Amsterdam Business School
MSc Business Economics: Finance
Master Thesis:
STRATEGIC CHANGES INITIATED BY THE NEW CEO AND HOW THOSE RELATE TO FIRM VALUE CREATION IN THE US
Student: Revega Anton
Supervisor: Dr. Torsten Jochem Date: 01/02/2015
Abstract
The overall performance of a company depends upon leadership and strategic decisions, as well as changes made by the Chief Executive Officer (CEO) in collaboration with other members of the management teams. CEO turnover in the firms occurs because of different reasons, such as retirement, dismissal, or poor performance among others. The aim of this research is to understand the effect of incoming CEO attributes, such as CEO experience on the company performance. This research also aims at finding the link between the strategic changes initiated by a new CEO upon turnover and the subsequent performance and value creation of a company. As a result, CEO experience in terms of CEO age has little effect on the firm performance. In addition, CEO tenure has also positive effect on firm performance. Besides, strategic changes, such as downsizing and cut of investment have significant and positive effect on firm performance in terms of market capitalization and stock return. In order to understand the topic of the research, a brief review of the literature is provided. Quantitative and qualitative research techniques are used to collect and analyze the data regarding CEO turnover and the value created by a new CEO in a company. All the data is taken from the ExecuComp, CRSP and Compustat and CRSP merged databases.
Table of Contents
Abstract 1
Table of Contents 2
CHAPTER ONE 3
1.0 Introduction 3
1.1 Rationale and Aim of the Research 5
1.2 Objectives of the Research and the Suggested Approach 5
1.3 Scope of the Research 5
CHAPTER TWO 6
2.0 Literature Review and Background 6
2.1 Relationship between Post-Turnover Strategic Changes and Performance 11
2.2 Summary of the Chapter 14
CHAPTER THREE 15
3.0 Introduction 15
3.1 Hypotheses Development 15
3.2 Data Sources, Variable Constructions and Methodology 17
CHAPTER FOUR 20
4.0 Introduction 20
4.1 CEOs’ Experience 20
4.2 CEOs’ Selected Strategies 21
4.3 Summary Statistic 22
4.4 Market Capitalization and Stock Return 24
4.5 Results and Interpretation 25
4.6 Summary of the Chapter 27
CHAPTER FIVE 28
5.0 Discussion 28
5.1 Conclusion 29
5.2 Limitations and Further Analysis 31
Reference List 33
CHAPTER ONE 1.0 Introduction
Corporate CEO turnovers are often associated with major changes and significant strategic decisions aimed at creating more value and improving performance of a company. Such post-turnover changes reveal the vision and strategies of the new CEO that should help handle all the challenges faced by a company. It is believed that the post-turnover changes and strategies depend on the CEO’s attributes. It is also of great importance whether the new CEO is an insider or outsider. The term ‘outsider CEO’ refers to any person who works for up to two years in a company before becoming CEO. The term ‘insider CEO’ refers to a person who has joined a firm more than two years before becoming CEO. In this aspect, it is considered that an outsider successor is more likely to carry out the process of error correction and initiate various organizational changes as he/she was not part of the wrong decisions made by the former CEO (Pan & Wang, 2012).
A CEO turnover may help to facilitate a restructuring and error correction in a struggling company, which can be considered as strategic initiatives implemented by the new CEO. Some of the strategic changes usually initiated by the new CEO upon turnover involve the composition of the critical production factors, for instance, capital and labor. It may involve divesting, downsizing and rechanneling of resources from the non-performing projects and investments into more performing ones in order to create more value. The strategies are meant to maximize the value of a company at minimum costs. In this research, the changes initiated by the new CEO will be referred to as ‘error correction’. The term ‘error’ refers to the poor prior investment decisions made by the former CEO that should be corrected in order to create value for the firms.
It is considered that error corrective strategies are more likely to take place when there is a CEO turnover because the new CEO is not part of the wrong decisions made by his/her
predecessor. The new CEO can initiate any change very quickly unlike the old CEO who might follow the status quo. It should be noted that the former CEO was the cause of this status. A CEO turnover can bring new experience and initiatives into the management of a company to implement various corrective actions. It is therefore expected that the post-turnover corrective strategies are value enhancing. For instance, initiating operational downsizing, such as divestiture or termination of previous unproductive investments, helps reverse the erroneous investment decisions that influence the value of a company obtained by the former CEO. Usually, operational downsizing, divesting and the termination of poorly performing investments increase the profitability and value of a company. It should be noted that such initiatives might reduce the cost of production, thereby increasing returns.
Other strategies, for instance the expansion of a company through internal investment or external acquisition, may also be taken by the new CEO after turnover, especially when there are growth opportunities in the market. These new investments may also create new value for a company. Therefore, this research is aimed at analyzing the different possible strategic changes, such as “downsizing” and “cut of investment”, initiated by the new CEO and the impact they have on value creation for the US-based companies. As a result, “error-correction” theory developed by Pan and Wang (2012) was supported in this research. The new incoming CEO’s are more likely to downsize and cut investments, which in turn brings significant and positive results for the company. Besides, it is also proved that CEO experience is also an important indicator that determines the performance of the company. After CEO turnover, experienced incoming CEOs tend to create value for the company.
1.1 Rationale and Aim of the Research
Understanding the link between the value creation strategies and CEO turnover is significant for the success and growth of US-based companies. Currently, the business press is paying much attention to CEO turnover because the CEO plays a crucial role in the performance, future development and growth opportunities of a company. Most of the existing theories suggest that some strategic changes occur in the company after CEO turnover has taken place in a company. However, most of the academic studies focus on the relationship between CEOs’ compensation and value creation of companies. As a result, relatively little attention is paid to the effect of the post-turnover actions on the value creation of a company. Thus, this research is aimed at identifying this gap and exploring the link between the value creation of a company in terms of market capitalization and the strategic changes initiated by the new CEO. The findings of the following research will help companies to create more value during CEO turnover events. The aim of the research is to give some insight into the value creation process that follows CEO turnover.
1.2 Objectives of the Research and the Suggested Approach
The objectives of this study are:
1. To investigate whether experienced new CEOs are more likely to create value to a company during CEO turnover event;
2. To understand the error-correcting actions that can be employed by the new CEO to reverse the previously poor managerial decisions.
1.3 Scope of the Research
This research is limited to the understanding of the strategic changes initiated by the new CEO after turnover and how those changes relate to value creation and performance of a company. Therefore, value and performance of a company under the predecessor and the
successor will be compared to identify the actions that create value for a company. The researcher will focus on the S&P 500 companies listed in the ExecuComp database.
CHAPTER TWO
2.0 Literature Review and Background
This chapter reviews some relevant literature on this topic of study.
Pan and Wang conducted their research in 2012. The authors investigated the value-creation process of incoming CEOs during CEO turnover events.
Pan and Wang (2012) started with 24,780 observations. They divided CEOs into two groups: insiders and outsiders. The researchers identified 2,221 CEO turnovers; out of which 659 incoming CEOs were classified as outsiders. Pan and Wang (2012) realized that downsizing was in most cases used as a corrective action by the new CEOs. According to researchers, downsizing is significantly and positively associated with post-turnover performance of companies. The following findings allow revealing that CEO turnover gives an opportunity to the new management teams to implement downsizing as a corrective action.
It should be noted that one of the key findings of the following research is that the main source of value creation associated with CEO turnover is the reversal of prior poor decisions made in a firm.
Pan and Wang (2012) develop the “error correction theory” of CEO turnover. According to this theory, the newly appointed CEOs are more likely to downsize and divest the previous unprofitable investments made by the former CEOs. Researchers also found that new outsider CEOs are likely to correct the errors made by their predecessors compared to the insider CEOs because outsider CEOs are not responsible for the previously made mistakes. Therefore, the research conducted by Pan and Wang is very relevant to the current
one as the scholars also focused on the process of value creation, which is followed by CEO turnover.
Downsizing and divesting are major strategies commonly adopted by new CEOs after CEO turnover events. These strategies allow reducing some operational expenditures and minimizing the costs of a company, especially when investments are underperforming (Pan & Wang, 2012). Cost minimization is of great importance since it provides a more continuous measure that ensures that wastages are minimized or reduced in any production segment. It creates more value for a company in terms of better utilization of resources and a higher return on investment.
According to a study conducted by Murphy and Zabojnik (2007), the outsider CEOs tend to perform better than insider CEOs in the short period of time. This is because the market reacts more positively to outsider CEOs, especially immediately after his/her appointment. Turnover signals the market that positive change in the strategy of a company is expected to follow, and subsequently, there could be better post-turnover performance. According to these findings, outsider CEOs are expected to create more value to shareholders than insider counterparts. This means that post-turnover error correction by the outsider CEOs is value enhancing and that outsider CEOs have a propensity for correcting the previous wrong decisions, thus improving performance of a company.
Boot (1992) also provided some explanations concerning the process of value creation. According to the researcher, career concerns make the unskilled managers reluctant to abandon the unprofitable investments because abandonment is perceived as a signal of low skills. Consequently, firing an unskilled manager and divesting unprofitable investments will create value. The second main finding is that a threat of a takeover can reduce managerial inefficiencies, but this threat should be credible. A takeover threat is only credible for those companies that have assets that are neither company specific nor too marketable. This means
that raiders should obtain positive rents from a takeover; otherwise, it is not profitable for them to engage into the takeover activity. Boot’s predictions are relevant as they bring an interesting insight that replacing inefficient CEOs and divesting unprofitable projects would lead to value creation. Therefore, in most cases, CEO turnover should lead to value creation. According to Boot (1992), the error correction also occurs in target management turnovers after corporate takeovers and mergers. Further divesting as a corrective measure, which is implemented after the forced management changes, is meant to improve the effectiveness of the internal monitoring mechanisms.
Weisbach (1995) analyzed a sample of 270 acquisitions made between the 1970s and early 1980s. The researcher supported Boot’s predictions and indicated that the chances of divesting the recent unprofitable acquisitions would be very high after CEO turnover of whatever form. This is because a dismissal of the unskilled managers from a company allows implementing optimal divestiture. According to the researcher, forced CEO turnover on average improves the value of a company when a CEO with a low ability is replaced by a person with a higher ability. This is based on the dynamic principal-agent theory that states that the effort put by the CEO determines the level of performance (Sannikov, 2008).
Normally, it is noted that new outsider CEOs have a higher error-correction propensity than the new insider CEOs. As a result, this leads to outperformance of new outsider CEOs post-turnover. This means that if a company intends to change its course, it will likely to hire a CEO from the outside. This is because outsiders are not completely responsible for the wrong decisions made within the company. Thus, the outsider CEO can initiate and implement an effective process of error correction. Post-turnover error correction implemented by the new CEO, especially the outsider, comprises a management shake-up (Pan & Wang, 2012). The top management shake-up results in post-turnover performance and value creation, usually witnessed in post CEO turnover.
According to Eisfeldt and Kuhnen (2011), the general industry shocks may also lead to CEO turnover. This means that besides managerial skills the industry and market conditions in which an organization is operating may drive performance. When the market trends and conditions change, the skills that are needed from the CEO will also change. For this reason, a company may experience poor performance since the current CEO is not familiar with the new market trends. Thus, there is a need to change management in order to improve performance of a company. This means that a company needs the experienced new CEO who has all desirable skills set under the new industry and market conditions and who is capable of changing its performance and creating more value. For instance, according to the theory, a negative industry shock may force a company to downsize, whereas a positive one can make it expand.
Anderson, Guibaud and Bustamante (2012) on the other hand pointed out that CEO turnover could provide various growth options. Growth may in turn lead to value creation, which is achieved through the efficient reallocation of resources or a possible expansion in line with the new opportunities. This means that the nature of the industry shocks may determine the post-CEO turnover actions. Downsizing or to divesting are usually instigated by the unfavorable industry shocks and are frequently preferred by the new CEO as corrective measures to improve performance of a company and its value creation. According to researchers, the new CEOs are not responsible for the previous mistakes made by the former ones.
Khurana and Nohria (2011) used a longitudinal data set in their research and focused on the performance consequences of CEO turnover. According to those scholars, the factors that precede a predecessor’s departure, either forced or natural turnover, and the origins of the successor, either an insider or outsider, influence subsequent performance of a company. According to Khurana and Nohria (2011), CEO turnover in the organizations comprises both
the departure of the predecessor CEO and the origin of the successor. Thus, the impacts of CEO turnover on the performance of a company should be understood based on the two interrelated events.
There are four types of CEO turnover events identified in the following research: (1) natural turnover followed by an insider CEO; (2) natural turnover followed by an outsider CEO; (3) forced turnover followed by the insider CEO; and (4) forced turnover followed by an outsider CEO (Khurana & Nohria, 2011). According to the findings obtained by those researchers, natural turnover succeeded by an insider CEO has insignificant effects on the consequent changes and performance of a company. The researchers also noted that forced turnover, which is considered the most disruptive style of a CEO’s departure followed by an outsider successor CEO, could result in some significant performance improvements in the subsequent years. This is because the outsider successors can initiate dramatic and overall organizational changes within a company. The researchers found convincing evidence that forced turnover when succeeded by an outsider could amend the subsequent performance of a company. The authors concluded that understanding CEO turnover necessitates considering the type of departure and type of succession to show the relationship between the executive succession and the performance of a company.
According to their study, natural turnover succeeded by an outsider CEO shows a positive relationship, whereas a forced turnover succeeded by an insider CEO fails to show a positive relationship with performance. This is based on the reasoning that while forced turnover provides some opportunities for change, the insider CEO is incapable of effecting the required change that could, in turn lead to improved performance. This is because the CEO may have been part of the wrong decisions and thus maintains the status quo.
In their study, Huson, Malatesta and Parrino (2004) researched the effect of managerial succession and performance of companies. According to their findings, financial
performance of companies tends to deteriorate prior to top management turnover. This indicates that the board of directors in the respective firms often punishes or fires the CEOs if there is poor performance. This means that a successor must initiate changes that will make the firm witness positive performance in order to avoid firing in the future. Thus, this allows explaining the reason behind post-turnover value creation and performance. Further, the notice of turnover positively impacts the stock returns since investors expect new CEOs to improve the performance of a company and to create more value for shareholders. Through their multivariate regression analysis, Huson, Malatesta and Parrino find that managerial quality and the expected operating performance of a company increases after CEO turnover and that institutional shareholdings are significantly related to post-turnover performance changes.
2.1 Relationship between Post-Turnover Strategic Changes and Performance
This research aimes at linking the strategic changes to value creation and overall performance of an organization.
According to Romanelli and Tushman (1994), new CEOs are usually not committed to the predecessor’s policies and strategies. As a result, new CEOs, particularly if they replace their predecessor from outside the organization, have a greater potential for the initiation and implementation of tough strategic changes, such as downsizing and restructuring or divesting the poorly performing investments and reducing over-investments in particular projects. They can minimize the capital expenditures or cut the research and development budget allocations.
Jenter and Kanaan (2014) investigated CEO turnover and relative performance evaluation. The scholars used a sample of 3,365 CEO turnovers from 1993 to 2009. According to Jenter and Kanaan (2014), CEOs are more likely to be fired after bad market performance. In addition, the industry and market returns influence the frequency of forced
CEO turnovers. Thus, a successor must initiate strategic changes to improve performance and value of a company. According to these researchers, boards partially consider peer group performance when they evaluate CEOs and permit the exogenous shocks to the performance of a company to influence their decisions concerning CEO turnover. In this case, turnover focuses on CEOs who have comparatively underperformed their peers based on the industry returns.
According to Virany, Tushman and Romanelli (1992), CEO turnover has a positive influence on performance of an organization. Researchers studied 59 minicomputer firms between 1968 and 1971 and noted that a new CEO could fundamentally alter the knowledge and skills of a senior management team. The improved skills and communication processes in turn assisted managers in dealing with the changing environmental conditions and strategies. As a result, a CEO’s succession allows changing the corporate environment in order to sustain and improve the performance of a company. However, it is essential to distinguish between a CEO’s succession and the change in the senior management team since the latter can independently improve performance of a company. In addition, the researchers also proved that in the long-run strategic reorientation, executive-team changes are helpful in improving the performance of a company. The findings by Virany, Tushman and Romanelli are very relevant to the following research because they indicate that the researcher should take into account executive team change based on its positive effect on performance of a company and CEOs’ succession in the long term.
In their research, Friedl and Resebo (2010) focused on the effects of CEO turnover events on the performance of companies. They analyzed Swedish companies between 1994 and 2009. According to their findings, there has been an increase in CEO turnover since 1994. In 2008, the percentage increase is from 8.4% to 16. 4%. The researchers collected data on CEO turnovers and stock performance of 341 companies, which are traded in the Swedish
stock exchange. After having conducted the analysis of the collected data, Friedl and Resebo (2010) confirmed that the change of a CEO could impact the performance of a company. According to their findings, CEO turnover negatively affects performance of a company mostly in the first year because the stock prices can fall after the CEO is replaced.Reasons of the negative effect of CEO turnover within the first year include: the new CEO wants to get rid of all the postponed expenses, to write down the values of the overvalued assets to more realistic figures, and to reveal some information that has been hidden from the public by the former management team. However, this is done in the first year; therefore, it can only explain negative return of a company in the first year. Then, a company can stabilize again in the subsequent years. However, the findings of the following study are very controversial. It can be suggested that it might be the case only in Sweden.
Coates and Kraakman (2010) also studied the relationship between CEO tenure, performance, and turnover of S&P 500 companies. Researchers analyzed three modes of CEO turnover: (1) ‘deal,’ in which external turnover is activated by a friendly acquisition of a firm; (2) ‘fired’ or forced internal turnover, which is initiated by the board, and (3) ‘retire’ and other types of internal turnover. According to their findings, thecharacteristics of a CEO in regard to tenure and ownership influences turnover. CEOs who hold large personal shareholdings and CEOs who own smaller ones have different tenure. In this case, turnover considerably depends on the performance of a company within the first four years since the very moment when the CEO is hired. According to Coates and Kraakman (2010), internal turnover, especially after the CEO’s first five years of working in the company, is unrelated to performance of a company.
Dezso (2006) studied whether voluntary or forced CEO turnover could be followed by changes in the performance of companies and whether managerial entrenchment could affect these changes. According to the researcher’s findings, the firms with manager-friendly
entrenchment provisions insulate inferior CEOs. The researcher collected the data from 800 U.S companies between 1980 and 2000. According to Dezso (2006), firms with entrenched CEOs exhibit poorer performance prior to forced CEO turnover. Such firms tend to record significant improvements in their performance within three years after forced CEO turnover. Improved performance is thereby attributed to improved management. This means that the manager’s degree of entrenchment and insulation can influence the performance of a company. Usually, forced CEO turnover is followed by turnover at the top-management level. It should be noted that poor pre-turnover performance also improves after the new CEO takes his/her position. This means that improvement should be attributed to the entire top-management team and not only to the new CEO. Overall, this study is very useful since it helps to understand why CEO turnover creates value for some companies, but not for others.
2.2 Summary of the Chapter
This chapter reviewed the relative literature in order to understand the effects of CEO turnover on the performance of companies. Empirical evidence indicates that CEO turnover followed by an outsider successor can have positive influences on value creation and improved performance of a firm. This is because outsider CEOs have a higher propensity to initiate and implement various strategic changes, such as downsizing, divesting, or reduction of the budget allocations to over-financed investments, as they are not part of the wrong decisions made by the former CEO and his/her team. In this regard, an error correction activity that is proportional to value creation and improved performance is the best-implemented strategy initiated by an outsider CEO.
CHAPTER THREE: RESEARCH DESIGN & METHODOLOGY 3.0 Introduction
This chapter provides the research methodology that will be applied in this study. It will focus on the research design, sampling procedure, data collection methods, and operational definitions of terms and variables.
3.1 Hypotheses Development
Change in market capitalization, especially after the changes in top management, is a common scenario in many companies. These changes can be either positive or negative not least due to the strategies employed by the new management team. This research seeks to analyze the CEO turnover effect on all S&P 500 firms that experienced a CEO turnover from 2004 to 2013. The strategic changes will be analyzed in three settings based on the change of the market capitalizations: (1) companies that experience increased market capitalization after the new CEO takes over, (2) companies whose market capitalization value remains constant even after the change in top management, and (3), companies with decreased market value after a change in the CEO. In a company, the managerial career concerns of internal managers, and the possibility of a bias in different investments decisions can impede the timely correction of different managerial errors made by the former CEO. Similarly incumbent managers may find it difficult to abandon or divest from the previously initiated non-performing projects. Upon CEO turnover, divesting and downsizing rather than expansions are often chosen as corrective actions by the incoming CEO. Error correction by means of divesting is considered as a value creation mechanism associated with CEO turnover since the cost of production is minimized and resources are re-deployed to better performing projects.
In order to meet the research objectives, the author investigates the following hypotheses:
Hypothesis 1: An experienced incoming CEO does not add value.
Alternative Hypothesis 1: An experienced incoming CEO does add value to a company after turnover.
The experienced CEO is a person who has been working for at least 5 years within a company, before he/she was promoted to the CEO position. This is because the post-turnover correction strategies initiated by the new CEO are determined by the experience of a manager. This creates post-turnover value for a company. In this case, experience helps the management of a company to identify the working strategies that will produce positive results and thus create more value for a company.
Hypothesis 2: Strategic changes initiated by the incoming CEO do not add value. Alternative Hypothesis 2: Strategic changes initiated by the incoming CEO do add value.
This hypothesis shall help in understanding whether the post-turnover is responsible for better performance after the strategic changes have been introduced and implemented. Some of the strategic changes may include downsizing and replacing of the employees responsible for the erroneous decisions that have led to poor performance and enhancement of the effectiveness of error correction methods and re-optimization. It should be noted that in addition to the direct corrective actions, the post-turnover corrective actions are value enhancing, especially when the new CEO facilitates the process of error correction in a company. It is expected that the combination of operational divesting or downsizing with the turnover of a top management team may bring more value than the implementation of downsizing alone.
The fundamental role of CEO in the development of the success of a company and the main changes in strategies analyzed in the research represent the understanding of the theoretical studies unified as a Hypothesis 1 and Hypothesis 2 in accordance with the expected variables identification in the process of the research progressing.
3.2 Data Sources, Variable Constructions and Methodology
The data was collected from the ExecuComp database, CRSP database, Compustat and CRSP merged (CCM) and the Fundamentals Annual table from Compustat. We started with 18.839 observations from 2004 till 2013, which have identifiable CEOs. Information on the date when they became CEO, the CEO annual flag and a unique identifier (execid) were used in order to determine the CEOs at each given company. Afterwards by using each company identification code, CEOs were compared to the previous CEOs in order to determine when CEO turnover has occurred and to construct the turnover variable. As a result, 2,310 turnover events occurred during the 2004 to 2013 period. The summary statistic table is provided in appendix (Table 1, Panel A). Two different measures of performance have been chosen: change in market capitalization and stock return. All those measures were constructed by using the CRSP, CRSP and Compustat merged databases and choosing companies based on gvkey and 4-digit SIC code. The CEO age variable was taken from the ExecuComp database. The variable “downsizing” was constructed by looking at the negative change in net operational expenses after CEO turnover. The variable “cut of investment” was constructed by looking at negative change in capital expenditures. Data on capital expenditure and net operational expenses was taken from Compustat database.
After having analyzed these cases, we measured the changes in market capitalization and stock return of each company (taken from Compustat and CRSP merged database) during the time when a certain CEO was in charge. The year when the CEO turnover occurred is year 0. Therefore, the strategies are implemented also in year 0. However, the effect of those strategies on company performance is measured from year 0 to year 1. For example, “stock return [1]” is the percentage change in stock price from year 0 to year 1. This reasoning is based on the assumption made, that the market reaction to post-turnover actions occurs after year 0. The “CEO experience” variable was constructed by using CEO age and the number
of years the CEO was working in the company before he/she was appointed as a CEO. By regressing market capitalization changes and stock returns during the CEO’s first year after CEO turnover, we later compute coefficients that relate the success of his/her strategies to the firm’s performance.
Operational definitions of the key concepts variables are given in Table 3.1. CEOs’ performance was a key variable in the following research. Consequently, the link between value creation of a company, in terms of market capitalization and stock return, and strategic changes initiated by the new CEO will be studied in the following research.
Table 3.1. Operational Definitions of Variables
1 Set of variables, such as: mkvt, prcc_f, xrd, dlc, lt, at, dltis, dltr, dvt, ni, capx has been downloaded from CRSP
and Compustat merged database.
Key Variables Operational Definitions and Construction Data Source CEO Experience in year t
(age measure)
It refers to the age of the incoming CEO at the moment when the CEO took office.
ExecuComp
Downsizing
(dummy variable measure)
Equals 1 if the company has reduced total operational expenses (xopr) between t & t-1
Compustat
CEO Experience within a firm in year t
CEO tenure
Equals the number of years the CEO was working in the company before he/she was appointed as a CEO.
ExecuComp
Change in Market Capitalization of company c between year t
and u
This variable was constructed by the following formula:
(mkvtc,u-mktvtc,t)/mktvtc,t1
CCM
following formula: (prcc_fc,u
-prcc_f
c,t)
/prcc_f
c,tLog Assets t This is the control variable that is constructed as logarithm of total book assets in year t.
CCM
Cut of Investment in company c in year t
(dummy variable measure)
Equals 1 if it was a decrease in capital expenditure (capex) in year t
Compustat
R&D intensity Equals total R&D expenses (xrd) divided by total sales
CCM
Leverage Equals debt in current liabilities (dlc) + long-term liabilities (lt)/assets(at)
CCM
Net LT Debt Issuance (dummy variable measure)
The variable was constructed by the following formula: long-term debt issues (dltis) - long-term debt reduction (dltr)/assets. This variable equal to 1 if the number is greater or equal to 2% and 0 otherwise.
CCM
Dividend Payout Ratio Equals to dividend (dvt)/ net income (ni) CCM Capx/Sale Equals to capital expenditures (capx)/ sale CCM
CHAPTER FOUR 4.0 Introduction
The research is based on the data collected from the ExecuComp, Compustat and CRSP databases. The traditional OLS regression function will be used in order to analyze the data and test the hypotheses.
4.1 CEOs’ Experience
It is worth noting that experience depends on the amount of time that each person occupies a similar position in other companies. On the other hand, experience of a person may depend on the time that he/she spent as a worker on lower positions in a company until he/she was appointed as the CEO.
In this research two measures such as CEO age, the number of years the CEO was
working in the company before he/she was appointed, as a CEO will be used as proxies of CEO experience. The first algorithm was based on the CEO age, which means in theory that the older the CEO is the better results he/she should deliver for the company. In addition the effect of CEO tenure within the same company will also be tested on the company performance. This is due to the fact, when a company decides to appoint the new CEO, top managers of a company can become possible candidates for this position. In case a top manager is promoted to the position of the CEO, he/she has zero experience as a CEO. This person has a lot of experience concerning the internal system and all peculiarities of a company. The specificity of such experience should not be ignored in this research. Therefore, we took into account the amount of years spent on different posts within a company as the variable that can be classified as CEO’s experience with a given company. Therefore, we considered the fact that the current CEO worked for the same company on different positions as a separate factor. As a result, the number of years the CEO was working
within a company before being appointed as a CEO is used as a proxy of CEO experience within a firm.
On the one hand, the experience of working as a top manager cannot be equated to CEOs’ experience. However, in the process of natural career development, the newly appointed CEOs were promoted from the high-ranking managers. Moreover, in case a top manager spent more than 5 years working for the same company, he/she has certain knowledge and specific awareness of how the company should be managed. Therefore, we considered experience of working for the same company (the year when the CEO joined the company and the year he/she became the CEO) as an additional factor.
Moreover, the analyzed data shows that the general tendency practiced is to promote the leading employees from their own companies rather than invite professionals from other companies. The effectiveness of this system will be discussed in the next sections. The main criterion of CEO’s working experience corresponds to the number of years spent within an organization.
When preference is given to CEOs from other companies, board of directors usually expects to see an experienced leader. However, it is important for the board of directors to analyze the work experience of the CEOs and to estimate the period of time that they occupied the same post in other enterprises before they take the final decision.
4.2 CEOs’ Selected Strategies
During the whole period of occupying the post, the CEO can use a number of strategies aimed at improving or supporting business progress. As a leading executive officer in a company, the CEO tries to minimize expenses and maximize profits of a company. Management shake-ups and downsizing are widely used by CEOs. They are aimed at implementing radical changes in the financial status of a company. On the contrary, cuts of
investments can bring systematic changes in policy and help to achieve more economizing use of physical capital and rationalize financial turnover of a company.
In order to construct cut of investment variable, change in net capital expenditure was used. Therefore, the “cut of investment” variable was equal to 1 if negative change in net capital expenditure occurred and 0 otherwise. (Appendix, Table 5). Besides, the variable “downsizing” was constructed by using change in net operating expenses. Consequently, “downsizing” is also a dummy variable, which equals 1 if negative change in operating expenses have occurred after CEO turnover and it equals 0 otherwise (Appendix, Table 5). In addition, the effect of others policy changes on company performance after CEO turnover has also been analyzed and reported (Appendix, Table 6). According to the table, change in research and development intensity, change in net long-term debt, change in leverage and change in dividend payout were used as proxies for the other strategic changes initiated by an incoming CEO after CEO turnover. The data was collected from CRSP and Compustat merged database.
4.3 Summary Statistics
First of all, by contemplating the number of CEO turnover, we recognized the unfeigned propensity to increase; hence we can assume two possible way-outs: the increase of publicly listed companies and the volatility and frequent turbulent shifts in business environments, that require CEOs, with more pertinent traits and skills, who better fit into the company by providing organizations with new controversial and unconventional market strategies and business visions (Appendix, Table 1). Furthermore, Table 2 (Appendix), without any doubts, creates the pattern of concrete interconnection between “downsizing” and “cut of investment”, during the whole 10-year count period. It depicts that, all reductions or increases in any of the variable mutually related to one another. In addition, the noticeable increase in
“downsizing” and “cut of investment” strategies adopted in 2009 by an incoming CEOs can be explained by the financial recession at that time, which means that incoming CEOs were required to decrease costs in order to survive and remain competitive. The meticulous glance on the numbers in «outgoing-incoming CEO» table 3 (Appendix) depict the crucial proportional changes between the incoming and outgoing CEOs actions towards companies' performance. Firstly, the low percentage of only 33.4% of outgoing CEOs (158 out of 473 CEO) who undertook at least some actions («cut of investment» or «downsizing») in terms of cost reduction strategies, whereas new incoming CEOs did nothing. On the other hand, the «incoming CEO» axis projects the exponential growth in ratio of attempted actions. In percentage ratio, 79.6% out of total number of incoming CEOs (numerically, 1227 out of 1542 CEO) contribute an action and this corollary creates the concrete meaningful propensity to action by new incoming CEO, in comparison with pretty unprolific outgoing CEOs. In other words, in 1227 out of 1542 cases new incoming CEOs adopted at least some strategy, while the outgoing CEOs did not do anything.
In 2004, 14.2% of General Directors left their posts in the largest companies - in about 2500 companies. In 2003, this percentage was equal to 9.8%. Moreover, in 2004, the highest turnover was observed at the level of CEOs in the industrial sector (19.5%), health (16.2%), and telecommunications (16%). The safest turnover for CEOs was recognized in the energy industry. In 2004, only 10.3% of CEOs changed in the following industry. In companies specializing in the production of raw materials and high-technologies, less than 12% of key executives changed.
After having analyzed the data from 2004 to 2013, we concluded that during this period, the proportion of CEOs’ dismissals increased by 300%. In 2005, 31% of CEOs’ dismissals in the U.S. were associated with the indicators of their effectiveness.
Turnover among directors is almost equal to its level of all other employees. It is stated that turnover in a typical American company is close to a 12% mark. Indices of turnover among the American directors were 11.7% in the year 2005. It should be noted that today, CEOs turnover is not different from turnover of an ordinary employee.
It is stated that the new CEO will devote all his/her attention to achieving the short-term results and long-short-term strategy. As a result, the value of the company could suffer in the future, as incoming CEO can be interested more in achieving short-term results rather than long-term performance of the company. Managers should carry out and put into practice a development program of their companies so that the pursuit of the short-term results will not prevent the implementation of the main strategies and impact their companies and them in the long run.
Today, not sufficiently high efficiency has become the most popular reason for firing a CEO, after the violations of ethics and the struggle for power. Change of leadership has a strong interrelation with the low income of shareholders. During the last year, the return on investment in companies where CEOs were fired was 7.7% lower than that in those companies where CEOs left voluntarily.
4.4 Market Capitalization and Stock Return
The results of strategies implemented by CEOs can be understood from the changes in total market value and stock return that can either increase or decrease comparing with the financial coefficient estimated before CEOs entering his/her workplace.
In our research, we collected the information about stock price and total market value of the companies within the period when CEOs occupied their posts. The measured difference between the data collected before and after CEO turnover was estimated as a
positive tendency (+) if the company increased its physical capital or as a negative tendency (-) if its capital decreased if to compare to the previous results.
The level of total market value represented by company’s capital before CEO turnover was estimated as basic funds, current achievement of a company equal to 100% in each case of the employment of the new CEO. The progress of a company after a CEO’s dismissal was regarded as his or her achievements as a CEO. Therefore, the impact of the strategy selected by the CEO was calculated as a percentage of changes in physical capital in accordance with previous one.
4.5 Results and Interpretation
After analyzing each case of CEO turnover among 2310 cases, we focused on CEO experience and company performance. The results of changes in market capitalization of companies and stock returns were regressed by different proxies of CEO experience (See Appendix, Table 4). According to the results, CEO age has a positive effect on performance of the company in all cases. It was proven that there was an increase in the market capitalization of the company and stock return. However, this effect is not very strong. Therefore, it can be concluded that the CEO age partly determines the increase in the company performance. This, in turn, means the older the incoming CEO is, the better results for the company he/she would deliver. This can be explained by the fact, that, in theory, older CEO should have more general working experience and life experience than younger CEOs. Considering the tenure of manager within the company, before he/she became a CEO, it can be concluded that the effect of such tenure has also positive effect on company performance in all cases. This can be explained by the fact that with the increase in tenure, manager obtains a lot of experience concerning the internal system and all peculiarities of a company. As a result, when he/she becomes promoted to the CEO position, it should have a positive effect on the firm performance at least in the long run. In other words, the longer the CEO
was working within a company before being appointed as a CEO the better effect it should have on company performance. Consequently, Alternative Hypothesis 1, which states that experienced new CEOs do add value, cannot be rejected at 5% level of significance. (Appendix, Table 4)
Furthermore, strategies such as downsizing, cut of investment were analyzed (See Table 5). According to the results of findings, downsizing and cut of investment have positive effect on company performance in all cases. Therefore, downsizing and cut of investment are proved to be the effective strategies, implemented by an incoming CEO. These findings supports Pan and Wang (2012) “error correction” theory, which states that newly appointed CEOs are more likely to downsize and divest unprofitable investments and create positive changes for a company performance. As a result, Alternative Hypothesis 2 cannot be rejected at the 5% level of significance. Consequently, it has been proved that strategic changes, in our case downsizing and cut of investment, implemented by an incoming CEO indeed tend to add value. For example, if we look at table 5, panel B, we can notice that companies that downsize their operations after CEO turnover outperform those that do not by 14% in market capitalization performance and by 29% in stock return performance in year 1. The first test was conducted without control variables and the second test by including control variables. As a result, after including control variables, the effect of both strategies in some cases became smaller and in other-larger but it is still significant.
In addition, we also conducted the test of other policy changes adopted by the new incoming CEOs and their effect on company performance. (Appendix, Table 6) According to the table, change in “research & development intensity” policy has negative effect on firm performance. As a result, increase in “R&D intensity” means that spending on the research and development increases, while sales remain constant, which in turn increases the risk of inefficient spending as it doesn’t produce any result, thus it creates a negative effect on
company performance. Furthermore, by looking at the change in “ net long-term debt issuance” we can notice that the effect of such policy change has also negative impact on the performance of the company. This means, that increase in net long-term debt issuance comparing to total assets increases the risk of financial indebtedness of the company. On the other hand, by looking at the table we can recognize the positive effect of change in “leverage” on company performance. If we look at the change in “dividend payout” policy the effect is also positive on the company performance. This can be explained by the fact that dividend payout directly linked to stock return. In other words, increase in dividend payout ratio leads to increase in stock price of the company as investors become more confident about the company and highly value its shares. Consequently, we must admit that some policy changes adopted by the new incoming CEOs have negative effect on company performance, while others have positive effect. (Appendix, Table 6) However, those corporate policies have no significant effect on post-turnover firm performance. As a result, it should be noted that error-corrective strategies, such as downsizing and cut of investment are more effective than non-corrective, as they create more value for the company.
Moreover, the test was also conducted in order to analyze the effect of “outsider” CEO on company performance. (Appendix, Table 7) By looking at the table, it can be concluded that outsider CEO has a positive effect on firm performance in both cases. This means, if new incoming CEO is hired from outside the company he/she will outperform the insider by 7.4% in terms of change in market capitalization and by 12.1% in terms of stock return. (Table7, Panel A)
4.6 Summary of the Chapter
The following chapter provides the complex analysis of 2310 companies functioning between 2004 and 2013, for which data was available. It reveals that CEO turnover affects
the general tendencies, regarding the interdependence between the background (age and tenure within a firm) of certain CEO and company performance. In addition, error-correcting actions employed by an incoming CEO tend to play crucial role in value creation for the company.
CHAPTER FIVE
CONCLUSION
5.0 Discussion
In previous estimations, the research was aimed at detecting the formal markers of CEOs turnover background and success. By means of quantitative analysis, the researcher prompted to determine the general tendencies of CEOs turnover and general success as a possibility to continue functioning on a certain post. However, CEOs’ success cannot be analyzed based only on the above-mentioned variables. Since a candidate for the Chief Executive Officer’s post is usually appointed by the board of directors, his/her further career and strategic moves are often coordinated by the top team and shareholders.
Therefore, the following discussion will be dedicated to the identification of key concepts of CEOs’ decision-making due to the noticed hesitations of incomes. On the one hand, if the shareholders depart from the guidelines and wants to hire the new CEO, it is unlikely that he/she needs an innovator and strategist. Therefore, succession planning is aimed at finding an experienced and sophisticated person who has authority in the team. Such a person is expected to follow the course in the future.
On the other hand, the board of directors might want to replace the former CEO who failed to achieve certain results and appeared as a threat for the success and sake of a
company. His/her successor will be expected to show more strategic decisions, change, and innovation. In each case, succession planning requires personal initiations, actions, and even risks. Each company requires initiative and authoritative chief executives, capable of actualizing a role depending on the circumstances.
However, the internal policy of a company may slightly differ from the general executive’s professional archetype. Interrelations between the board of directors and the CEO are not usually suggested for public witnessing. However, the analysis of the movement of market value of a certain companies and the frequency of CEOs’ turnover during the period from 2004 to 2013 or during smaller periods of time allows estimating whether the CEO functioned as a crisis manager, was hired to make radical and risky solutions, or acted as an executive performer whose main target was to support the achieved results.
5.1 Conclusion
This research was conducted in order to understand whether incoming CEO’s experience plays an important role in creating value for the company and whether strategic changes, in terms of error-correcting actions, initiated by the new incoming CEO does add value for the company. The peculiarities of CEO turnout among 2310 CEOs were analyzed in the following research. As a result, it was proven that CEO experience indeed is important, as it has a positive effect on company performance. In other words, the more experienced new incoming CEO is, the more value he/she adds to the company. It was also proven that the duration of CEOs’ functioning within a company has a positive effect on the firm performance. This means, that the longer period the CEO was working in the company, before becoming appointed as a CEO, the better results he/she would deliver to the company. Consequently, Alternative Hypothesis 1: An experienced new CEO does add value to a company after turnover could not be rejected at 5% level of significance. Unfortunately, CEO
experience was proxied only by two measures, but still it contributes to the existing literature, by supporting the main theory.
Furthermore, it was also proven that strategic changes initiated by the new CEO tend to create value for the company. According to the research, error-corrective strategies, such as “downsizing” and “cut of investment” have a positive impact on the company performance in terms of change in market capitalization and stock return. Therefore, Alternative Hypothesis 2 found strong support and proved the “error correction” theory, developed by Pan and Wang (2012). For example, after CEO turnover companies that downsized their operations tend to outperform those that did not by 14% in terms of market capitalization.
In addition, other policy changes initiated by the new incoming CEO after CEO turnover were also analyzed. (Appendix, Table 6) Therefore, some of the post-turnover policy changes have negative effect on the company performance, while others have positive effect. However, all those corporate policy changes are found to be not statistically significant comparing to error-correcting strategies explained above.
Besides, the effect of CEO succession origin on company performance was also analyzed. (Appendix, Table 7) According to the conducted tests, “outsider” CEO tends to create value for the company. For example, if the company would hire new CEO from outside, he/she will outperform insider CEO by 7.4% in terms of change in the market capitalization.
After having contradistinguished the achieved results, we summarized that the complex of such strategies as “downsizing” and “cut of investment” appeared the most effective, whereas the CEO experience, especially in terms of CEO age plays only the minor role in company performance.
5.2 Limitations and Further Analysis
In this secton I would explained the limitations that I have faced during my research. I
would like to start with the econometric issues, such as omitted variable bias (OVB), reverse causation, multicollinearity and selection. Due to the fact that the data is not available and observable for some key variables that must be included in the regression equation leads to the omitted variable bias. Therefore, the coefficient estimate can have negative or positive bias and standard error can also be biased positively. Moreover, there is also a possibility of reverse causation bias, which means a two-way causal relationship. For example, “cut of investment” is associated with the stock return, so cut of investment leads to the change in stock return. However, it is also possible that the change in stock return influences cut of investment. Furthermore, multicollinearity can also be an issue as it occurs when independent variables in multiple regression model are closely correlated to one another. For example, in appendix in table 6 there is a possibility that the change in R&D is correlated with the change in dividend payout. In addition, there is also a possibility of selection bias, which means that the particular sampling group of CEOs was taken more often than other groups included in the research. Unfortunately, not all the data was available for each company, which made it impossible to analyze each turnover event that was identifiable. Two different measures for company performance have been chosen. However, market capitalization of company that was chosen as the first measure is affected by many individual factors, which makes it very hard to construct the direct link between CEO age and those variable. For example, different factors such as news, industry performance, internal financial position of a company, etc. influence the market capitalization of the company. Stock return is also affected by many independent outside factors. In addition, market capitalization and stock return are very similar indicators of market performance, therefore they should not produce the expected difference in company performance. On the other hand, all those variables were chosen as
proxies of market performance, since the data was available. For the further analysis I would suggest to test, whether change in company performance is the result of strategic changes initiated by the new CEO or the result of luck. There is a possibility to find completely new results, that would despute with the already existing theories. However, at the moment it was quite difficult to proxy such variable as luck. I assume, that knowledge in finance is not sufficient to perform such analysis and broaden knowledge in other scientific fields is required.
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Appendix
Table 1: Summary Statistics
Panel A: CEO Turnovers
This table presents the number of CEO turnovers each year, starting from 2004.
Year
♯of CEO turnovers
2004 68 2005 115 2006 166 2007 210 2008 226 2009 213 2010 238 2011 279 2012 362 2013 433 Total 2310
Panel B: Post Turnover Performance, Control Variables and CEO’s
attributes
This table represents different measures of performance after CEO turnover, which are expressed in terms of difference between the year when CEO took the office and a year before. Besides, it also shows control variables, such as capital expenditures and CEO’s attributes.
Variables N Mean Std. Dev Min Max
Post-‐Turnover Performance: Δ Market Capitalization 1650 0.4411 0.658 -‐0.986 2.925 Stock Return 1784 0.549 0.631 -‐0.9943 11.772 Control Variables Capx/Sales 2125 0.069 0.149 0 2.245 Log(Assets) 2155 7.814 1.859 2.303 14.67 CEO's Attributes: Age 2246 54.052 6.913 29 87 Tenure 2310 3.226 7,254 0 58 CEO's Strategies: Downsizing 2310 0.309 0.462 0 1
Cut of Investment 2310 0.341 0.474 0 1 R&D Intensity 2310 0.033 0.074 0 0.668
Leverage 1409 0.46 0.16 0.028 0.69
Net LT Debt Issuance 965 0.25 0.43 0 1 Dividend payout 1225 0.132 0.197 0 0.799
Table 2: Univariate results on strategic changes
This table represents the number of incoming CEOs that have undertaken the following strategic changes during the period from 2004 to 2013.
Year
In c o m in g C E O 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Total Nothing 12 26 28 45 88 32 50 39 85 68 473 Downsizing 0 23 24 38 72 123 88 70 127 151 716 Cut of Investment 22 34 58 70 79 103 107 97 99 121 790 Downsizing & Cut ofInvestment
0 4 11 12 32 71 50 31 51 69 331
Table 3: Univariate analysis on strategic changes of outgoing and
incoming CEO
Outgoing CEO
I n c o m i n g C E ONothing Downsizing Cut of Investment Downsizing & Cut of investment Totals Nothing 315 65 73 20 473 Downsizing 500 71 112 33 716 Cut of Investment 532 128 85 45 790
Downsizing & Cut of Investment
195 54 68 14 331
Table 4: CEO experience and value creation
Panel A
This table represents number of years the CEO was working in the company before he/she was appointed as a CEO and CEO age, which is used as a proxy of CEO experience. Robust standard errors are reported in parentheses, ***. ** and * indicate 1%, 5% and 10% level of significance.
Change in Market Capitalization [1]
CEO Tenure Within a firm 0.0013** (0.002)-
-
-
CEO age-
0.010** (0.006)-
-
CEO age^2-
-
0.00010 (0.00005)-
CEO age [40,60]-
-
-
0.002** (0.003) Controls no no no no N 1621 1778 1778 1458 Adjusted R-squared 0.0003 0.0042 0.0052 0.0003Panel B
This table shows the effect of CEO experience and tenure on the performance of the company in terms stock return. Robust standard errors are reported in parentheses, ***. ** and *
indicate 1%, 5% and 10% level of significance.
Stock Return [1]
CEO Tenure Within a firm 0.0015** (0.002)-
-
-
CEO age-
0.0034** (0.004)-
-
CEO age^2-
-
0.000037 (0.00004)-
CEO age [40,60]-
-
-
0.057** (0.012) Controls no no no no N 1663 1920 1920 1577 Adjusted R-squared 0.0005 0.002 0.0006 0.001Table 5: Effect of cut of investment and downsizing on firm
performance
Those tables represent the effect of cutting investment in terms of decrease in capital
expenditures and downsizing on company performance. Two different measures are used for market performance. Both variables are dummy, so each variable equals 1 if strategic change has occurred after CEO turnover and 0 otherwise. . Robust standard errors are reported in parentheses, ***. ** and * indicate 1%, 5% and 10% level of significance.
Panel A: Effect of cut of investment on company performance
Change in Market Capitalization [1] Stock Return [1] Cut of Investment (Decrease in CapEx) 0.084*** (0.048) 0.032*** (0.065) Controls no no N 1461 1600 Adjusted R-squared 0.002 0.0001Panel B: Effect of downsizing on firm performance
Change in Market Capitalization [1] Stock Return [1] Downsizing 0.14*** (0.053) 0.29*** (0.105) Controls no no N 1461 1600 Adjusted R-squared 0.0052 0.009Panel C: Effect of both downsizing and cut of investment on firm performance
Change in MarketCapitalization [1]
Stock Return [1]
Downsizing and Cut of Investment 0.19*** (0.079) 0.199*** (0.082) Controls no no N 1461 1600 Adjusted R-squared 0.0062 0.0025
