An Empirical Investigation of Internal Governance∗

Acharya, Myers, and Rajan (2009) theorize that self-serving actions and rent extraction by CEOs can be constrained by subordinate managers when the managers’ efforts are needed in production. This force, which they call internal governance, works best when the CEO and the managers are both important to firm output, in the sense that their relative contributions to firm value are balanced. We empirically examine the effects of internal governance on firm investment and performance. We develop a measure of internal governance that captures the relative contribution of the CEO compared to non-CEO executives in firm value creation. Consistent with the theory, we find that there is a hump-shaped relation between relative contributions and corporate investment measured as either capital expenditures or R&D spending. We also find a hump-shaped relation between relative contributions and several measures of firm performance: Tobin’s Q, ROA, and free cash flow. The hump-shaped relations between investment and relative contributions and between firm performance and relative contributions are more evident for firms with young managers and firms with a greater age difference between the CEO and the managers. These results are consistent with divergences in career horizons between CEOs and managers being a crucial determinant of the strength of internal governance. However, neither external governance nor board governance diminishes the importance of internal governance. Overall, our results are strongly supportive of the theory. ∗We thank Todd Gormley, Jayant Kale, Ron Masulis, Ragu Sundaram, Yishay Yafeh, and seminar audiences at Nanyang Technological University, the European Summer Symposium on Corporate Finance at Gerzensee, the Indian School of Business Corporate Finance Conference, the Washington University in St. Louis Corporate Finance Conference, Texas Christian University, and the University of Minnesota for helpful comments. All errors are our own.