
Kaplan and Reishus, 1990). Thus, performance and governance structures are jointly
determined.
A number of recent empirical papers have used simultaneous equations meth-
ods, such as two- and three-stage least squares to model the relations between
corporate governance variables and firm valuation (e.g., Agrawal and Knoeber,
1996; Bathala, Moon, and Rao, 1994; Chung and h i t t , 1996; Jensen, Solberg, and
Zorn, 1992). However, current theory provides little guidance in the specification
of corporate governance models, and the econometric literature points out that
misspecification of any of the equations in a system may result in serious bias in
all of the equations. In fact, ordinary least squares (OLS) tends to be less sensitive
to misspecification error (Rhodes and Westbrook, 1981).
This paper investigates the combined effects of ownership structure and board
composition on corporate performance, using an instrumental variables approach.
This approach is more general than three-stage least squares, and more importantly,
it allows the final results to be subjected to sensitivity analysis to changes in the
instruments.
The evidence indicates that inside ownership, board composition, and firm
performance are jointly determined. However, estimates from each equation in the
three-equation system are quite sensitive to reasonable changes in both the overall
model specification and the first-stage regressions. In fact, coefficient estimates and
test-statisticsvary widely with changes in the first-stage regressions, even for identi-
cal model specifications.
The empirical results indicate the sensitivity of corporate governance models
to various empirical methods and specifications. For example, an OLS specification
that includes industry dummy variables, similar to Morck, Shleifer, and Vishny
(1988), supports their findings of a curvilinear relation between managerial owner-
ship and Tobin’s Q. However, an OLS model that omits industry dummies shows
no relation between managerial ownership and Q . In addition, simultaneousequations
models with and without industry dummies also show no relation between managerial
ownership and Q. The results do provide weak evidence of a curvilinear relation
between the proportion of outside directors and firm performance.
Most importantly, the results strongly suggest that sensitivity analysis is essen-
tial in most corporate governance research, where no formal structural model has
been developed and a variety of models exist that are similar in concept but different
in specification, functional form, and control variables. In situations such as this,
where the structure of empirical models is uncertain, systems estimation results
should be interpreted cautiously, sensitivity analysis should be conducted, and OLS
results should not be casually dismissed.
Section 2 reviews the theoretical and empirical research on the relationship
between corporate governance structure and corporate performance, concentrating
 S. W. Barnhart, S. RosensteidThe Financial Review 33 (1998)1-16 3

on work that addresses the endogeneity problem. Section 3 describes the data set
and variables. Section 4 outlines the empirical methods. Empirical results and
comparisons to previous work follow in section 5, with conclusions and limitations
in section 6.

2. Corporate governance structure, corporate performance, and

the endogeneity issue
Morck, Shleifer, and Vishny (1988) examine the relation between firm valua-
tion, as measured by Tobin’s Q, managerial ownership, and the composition of the
board of directors. Using a single equation model, they fit a polynomial function
in which Q first rises as ownership increases to 5%, then falls for ownership
levels between 5% and 25%, and finally rises as ownership continues to increase.
McConnell and Servaes (1990) provide supporting evidence, finding a significant
quadratic relationship between Q and managerial ownership.
Several recent papers model these relationships using simultaneous equations
methods.’ For example, Agrawal and Knoeber (1996) examine the interrelationships
among seven “control mechanisms” using a six-equation simultaneous equations
model. Using OLS to estimate each model in their system, they find that ownership
by officers and directors is a significantly positive determinant of Q, the proportion
of outsiders on the board is significantly negative, and ownership by institutions
insignificant. Using three-stage least squares (3SLS) the results change drastically;
ownership by officers and directors and the proportion of outside directors are now
insignificant, while institutional ownership is now significantly positive.
Chung and M i t t (1996) model CEO ownership, CEO compensation, and Q
in a simultaneous equations framework using a log-linear specification. Using both
OLS and 3SLS, they find that the three variables are jointly endogenous, with
Q being a significantly positive determinant of both CEO ownership and CEO
compensation, and CEO ownership a significantly positive determinant of Q. How-
ever, in the Q equation the 3SLS coefficients for CEO ownership are twenty times
larger than the OLS estimates.
Jensen, Solberg, and Zorn (1992) examine cross-sectionaldifferences in insider
ownership, debt, and dividend policies. Presenting only 3SLS results, they find that
levels of insider ownership differ across firms, with high inside ownership firms
choosing lower levels of both debt and dividends.
Bathala, Moon, and Rao (1994) examine the effects of institutional ownership
on managerial ownership and debt policy. Although their OLS regressions show no

In addition, a number of studies recognize the joint-endogeneity issue and address it in a variety of
ways without resorting to a simultaneous equations framework (e.g., Hermalin and Weisbach, 1988,
1991; Kaplan and Reishus, 1990; Gilson, 1990 Baysinger and Butler, 1985; Demsetz and Lehn, 1985;
and Kole, 1996).
4 S.W.Barnhart, S. Rosenstein/The Financial Review 33 (1998) 1-16

relation between debt ratio and managerial ownership, their 2SLS models show that
debt ratio and managerial ownership are jointly determined.
The joint determination of the variables leads to misspecification of OLS
models. However, in the above papers no formal structural model of firm behavior
is specified, leading to questions about the robustness of simultaneous equations
techniques. The final results of these techniques depend critically on the instruments
used in first stage regressions and the final specification of the second stage. The
problem is exacerbated by the need to add exogenous variables for the purpose of
identification. Thus, the main goal of this paper is to examine the sensitivity of
empirical models to “reasonable” changes in both frrst and second stage specifica-
tions.

3. Data and variable selection

3. I . Data
The initial data set is the 1990 Standard and Poor’s 500. After eliminating
regulated utilities, financial institutions,2 and observations with missing data or, as
in McConnell and Servaes (1990), observations with severe outliers, the final sample
contains 321 firms.
Financial statement data is obtained from the Industrial Cornpustat tapes. Cor-
porate governance data, such as board composition and managerial ownership are
obtained from a proprietary database supplied by Institutional Shareholder Sewices
(ISSj.3

3.2. Variable selection

As in most recent board of directors research, the proportion of nonaffiliated
or independent outside directors (OUT) is used in empirical specifications of board
composition.These are directorswho have no observablebusiness or familial connec-
tions with the company (e.g., Baysinger and Butler, 1980; Byrd and Hickman, 1992;
Gilson, 1990; Lee, Rosenstein, Rangan, and Davidson, 1992;Rosenstein and Wyatt,
1997; Shivdasani, 1993).
Managerial ownership (OWN) includes the percentage of shares owned by
officers and directors as a group, including shares for which officers have shared
voting power, plus shares available for purchase and options or warrants exercisable

Specifically, we exclude all fm with SIC Codes 4911 (electric services); 4922,4923,4924 (natural
gas transmission and distribution);and 4941 (water supply). We also exclude all firms with two-digit
SIC Codes 60 (commercial banks and savings institutions); 61 (federal credit agencies, personal credit
institutions, short-term business credit, mortgage bankers, and financial services); and 62 (securities
brokers and dealers, investment advice); and 64 (insurance agents, brokers, and service).
Only one year of ISS data are available to us.
 S.W.Barnhart, S.Rosenstein/The Financial Review 33 (1998)1-16 5

within sixty days of the proxy date. Both board composition and managerial owner-
ship data come from ISS.
Several other variables that describe governance structure may bear on f m
performance. Overall board size (BDSIZE) is used as a measure of board cohesive-
ness (Yermack, 1996).Institutional holdings of common stock (INST) are a measure
of institutional monitoring (Black, 1992a, 1992b, 1992~).These data also come
from ZSS.
Research and development (RD) and advertising (ADV) expenses are added,
both relative to total assets, as control variables to make results more easily compara-
ble to prior research (e.g., Hermalin and Weisbach, 1992; McConnell and Servaes,
1990 Morck, Shleifer, and Vishny, 1988). Financial leverage is controlled for with
the debt-to-total asset ratio (DT); f m size is controlled for with total assets (TA).
The measure of firm performance used is Tobin’s Q. The method developed
by Chung and Pruitt (1994) is used to measure Q. As in Morck, Shleifer, and Vishny
(1988) and McConnell and Servaes (1990), one specification of the model includes
dummy variables representing three-digit SIC codes.

4. Empirical methods

4.1.Methodological issues
It is well known that OLS estimation of simultaneous equations models yields
estimators that are biased and inconsistent? Although the 2SLS and 3SLS estimators
are consistent (with the 3SLS estimator also being asymptotically efficient), these
estimators are biased and their exact distributions are known only for special cases,
leading to questionable point estimates and statistical tests. For correctly specifzed
models, the choice of instruments involves substantial tradeoffs between bias and
efficiency (Phillips, 1980).
In addition, Pindyck and Rubinfeld (1991, p. 315) point out that a serious
specification error in one equation can affect the parameter estimates in the other
equations. Thus, systems estimation “involves a trade-off between the gain in
efficiency and the potential costs of specification error.”
Rhodes and Westbrook (1981) examine the exact density functions of OLS
and 2SLS estimators when exogenous variables are wrongly excluded. They find
that under misspecification, OLS may be the superior estimation technique.
In empirical corporate governance research, model specifications are often ad
hoc and do not come from well-specified theoretical models. Thus, great care must
be taken to examine the sensitivity of the results. The methodology in this paper is
developed to investigate the sensitivity of systems methods to changes in specifi-
cation.

See Judge, Hill, Gnffiths, Lutkepohl, and Lee (1982, p. 398).

6 S.W. Barnhart, S. RosensteidThe Financial Review 33 (1998) 1-16

4.2. Empirical methods

Firm performance, managerial ownership, and board composition are examined
within a three-equation simultaneous system using an instrumental variable tech-
nique. The seemingly unrelated regressions technique is used to take into account
cross-equation covariances, i.e., 3SLS. The primary hypothesis is that each of the
governance variables of main interest-Q, OUT, and OWN-is a function of the
other two and several control variables. Board size (BDSIZE) and institutional
ownership (INST), both of which are correlated with firm size, are added as additional
corporate governance variables. These variables, along with the control variables,
ADV, RD, DT, and TA, enter the system lagged one period to ensure exogeneity.
As most of these variables are highly serially correlated, this procedure does not
alter significantly the explanatory power of the regressions. Specifically, the system
is modeled as:

Equations (1) and (3) are exactly identified and equation (2) is overidentified.
In the second specification of equations (1)-(3) above, three-digit SIC dummy
variables are added as additional exogenous variables. One hundred twenty-six
different industry classifications are obtained.
To examine the sensitivity of the results, four separate sets of instruments are
developed for the three endogenous variables. The first set of instruments (IV1) is
simply the set of exogenous variables (i.e., ADV, DT, INST, TA BDSIZE, and
RD), all lagged one period, along with the industry dummies and one lag of Q. In
the second set (IV2), a simple stepwise regression procedure is used to cull variables
from the first instrument set (IV1). The third set of instruments (IV3) includes five
lags of each of the variables listed above, except for only one lag of BDSIZE and
INST.’ For the fourth instrument (IV4), a stepwise regression procedure is again
used to remove variables from the third instrument set. This procedure yields four
similar sets of instruments for each of the two similar specifications.
The estimation of a simultaneous system using managerial ownership and the
proportion of independent outside directors as dependent variables presents an
additional econometric problem, not previously addressed in the corporate gover-
nance literature. Each of these variables ranges from zero to one, but there is no
guarantee that estimators from a linear model will fulfill this restriction. To address
this issue, a logit transformation is used for equations where managerial ownership
and the proportion of independent outside directors appear as dependent variables.
Equations (2) and (3) above are estimated using weighted least squares to correct

The available ISS data include only one lag of BDSIZE and INST.
 S. W. Bamhart, S.Rosenstein/The Financial Review 33 (1998) 1-16 7

for the heteroskedasticity that accompanies logit transformations. Once this adjust-
ment is made, OLS can be used and the standard assumptions concerning the t- and
F-statistics are valid (Cox, 1970, p.34). See the appendix for details.
The 3SLS systems are estimated by first obtaining the first-stage estimates of
the three endogenous variables, i.e., Q, OUT, and OWN. The estimate of Q is used
directly as an independent variable in the OUT and OWN equations. However, the
estimates of the two dichotomous variables, OUT and OWN, obtained from the
logit regressions are converted back to their original proportions (see the appendix).
These estimated proportions and estimates of Q are then used as independent vari-
ables to obtain second-stage estimates where, again, the OUT and OWN equations
are estimated in logit form. In the usual manner, these two-stage estimates and the
original explanatory variables are used to construct a 3 x 3 covariance matrix that
is then used to obtain generalized third-stage estimates (see Greene, 1993, pp. 610-
6 12).6Goodness-of-fitfor each separate equation is measured using the R2developed
by Carter and Nagar (1977).

5. Empirical results

5.1. Sample characteristics

Sample characteristics are presented in Table la. Q ranges from 0.048 to 4.47,
with a mean of 2.01. Proportions of independent outside directors, managerial
ownership, institutional ownership, advertising expenses and research and develop-
ment expenses are similar to those reported by Morck, Shleifer, and Vishny (1988).
Most notably, there are very few insider-dominatedboards and managerial ownership
is relatively low, with a mean of just 6.44%.Institutional ownership is about 54%
for these large corporations.
The simple correlation matrix, shown in Table lb, indicates that Q is negatively
related to OUT, and positively related to OWN. Managerial ownership is negatively
related to OUT and INST, suggesting a substitution effect. Structural factors, such
as firm size for example, may underlie several of these relationships.
Table 2 presents the joint bivariate frequency distributions of Q with OWN and
OUT, respectively. The data indicate a nonlinear relationship between managerial
ownership and Q, similar to those reported by Morck, Shleifer, and Vishny (1988)
and McConnell and Servaes (1990). Ownership is clustered in the 0-5% range.
Thus, inferences with respect to managerial ownership greater than roughly 25%
must be made with caution due to the paucity of data over that level. Likewise, few
firms have fewer than 30% independent outsiders. Over the relevant range of 30-
loo%, the relationship between board composition and Q appears curvilinear.
This GLS procedure is identical to that which differentiates 2SLS from 3SLS. Our approach is more
general than 3SLS in that the instruments for the endogenous variables are not limited to the exogenous
variables in the model.
8 S.W. Barnhart, S. RosensteidThe Financial Review 33 (1998) 1-16

Table 1
Descriptive statistics
The sample includes 321 f m s taken from the 1990 Standard and Poor’s 500. Financial f i m s and utilities
are excluded from the sample. Data for Tobin’s Q, advertising expense-to-total assets (ADV), research
and development expense/total assets (RD),long-term debt-to-total assets (DT) and total assets (TA)
are from Cornpustat. Data for the percentage of outside directors (OUT), managerial ownership (OWN),
size of the board of directors (BDSIZE), and institutional ownership (INST) are from Institutional
Shareholder Services.

Variable Mean Standard Deviation Minimum Maximum

Panel A: Descriptive Statistics

Q 1.006 0.742 0.048 4.470

OUT 60.100 17.930 0.000 93.750
OWN 6.440 9.690 0.000 66.000
BDSIZE 12.420 3.440 4.000 33.000
INST 53.890 14.760 1o.Ooo 98.000
ADV 0.021 0.045 0.000 0.337
RD 0.023 0.035 0.000 0.180
DT 0.188 0.161 0.000 1.450
TA 9344.940 21070.080 129.260 180236.000

Panel B: Correlation Matrix

OUT OWN BDSIZE INST ADV RD DT TAQ

Q -0.173** 0.119** 0.083 -0.085 0.327** 0.056 -0.020 -0.170**
OUT -0.237** 0.091 0.114** -0.040 -0.012 0.027 0.032
OWN -0.179** -0.359** 0.100 -0.114** 0.101 -0.105
BDSIZE -0.088 0.022 -0.126** 0.039 0.165**
INST -0.036 0.172** -0.009 0.052
ADV 0.083 -0.OOO -0.097
RD -0.245** -0.065
DT -0.009

**Indicates statistical significance at the 0.05 level.

5.2. Regression results

Results for each of the three equations using the system estimation procedures
are shown in Tables 3A-3C. The Q equation is presented in Table 3A. The first
two rows show the Rzfor the fist-stage regressions used to obtain estimates of the
other two endogenous variables in the equation. Columns 1-5 show results for the
model that does not include industry dummies, and Columns 6-10 show results for
the model that does. The OLS results in Column 1, without industry dummies,
indicate that neither the proportion of outside directors (OUT) nor the percentage
of managerial ownership (OWN) are significant determinants of Q, although the
signs are consistent with Morck, Shleifer, and Vishny (1988). Columns 2-5 show
 S.W. Bamhart, S. RosensteidThe Financial Review 33 (1998) 1-16 9

Table 2
Mean values of Tobin’s Q for varying levels of management ownership and percentage of outside
diIWt0I.S
The sample consists of 321 observations taken from the 1990 Standard and Poor’s 500. Financial f m s
and utilities are excluded.

Management Ownership Outsiders on the Board

(OWN) (OUT)
Number of Number of
Percentage Firms Mean Q Firms Mean Q
0.00% 58 1.014 5 1.150
>0.00-5.00% 157 0.915 0 -
>5,00-10.00% 45 1.062 0 -
>10.00-15.00% 19 1.063 1 0.727
>15.00-20.00% 15 1.365 3 2.200
>20.00-25.00% 11 1.061 4 1.750
>25.00-30.00% 3 0.648 8 0.835
>30.00-35.00% 3 1.830 7 0.541
>35.00-40.00% 5 1.296 14 0.974
>40.00-45.00% 2 1.562 15 1.210
>45.00-50.00% 1 0.666 32 1.390
>50.00-55.00% 1 0.655 23 1.010
>55.00-60.00% 36 1.230
>60.00-65.00% 38 0.806
%5.00-70.002 40 1.070
>70.00-75.00% 36 0.743
>75.00-80.00% 21 0.790
>80.00-85.00% 23 0.821
>85.00-90.00% 9 0.783
>90.00-95.00% 6 0.988

the various IV estimations. As expected, first-stage regressions that use stepwise

elimination of exogenous variables (IV2 and IV4) have higher R2 than those that
do not (IV1 and IV3). In the IV2 and IV4 estimations, all coefficients for OUT are
statistically significant, and the signs are consistent. The relation is curvilinear. As
in the OLS specification, neither of the two OWN coefficients is significant.
When industry dummies are added to the specification, as in Morck, Shleifer,
and Vishny (1988), all of the coefficients for OUT are significant in the OLS
estimation (Column 6). The coefficients for OWN are also significant, indicating a
quadratic relation, with a maximum when OWN equals 34%. The shape of this
relation is similar to that found by Morck, Shleifer,and Vishny (1988) and McConnell
and Servaes (1990). However, OWN is greater than 30% for only 13 sample f m s ,
making inferences regarding the downward sloping portion of the curve essentially
meaningless. Column 7, the 3SLS specification, indicates no relation between OUT,
or OWN, and Q. These results are consistent with Agrawal and Knoeber’s (1996)
3SLS formulation. In Columns 8 and 9, N 2 and IV3 are consistent with the 3SLS
Table 3 !s
Estimation of a three-equationsimultaneous system using ordinary least squares (OLS) and instrumental variables
The dependent variables are Tobin's Q, the proportion of outside directors on the board of directors, and the percentage of managerial ownership. Two different FR
stnrctural models are presented. Each the same control variables; the difference between models is that one model does not include industry dummy variables 3
and the other does. OLS and inshumental variables, with four different sets of instruments (IV1 - IV4) are shown.
Panel A Dependent Variable: Q
2
1 2 3 4 5 6 I 8 9 10
5
3
OLS IV 1 N2 IV3 IV4 OLS IV1 (3SLS) IV2 N3 N4 w
l
R2(OUT) - 0.40 0.28 0.47 0.30 - 0.40 0.28 0.47 0.30 %
R2 (OWN) - 0.74 0.68 0.81 0.74 - 0.74 0.68 0.81 0.74 2m
Intercept 0.9960 1.9323 -7.9212 3.4614 -5.0493 0.3701 13.1674 36.01774 2.9922 -9.1501
(b
(3.14)* (1.03) (- 1.86)* (2.27)* (-1.60) (1.11) (1.36) (1.40) (1.37) (-1.22)
s
OUT 0.0151 0.0616 0.6328 -0.0372 0.4771 0.03400 -0.3066 - 1.0477 0.0314 0.8689 \
''
(0.74) (0.58) (2..59)* (-0.42) (2.66)* (1.81)* (-0.57) (-0.76) (0.24) (1.92)* Y
OUT2 -0.OOO4 -0.0022 -0 1)1244 -0.0003 -0.0098 -0.011 -0.0009 0.0050 -0.0025 -0.0195 iF
(-0.93) (-1.13) (-2.80)* (-0.20) (-2.99)* (-2.45)* (-0.09) (0.20) (-0.97) (-1.33) 3
OUT' 2.550E-6 1.47OE-5 0.0007 4.035E-6 5.870E-5 8.122E-6 3.66E-5 3.800E-5 1.98E-5 0.0001 3
a
(0.83) (1.30) (2.83)* (0.41) (3.06)* (2.64)* (0.60) (0.24) (1.20) (2.16)*
OWN 0.0046 -0.01 84 -0.0256 -0.0129 -0.0172 0.0253 0.0940 0.0678 0.0165 -0.0006 2
(0.46) (-1.63) (-1.14) (-1.19) (- 1-00) (2.44)* (1.57) (0.86) (0.92) (-0.80)
OWN2 -2.661E-5 0.0003 0.0002 0.0003 0.0001 -0.0005 -0.0009 -0.0007 -0.0003 4.6741 2
(-0.12) (1.17) (0.49) (1.35) (0.30) (-1.85)* (-0.90) (-0.52) (-0.83) (2.33)* s.
ADVl 4.8545 4.0987 4.43 11 4.7013 3.6356 1.6908 5.9610 5.3482 0.9971 5.9733 m
(5.63)* (4.89)* (2.64)* (4.23)* (3.59)* (1.39) (2.00)* (1.28) (0.80) (1.94)* T:
RD1 0.5531 0.8421 1.7079 0.6258 1.3192 2.7022 4.9936 12.3468 0.8551 UJ
1.3642 I*,
(0.48) (0.75) (0.78) (0.55) (0.76) (1.34) (1.w (1.94)* (0.42) (2.19)* -
DTl -0.0477 0.263 1 -0.0289 0.1594 0.3890 0.1089 0.7338 1.0120 0.448 1 3.199E-6
(-0.19) (1.02) (-0.06) (0.60) (1.01) (0.45) (0.74) (0.77) (1.36) (0.94)
TA1 4.962E-6 4.49656 -3.689E-6 4.592E-6 4.1308-6 1.082E-6 1.056E-6 2.4066B-6 2.2355E-7 -2.462E-6
s
L
(-2.49)* (-2.34)* (-0.98) (-2.35)* (-1.37) (-0.52) (0.24) (0.03) (0.10) (-0.78) c,
Industry No No No No No Yes Yes Yes Yes Yes I
r,
Dummies m
R2 0.16 0.73 0.78 0.71 0.77 0.68 0.81 0.76 0.89 0.90
See page 13 for notes.
 S. W. Barnhart, S. Rosenstein/The Financial Review 33 (1998) 1-16 11

formulation, but IV4 (Column 10) indicates a significant cubic relation between Q
and OUT, and a significant quadratic relation between Q and OWN.
Overall, there is some support for the curvilinear relation between managerial
ownership and performanceposited by Stulz (1988) and found empirically by Morck,
Shleifer, and Vishny (1988) and McConnell and Servaes (1990). There is also
stronger evidence of a curvilinear relation between firm performance and the propor-
tion of outside directors. However, the coefficients and t-statistics are extremely
sensitive to the choice of instruments. This finding is not altogether surprising; what
is surprising is that other papers using systems techniques provide no evidence, or
even awareness, of this problem. In addition, goodness-of-fit measures on the first-
stage regressions give little indication of statistical significance of the endogenous
variables in the second stage. Finally, although the addition of industry dummies
yields a more successful OLS estimation, the IV estimations create doubt as to the
relation between board composition, managerial ownership, and firm performance.
Table 3B presents the results for the outside director (OUT) equation. The
linear and quadratic coefficients for OWN are statistically significant,with consistent
signs in every estimation. Noting again that only eighteen sample firms have OWN
greater than 25%, the results indicate that the logit transformation of OUT is nega-
tively related to OWN. It appears that managerial ownership and board composition
are substitutes, and that strong performance allows insiders to retain control of
boards of directors. All 10 estimations also indicate that OUT is negatively related
to Q. This evidence is consistent with Kole (1996), who also finds that causality
runs from performanceto managerial ownership. Note also that the OLS coefficients
for these variables are many magnitudes larger than those of the IV coefficients.
Thus, the economic significance of these variables differs substantially across meth-
odologies.
The coefficient for board size is significantly negative in three of the four IV
estimations. This evidence is consistent with Yermack (1996), who finds that firms
with smaller boards (at a given proportion of outside directors) tend to outperform
those with large boards.
The results for the managerial ownership (OWN) equation are presented in
Table 3C. In the regressions excluding industry dummies, the OLS estimation
indicates no relation between OUT, Q, and OWN. However, all four IV regressions
indicate a quadratic relation between outsiders on the board and managerial owner-
ship; each has a maximum value of OWN when OUT is roughly 40%, declining
thereafter. The relationship is essentially negative for most of the sample, indicating
the same substitution effect noted in equation 2. Q is negatively related to OWN
in IV3 and IV4.
When industry dummies are included, the results for OUT are mixed; the linear
and quadratic terms are significant in both IV1 (3SLS) and IV3. It is also notable
that the signs of the coefficients for OUT are reversed in IV2. For this specification,
the choice of instruments not only affects measures of significance, but the shape
of the relation. Q is insignificant in all of these specifications. Interestingly, board
Table 3
Panel B: Dependent variable: Logit Transformation of Percent Outsiders (OUT)
1 2 3 4 5 6 I 8 9 10 Fo
OLS IV1 IV2 IV3 IV4 OLS IV1 (3SLS) IV2 IV3 IV4
R2 (Q) - 0.94 0.93 0.95 0.93 - 0.94 0.93 0.95 0.93
R2 (OWN) - 0.74 0.68 0.81 0.74 - 0.74 0.68 0.81 0.74
Intercept 65.4207 1.0094 0.8576 0.9678 0.8017 66.3266 0.8769 0.8321 0.5946 0.8200
(1627)* (6.96)* (5.45)* (6.75)* (5.08)* (9.32)* (4.33)* (4.04)* (2.83)* (3.86)*
*OWN -1.3496 -0.0359 -0.0353 -0.0247 -0.0306 -1.5341 -0.0448 -0.0428 -0.0042 -0.041 1
(-517)* (-360)* (-332)* (-213)* (-288)* (499)* (-3.10)* (-3.19)* (-033) (-289)*
OWN2 0.0244 0.0007 0.0005 0.0005 0.0006 0.0302 0.0010 O.OOO9 0.0001 0.0008
(4.53)* (2.94)* (2.14)* (2.57)* (2.38)* (4.12)* (3.39)* (3.24)* (0.30) (2.92)*
Q -3.3564 -0.3682 -0.1 187 -0.3997 -0.1607 -3.7566 -0.3504 -0.3155 -0.5332 -0.3437
(-262)* (-821)* (-255)* (-899)* (-339)* (-115)* (-5.57)* (4.93)* (-929)* (-583)*
DT1 4.7678 0.3395 0.3875 0.2514 0.2874 5.2396 0.5292 0.4523 0.3472 0.4191
(0.82) (1.58) (1.81)* (1.17) (1.34) (0.72) (2.37)* (2.05)* (1.51) (1.84)*
BDSIZEl 0.2049 -0.0070 -0.0101 -0.0076 -0.0085 0.1032 -0.0176 -0.0167 -0.0035 -0.0173
(0.73) (-019) (-109) (-087) (-090) (0.27) (-2.26)’ (-2.04)* (-039) (-2M)*
Industry No No No No No Yes Yes Yes Yes Yes
Dummies
R2 0.14 0.36 0.34 0.35 0.30 0.45 0.56 0.54 0.54 0.56
Table 3
Panel C: Dependent Variable: Logit Transformation of Proportion of Managerial Ownership (OWN)
1 2 3 4 5 6 7 8 9 10
01,s lV1 IV2 w3 IV4 OLS Iv1 (3SLS) IV2 Iv3 IV4
R2(Q) - 0.94 0.93 0.95 0.93 - 0.94 0.93 0.95 0.93
RZ(OUT) - 0.40 0.28 0.47 0.30 - 0.40 0.28 0.47 0.30
Intercept 29.2814 -2.0952 -0.3125 2.2611 -2.4031 32.3860 48.1693 -125677 3.0788 2.8851
(7.82)* (-148) (-1.69) (-215)* (-134) (5.87)* (2.36)* (-0.49) (1.68) (0.74)
OUT -0.0976 0.1129 0.0746 0.0808 0.1342 -0.1636 -1.2939 3.1407 -0.1255 -0.0563
(-086) (2.19) (1.37) (2.14) (2.12) (-114) (-2.33) (0.65) (-179) (-036)
O W o.oO01 -0.0013 -0.0012 -0.0008 -0.0016 0.0008 0.0078 -0.01 69 0.0012 0.0002
(0.06) (-264)* (-2.29)* (-213)* (-266)* (0.62) (1.99)* (-1.02) (1.93)* (-013)
Q 0.7492 -0.1036 -0.2493 0.1549 -0.2337 '1.5255 -3.2443 6.5939 -0.0174 -0.1869
(1.07) (-1W (-2.68)* (1.97)* (-230)* (1.37) (-1.71) (0.31) (-013) (0.76)
BDSIZEl -0.5763 -0.0287 -0.0197 -0.0220 -0.0172 -0.6697 -0.1495 -0.0 182 -0.0772 -0.1270
(-395)* (-145) (-1.05) (- 129) (-083) (-333)* (-2.01)* (-0.10) (-317)* (-389)X
INSTl -0.2295 -0.0377 -0.0329 -0.0386 -0.0367 -0.2272 0.0100 -0.1446 -0.037 1 -0.0324
(-6941)* (-777)* (-7.04)* (-921)* (-710)* (-501)* (0.21) (-0.27) (-633)* (-367)*
DTl 6.6146 0.93 15 0.9415 0.9415 1.1076 7.3149 4.2035 0.5889 1.2732 1.5107
(2.24)* (2.29)* (2.70)* (2.70)* (2.53)* (1.93)* (2.47)* (0.19) (3.48)* (2.70)*
ADVl 14.1427 1.7332 .86172 0.8617 2.4053 2.5432 -8.0679 -12.3383 -2.7846 -1.8429
(1.26) (1.20) (0.68) (0.68) (1.54) (0.13) (-0.82) (-0.60) (-099) (-051)
Industry No No No No No Yes Yes Yes Yes Yes
Dummies
~~

R2 0.23 0.83 0.82 0.82 0.83 0.51 0.90 0.79 0.93 0.90

*Indicates statistical significance at the 0.10 level.

MB = Market-to-book ratio of common equity; Q = Tobin's Q; OUT = The percentage of directors classified as outsiders by Institutional Shareholder Services Inc. (ISS); OWN =
The percentage of shares outstanding owned by managers of the firm from ISS; BDSIZEI = The total number of directors, insiders, greys and outsiders, on the board of directors
for each fm, lagged one year; INSTl = The percentage of shares outstanding owned by institutions from ISS, lagged one year; ADVl = Advertising expenditures divided by total
assets, lagged one year; RDI = Research and development expenditures divided by total assets, lagged one year; TAl = Total assets, lagged one year; DTl = Total debt divided by
total assets, lagged one year; IVl is the set of exogenous variables, including the industry dummies; IV2 differs from IVI in that a stepwise regression procedure is used to remove
variables; IV3 includes five lags of each of the exogenous variables and the industry dummies for both second stage specifications;IV4 differs from IV3 in that a stepwise regression
procedure is used to remove variables.
14 S. W. Barnhart, S. Rosenstein/The Financial Review 33 (1998) 1-16

size (BDSIZE) is negative in four of the five estimations. Institutional ownership

(INST) is essentially negative as well, but this variable may be a proxy for firm
size. Smaller, perhaps younger firms would be expected to have larger managerial
holdings and smaller institutional ownership.
Overall, this equation lends further support to the hypothesis that managerial
ownership, board composition, and firm performance are jointly determined, and
provides relatively strong support for Demsetz and Lehn’s (1985) finding that
governance structure changes in response to outside factors in a manner that is
consistent with value maximization.As might be expected, it appears that managerial
ownership has a greater effect on board composition than vice versa.

6. Concluding comments
Several recent papers model board composition, ownership structure, and firm
performance as a jointly determined system. However, a variety of models that are
similar in concept but different in specification,functional form, and control variables
are used. This complexity increases the probability of model misspecification, which
is much more problematical with systems of equations than with single-equation
models. None of these papers, however, examine the sensitivity of their models to
changes in the variables used as instruments or in the specification of the final
model.
This paper examines board composition, managerial ownership, and firm per-
formance using a three-equation system. Sensitivity analysis is conducted to examine
the robustness of simultaneousequations estimates. The results indicate some support
for the curvilinear relation between managerial ownership and performance posited
by Stulz (1988) and empirically determined by Morck, Shleifer, and Vishny (1988)
and McConnell and Servaes (1990).
There is also weak evidence of a curvilinear relation between the proportion
of outside directors and firm performance, as found by Weisbach (1988). There is
stronger support, however, for Demsetz and Lehn’s (1 985) finding that governance
structure and performance are jointly determined, in that governance changes over
time to allow for value maximization.
The results also suggest that institutional ownership and board composition
are substitutes for managerial ownership, and that managerial ownership has a
greater effect on board composition than vice-versa. It also appears that strong
performance may allow insiders to retain control of the board of directors.
The empirical results are strongly dependent on the specification of the overall
model and of the first-stage regressions. Relatively minor changes in either have
profound effects on overall results. While this is only one model of corporate
behavior, it is likely that the estimation issues presented here are widespread in this
area of research. This leads to the conclusion that results using simultaneous equa-
tions methods must be interpreted cautiously, that ordinary least squares estimates
 S,W. Barnhart, S. Rosenstein/The Financial Review 33 (1998) 1-16 15

should not be casually dismissed, and that sensitivity analysis is essential when
estimating an empirical model whose structure is uncertain.

Appendix
In its simplest form, the probability P of independent directors can be mod-
eled as:

P/(l-P) = exP, (All

where X represents a matrix of observations and beta represents a vector of coeffi-
cients. Taking logs of both sides yields:

z = xp, ('42)
where each Zj = lnP/(1 - P). The form of the equation to be estimated is then Z =
Xp + u, where u is the vector of error terms. For grouped data, this transformation
guarantees that estimated proportions of outside directors and managerial ownership
will lie in the zero-to-one range.
An added complexity is that a large number of managerial ownership observa-
tions are clustered around zero (OWN is 0.00 for 58 of the 321 firms). Cox (1970)
provides a remedy, suggesting the logit model be constructed as:
Zj = In [(Rj + a)/(n, - R, + a)], (A31
where Rjis, for example, in the independent director equation the number of indepen-
dent directors for firm j and nj is the total number of directors on the board. For
the ownership equation, Rj is the number of shares owned by the management of
f i i j and n, is the total number of shares outstanding. The constant alpha equal to
0.5 solves the problem of taking the log of either of these extremes when the
percentage being investigated is either zero or one (Cox, p. 33). To convert the
estimated logits back to the proportions use P = (l/(l+ewxb)).
The variance of the logit model's disturbance term is heteroskedastic in that
it depends on the probability Rj / nj in a predictable manner. The model must be
estimated using weighted least squares to obtain efficient estimators. The weight
used is the square root of the inverse of the variance of the error term u, i.e.,
Var(uj) = (nj + l)(nj + 2) / nj(Rj+ l)(nj - Rj+ 1). (A41

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