The Alignment of Internal and External Control Mechanisms: The Differential Market Valuation and Performance Effects in High-Growth Versus Low-Growth Industries

Abstract

We examine the impact of the alignment of internal control mechanisms (governance and management control systems) with external control mechanisms on market valuation and operating performance for 1,693 firm observations over the period 2000-2006 in high versus low-growth industries. The probability of acquisition (merger activity) is used as a proxy for external control. Consistent with theory, the probability of acquisition is hypothesized to be traded off against the two internal control systems, governance and management control systems. We find that firms in high-growth industries generally experience operational benefits from an internal and external controls alignment that emphasizes external control. In contrast, we find that firms in low-growth industries benefit operationally from an alignment of internal and external controls that emphasize internal controls. Further, we find that in low-growth industries, a control alignment that favors internal controls is directly related to equity and debt market valuation effects, while in the high-growth industry, an emphasis on internal controls is inversely related to equity market valuation effects, yet directly related to debt market valuation effects. This suggests that firms in low-growth industries may not be able to take advantage of the level of external control (merger activity) and may consequently be rewarded for investments in internal control mechanisms. Conversely, in high-growth industries, merger activity or opportunity for external growth may be more important to equity investors than increased investments in internal controls. However, these same internal control investments may serve to protect debt holders who do not stand to gain from risky high-growth firm activities. Our results imply that management's investment in internal control systems may be mitigated by the firm's operational environment and its growth strategy, a matter of concern for regulators as evidenced by Sarbanes-Oxley Act.