"The board governance fad is being kept alive by a bunch of consultants and academics ... there is no evidence that board governance matters to shareholders. When I see some evidence, I’ll take this more seriously."

So says the CEO of a Fortune 500 company—and he is not alone in his skepticism. Though there are some CEOs who firmly believe in the importance of good board governance and have taken steps to strengthen their company’s governance processes, many others remain doubtful about the benefits of taking action. "So many other things matter more—competitors, financials, marketing—board governance is just not on my screen," said one CEO. Another argued, "Fund managers are very short-term oriented; not much use talking about boards with them—it’s too long-term an issue."

To try and ascertain the real worth of good governance, McKinsey, in conjunction with Institutional Investor, Inc., conducted a survey of over 100 major investors, CEOs, and senior executives. According to the survey findings, good governance practice really does make a difference—a difference that many investors are willing to pay for.

(See the boxed insert for details of the survey.)

Just how much is good corporate governance worth?

We asked investors to compare two well performing companies (such as those with consistent profits and number one or two in terms of market share) and state whether they would pay more for the stock of one of these companies if it were well governed. Two-thirds of the investors said they would (Exhibit 1). As one respondent put it: "Companies with good board governance practices have a shareholder-value focus."

Among those willing to pay more for good governance, the average premium specified was 16 percent. However, a minority of those investors who said they would pay more felt the actual premium was hard to quantify. Based on the entire survey group, including those who said they would not pay more, the average premium was 11 percent (Exhibit 2).

An 11 percent increase in share price would equate to an increase in earnings before interest and tax (EBIT) of 11 percent in perpetuity. To put that figure into perspective, consider the scope and intensity of effort that would be required to earn a similar increase through measures such as cost cutting or higher productivity (Exhibit 3).

Who cares most about good governance?

If it is clear that many investors are willing to pay significantly more for the stock of companies that have good governance practices, how can those investors be identified? The survey reveals three key variables that influence the importance certain investors place on good governance:

Portfolio turnover. Investors with lower turnover ratios in their portfolios value governance most (Exhibit 4). They hold stocks longer and believe good governance will help improve performance in the long term.

Asset management philosophy. Investors who pursue a "value" strategy (for example, those who invest in undervalued companies with low price/earnings ratios and/or stable companies with regular dividends), are more willing to pay for good governance than those who pursue a "growth" strategy (for example, those who pick companies with high price/earnings ratios in the hope the companies will grow) (Exhibit 5). Sixty percent of the investors who said they would pay more for good governance described themselves as value investors. Of those who said they would not pay more, only 42 percent were value investors.

Some value investors believe that the price/ earnings ratio of value stocks can be improved through good governance. As one stated: "A good board may help lift an underperforming stock and capture hidden value."

Good governance is perceived as less important to some of those in the growth camp because they feel that if the stock already has a high price/earnings ratio and is attractive because of perceived growth, then management is likely to be outstanding or the industry explosive. Under such conditions, a strong board might not make a lot of difference. "One major shareholder ... said that he did not want to talk about governance or anything else and had bought our stock only because of a growth trend he foresaw in the industry as a whole," said one CEO.

Client base. Investors who manage money for high net worth individuals, endowments, foundations, and public pension funds are more willing to pay for good governance than those who manage money primarily for corporate pension funds (Exhibit 6). Many managers of public and individual funds believe that governance affects share price, so they are taking a hard look at the governance practices of the companies in which they invest. Managers of corporate funds, however, may feel less comfortable confronting senior management. Yet if companies increasingly adopt confidential voting, corporate funds managers may consider governance issues more in their investment decisions.

Three reasons why investors care

There are three main reasons why investors will pay a premium for good governance. Some believe that a company with good governance will perform better over time, leading to a higher stock price. This group is primarily trying to capture upside, long-term potential.

Others see good governance as a means of reducing risk, as they believe it decreases the likelihood of bad things happening to a company. Also, when bad things do happen, they expect well-governed companies to rebound more quickly.

Still others regard the recent increase in attention to governance as a fad. However, they tag along because so many investors do value governance. As this group sees it, the stock of a well-governed company may be worth more simply because governance is such a hot topic these days.

Governance matters more in some circumstances than in others

Another essential question is, "When is good governance important?" Respondents felt it was most important during crises, or when CEOs might be tempted to spend too freely unless constrained by a strong board (for example, in a declining industry with high cash flows). By contrast, governance is perceived as least important in highly competitive industries, where market pressures keep CEOs on their toes more effectively than any board ever could (Exhibit 7).

CEOs cannot, however, simply build board strength when it suits them. Many qualified directors are unlikely to relish the prospect of joining a board during a scandal or takeover. CEOs would therefore be well advised to get their governance reforms in place while the company is out of the headlines.

CEOs value good governance too

The survey also examined whether CEOs and other top executives were willing to pay more for the stock of well-governed companies. As with investors, two-thirds of the CEOs and top executives surveyed said they would pay more. Yet on average, they were willing to pay an even higher premium than investors—24 percent for those who said"yes," and an average of 16 percent among all respondents (Exhibit 8).

The high premium placed on board governance by CEOs and top executives is hardly surprising given that they are the ultimate long-term investors, having large holdings in their own companies. In a follow-up interview, one CEO stated, "Good corporate governance is somewhat akin to headlights on a car. If these two companies are in a daytime race—nothing goes wrong—then they’re evenly matched. If the race goes on past dusk, however, the company with good governance has the headlights to deal with the problem."

Good governance also has value in poorly performing companies

Investors and CEOs alike strongly endorse the value of good governance in well performing companies. But does it have value in poorly performing companies? The survey asked participants to compare two companies whose sales and profits were declining, and state whether they would pay more for one of the companies if it were well governed. Once again, board governance was valuable, though less so than in well performing companies as many CEOs and investors do not like to invest in poorly performing companies at all (Exhibit 9). "The good governance company has a significantly higher probability of a successful turnaround," was the verdict of one investor.

The value of governance is no longer a question of faith

The survey findings should be viewed in the light of two caveats. First, such a survey can only be a rough attempt at quantifying the value of board governance. Second, the findings do not suggest that governance should be the top priority for CEOs. A number of items rank higher, including strategy, cash flow, competitive position, quality of the management team, and cost control. Nonetheless, the survey indicates clearly that governance deserves a position somewhere on that priority list.¹ Moreover, the findings of our survey and interviews are supported and supplemented by a growing number of independent academic studies.²

Believing in the value of corporate governance should no longer be a question of faith. Some investors will pay a significant premium for good governance. And though it is more important in some circumstances than in others, and more important to managers of some types of funds than others, it remains clear that good board governance can serve as a tool for attracting certain types of investors, as well as influencing what they will pay for stock.

Given that many investors do care about board governance, what action can companies take to improve their own practices? A good first step would be for senior executives, investors and board members to learn how to talk together about substantive governance issues in a productive way. The survey indicates that a much broader consensus exists on board issues between management and investors than has typically been portrayed, and that there are likely to be opportunities for much productive discussion.