Connectedness Drives Performance

C ONNECTEDNESS D RIVES P ERFORMANCE -­‐ A study into organizational connectivity and diversity.

The cry for diversification on boards is loud and clear. But how much diversification is enough? As with any diversification strategy, too much can actually damage performance.

How can Boards identify the ‘right’ balance to optimise financial performance? Is a gender quota really the answer?

The diversification argument doesn’t stop at the front door. What is the right balance of diverse experiences and specialisation for our future leaders? What is the right balance between disruptive and incremental innovation? How flat should our organisational structure be? These are questions that all senior executives face at some time or other. What is lacking is specific guidance with some quantitative measures, linked to bottom line outcomes.

Laurence Lock Lee / Cai Kjaer 31 A ugust 2012

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31 August 2012

WHITE-­‐PAPER: CONNECTEDNESS DRIVES PERFORMANCE -­‐ A study into organisational connectivity and diversity The cry for diversification on boards is loud and clear. But how much diversification is enough?

As with any diversification strategy, too much can actually damage performance. How can Boards identify the ‘right’ balance to optimise financial performance? Is a gender quota really the answer?

The diversification argument doesn’t stop at the front door. What is the right balance of diverse experiences and specialisation for our future leaders? What is the right balance between disruptive and incremental innovation? How flat should our organisational structure be? These are questions that all senior executives face at some time or other. What is lacking is specific guidance with some quantitative measures, linked to bottom line outcomes.

How powerful would it be to have a quantitative measure for diversity that is clearly linked to your bottom line performance?

The following diagram provides a ‘birds eye view’ of how ASX boards are connected through shared board memberships:

The above diagram clusters the interconnections by industry sector. The nodes represent listed companies and are sized by the number of connections that they have. One can see that there are centrally connected firms in nearly all sectors.

Taking a closer look at a particular example using the Optimice’s Company Mapper tool1, one can see which particular directors are providing connections to other firms. It is these directors that have the potential to provide the diversity of thought and experience as garnered from their other board memberships.

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See http://www.optimice.com.au/companymapper

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In this paper we identify the extent to which board connections with other companies i.e. shared directorships, potentially contribute to bottom line performance. We have found that there is a ‘sweet spot’ beyond which additional connections can actually harm performance.

Our sample is the 583 listed firms from the ASX (Australian Stock Exchange) who have reported revenue and market capitalisation results for the period 2004-­‐2012. We studied these companies to identify the company ‘connectedness’ by measuring the number of other companies they are interconnected with via a shared board member.

The number of connections ranged from zero to 18. We hypothesised that connections were good, as they provided the potential for bringing a diversity of opinions and experience to a board. We also speculated that having too many connections might cause boards to lose focus and become distracted by the pure breadth of diversity being brought to the table.

We plotted the number of company connections against the % CAGR in revenue. While we found a modest linear relationship favouring more connections, the enduring pattern came when we investigated the non-­‐linear patterns. A quadratic curve fit identified a clear ‘sweet spot’ where %CAGR was optimal, and that occurred in the range between 7 and 9 connections.

The 83 companies in this sweet spot achieved an average 15% CAGR in revenue as opposed to the 108 firms who had no connections and achieved on average a 4.8% CAGR in revenue. The CAGR in revenue dropped off for those firms having more than 9 connections.

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The average number of connections per firm is 4.18, suggesting that a majority of listed organisations would benefit from increasing their diversity through connections to other companies. Inviting a board member who is well connected may be a good way of substantially increasing your growth rates into the future.

Connectedness and Diversity Inside Organisations One of the luxuries one has in working with stock market data is that bottom line performance data is readily available for assessing potential impacts of different business characteristics.

Most executives however sit inside organisations, with very much an internal focus. Bottom line performance measures for internal departments can be problematic. In many cases internal measures can even lead to value destroying internal competition. Inherently executives accept that a diversity of experience is a good thing. But there is no ruler calibrated for diversity. How much is enough? What is an appropriate investment in diversity? Is there a magic number?

Professor Ron Burt from the University of Chicago has spent a career analysing the contribution ‘bridges and brokers’ play in business. Overlapping board memberships are an example of a broker or bridge role.

Framed in the context of ‘social capital’, Burt has quantified correlations between leaders identified as brokers being promoted faster, being paid more and having their ideas more readily accepted.

However, Burt also acknowledges that those that are central to a closed network i.e. our acknowledged ‘specialists’, provide a complementary source of value2. Specialists gain their reputation from being acknowledged by their peers in what is often a dense and exclusive network. Overall organisational value is therefore gained by achieving a balance between diversity and specialisation. So can we identify the balance point by extrapolating our findings from this study into internal company connectedness?

The average number of board members from our selected sample is 7. We found that on average these 7 directors provided 4.18 connections to other companies or just under 0.6

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Burt, R.S. (2005), “Brokerage& Closure”, Oxford University Press

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connections per director. Our ‘sweet spot’ indicated a range of 7 to 9 connections being optimal. To achieve this we need to either improve the number of connections provided per director to over 1 per director. Alternatively we can raise the number of board members to a level that can naturally achieve our ‘sweet spot”. The optimum board size based on a 0.6 connection/director would therefore be between 12 and 15, to achieve an adequate level of diversity.

Is this also the answer for internal senior management teams? This number may appear to be a little excessive, but not uncommon for internal management teams. This could be reduced if the members’ diversity performance can be raised i.e. on average the senior management team can demonstrate an ability to represent at least one other internal department or function, other than their own. Lets see how this may play out in a practical sense:

In conducting a standard organisational network analysis, we survey respondents asking them to nominate people that they critically depend on to get their work done. We also ask them to nominate which business unit they belong to. One of the outputs from this data is what we call our “Demand” chart, identifying the nature of the dependencies within and between business units.

The chart plots the nominations that an individual receives against the % of those nominations that come from outside their own business unit. The quadrants are designed to depict where individuals are placed in the organisation’s dependency network. Those on the right hand side of the chart are ‘in demand’ staff, divided into ‘specialists’, who are mostly nominated by those inside their own business area, and the ‘ambassadors’ who are largely nominated by those from outside their own business unit. It is not uncommon to see the senior management occupy the ambassador positions, or indeed high potential staff may also be seen in this quartile.

On the left hand side are the less in demand staff, divided into the ‘practitioners’, who are mainly nominated from within their own business area, and the ‘agents’ who tend to be nominated from outside their own business units. Typically we will see the practitioner quartile being the most populated. The agent quartile may typically contain internal service line staff.

In terms of diversity, the question is how many ‘ambassadors’ should we be looking to develop?

What is the right balance to between having a cohesive network of internally focused staff and the diverse external contacts required for maximum performance? Firstly we want to get as many as possible on the right hand side of the demand matrix. A heavily populated right hand

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side means more cohesive networks. From the connectedness study, the magic number is 7 to 9 interlocks, which at current rates of connectivity maps to an optimum board size of 12 to 15.

Now this isn’t to suggest that the load should be evenly spread, but we would suggest, based on a previous study3, that diversity should be contributed by at least 2 of that 12 to 15, or roughly between 13% – 17%. So here is our ‘rule of thumb’ for diversity: “For optimal performance, organisations should aim to allocate 15% of their resources to diverse non-­‐core activities”.

We could also suggest that organisations should aim to have 15% of staff in the ‘Ambassador” quadrant, 15% of the innovation investments directed to ‘breakthrough’ ideas, 15% of staff time free to develop their own ideas for the business, 15% of management teams drawn from minorities…the list could go on.

Some Closing Thoughts We started this paper with some very compelling evidence that a specific optimal measure of connectedness, introduced through overlapping board memberships, can be determined where company growth is maximised. That number is between 7 and 9 board connections.

Organisations with that number of company connections delivered on average 15% CAGR in revenue over a 9 year period, in contrast to 4.8% CAGR delivered by companies with no connections. We then took these findings and extrapolated them to how they may be interpreted to provide internal guidance on diversity. We came up with the magic number of 15%. While the science becomes more dubious with each extrapolated step, in the absence of a better number we offer this number to guide your diversity efforts.

About Optimice

Optimice provides specialised consulting services and tool to help organisations map and improve business relationships. Optimice identifies relationship patterns between people, organisations or markets, and we have improved the basic techniques to optimise these relationships in a compelling business-­‐focused context.

Optimice Pty Ltd Level 6, 20 Loftus Street Circular Quay Sydney NSW 2000 Phone: 02 8002 0035 www.optimice.com.au

About Hargraves

The key to the Hargraves Institute is ‘Collective Wisdom’, shared amongst the members through the art of trusted conversations.

Collective wisdom comes from the interactions of our diverse network and members and the solutions are created in the body of knowledge developed by these talented people.

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3 In our study on “Networked Board Members” we found higher financial performance is associated with dual board members interlocks. www.optimice.com.au

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