How Management Risk Affects Corporate Debt

A firm’s default risk reflects not only the likelihood that it will have bad luck, but also the risk that the firm’s managerial decisions will lead the firm to default. Management risk occurs when the impact of management on firm value is uncertain, and, in principle, could meaningfully affect the firm’s overall risk. Practitioners have long understood the importance of management risk, and regularly characterize it as an important factor affecting a firm’s risk. However, the academic literature on corporate default risk and the pricing of corporate debt has largely ignored management risk. In our paper, How Management Risk Affects Corporate Debt, which was recently made publicly available on SSRN, we evaluate the extent to which uncertainty about management is a factor that affects a firm’s default risk and the pricing of its debt.

We identify the effect of management risk using the idea that uncertainty about future managerial decisions rises around executive turnovers, particularly CEO turnovers, and decreases over time as the manager’s actions are observed. When a senior manager departs, there is an immediate increase in the uncertainty about who his replacement will be, and also about the impact the new manager will have on firm value. Part of this uncertainty is resolved when the incoming manager’s identity is revealed, but substantial uncertainty remains about his ability and the quality of match between him and the firm. If the ex ante expectation of a manager’s quality is on average correct, then there should be no systematic change in the market’s estimate of an average manager’s ability over his tenure in office. What will decline unambiguously, however, is the noise in this estimate, since more observations of his actions will allow the market to learn more about the manager. Therefore, management risk, which arises because of the uncertainty of the manager’s value added, should decline with a manager’s tenure. If management risk increases the market’s assessment of a firm’s default probability, then the default risk embedded in the pricing of firms’ debt should also increase around the time of executive turnover and subsequently decline over the executive’s tenure.

Using a sample of primarily S&P 1500 firms between 1987 and 2012, we characterize the way that the risk of a firm’s corporate debt varies with the uncertainty the market likely has about its management. The announcement of a CEO’s departure is associated with an increase in the firm’s CDS spread, reflecting an increased market assessment of the firm’s default risk. The CDS spread declines at the announcement of the successor, and further declines during the new CEO’s time in office, approximately back to the pre-turnover level after about three years. Holding other factors constant, the 5-year CDS spread is about 35 basis points (22% relative to the sample mean) higher when a new CEO takes office than three years into his tenure. Spreads on shorter-term CDS contracts exhibit an even larger sensitivity to CEO turnover and tenure. Spreads on loans and bond yield spreads also decline following CEO turnovers. These patterns occur regardless of the reason for the turnover; changes in spreads following turnovers that occur because of the death or illness of the outgoing CEO are not economically or statistically significantly different from changes in spreads in the entire sample.

The CEO, however, is not the only member of the management team that is relevant for decision-making in the firm. We examine the effect of Chief Financial Officers’ (CFOs’) turnovers as well. Our estimates indicate that, similar to CEOs, spreads on a firm’s CDS and new debt decline over the first three years of its CFO’s tenure, but the magnitude of the decline is smaller than that following CEO turnovers, especially if the CFO turnover is not accompanied by a CEO turnover.

The observed decline in default risk over tenure potentially reflects the resolution of uncertainty about management and hence a decline in management risk. To evaluate whether this interpretation is the appropriate one, we examine cross-sectional variation in the way that ex ante uncertainty gets resolved across CEOs and firms. In particular, Bayesian learning models imply that if the changes in spreads around CEO turnover occur because of changes in management risk, then when ex ante uncertainty about management is higher, spreads should increase more around management turnover and decline faster subsequently.

Consistent with this prediction, our estimates suggest that the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of uncertainty there is about the new management. For example, the increase in CDS spreads at the announcement of a CEO departure when the firm does not have a presumptive replacement is almost three times as high as when there is such an “heir apparent.” The revelation of the new CEO’s identity leads to smaller declines in spreads prior to the time when he takes over if the new CEO is younger than if he is older; presumably less is known about the young CEOs ex ante so less uncertainty is resolved when they are appointed. But once a younger CEO does take over, the market learns more about his ability from observing his performance, so the spreads decline faster.

In addition, when the CEO has an existing relationship with a lender before he takes his current job, the lender is likely to know more about the CEO’s ability and future actions, leading to lower management risk. Consistent with this argument, we find that the sensitivity of interest rates to the CEO’s time in office is 39-57% lower for loans in which the CEO has a prior relationship with the lender compared to those without such a relationship. This relation holds even if the CEO is an outsider and the relationship was built while he worked at a different firm, so the existence of the relationship is exogenous to the credit condition of the current firm. Further, any additional management-induced risk should have a larger impact on the default risk and the pricing of riskier debt than of safer debt. Consistent with this prediction, we find that the firm’s spreads are more sensitive to CEO tenure when the firm is more highly levered, for term loans and for junior bonds. Overall, the cross-sectional evidence is consistent with the notion that the decline in spreads over executive tenure reflects the resolution of uncertainty about management.

Since uncertainty about management is likely to be idiosyncratic rather than systematic, it theoretically should not affect a firm’s cost of debt (i.e., the expected return on debt). Accordingly, firms should not adjust the cost of capital they use for capital budgeting purposes because of management-related uncertainty. In addition, since variation in management risk appears to be relatively short-term, it is unlikely to affect firms’ long-term capital structure targets. However, since management risk increases the volatility of cash flows, it should increase the demand for precautionary savings. Consistent with this idea, we find that firms facing higher management risk tend to have higher cash holdings. In particular, cash holdings decline with executive tenure, but only for firms for which management risk is likely to be high.

Understanding the way management risk affects corporate default risk and the pricing of corporate debt has a number of implications. First, our study identifies an important yet unexplored source of corporate default risk and a potentially important determinant of the pricing of corporate debt. The corporate finance literature on corporate debt pricing has focused on variables intended to capture risks coming from economy-wide factors, or those correlated with the nature of firms’ assets (see for example van Binsbergen, Graham, and Yang (2010)). A parallel literature in asset pricing models a firm’s credit risk, usually again as a function of economy-wide factors and firms’ assets. However, Collin-Dufresne, Goldstein, and Martin (2001) find that these traditional credit risk factors and liquidity measures fail to explain the bulk part of the credit spread changes. Our analysis suggests that models predicting credit risk could be meaningfully improved by including variables that capture management risk, such as the CEO’s tenure and his background including his age and whether he is an heir apparent.

Second, our study suggests that the effect of management risk on corporate debt pricing can be used to quantify the relative value impact of different types of managers. For example, our estimates suggest that the impact on debt price from the uncertainty about CFO is about 40-66% of that from the uncertainty about CEO. In addition, the fact that there is not a significant difference in the impact of tenure on spreads between insider and outsider CFOs, while there is a significant difference between insider and outsider CEOs, suggests that the managerial skills required by the CFO job are more general and transferrable than those required by the CEO job. These results complement prior studies using interview scores or employment history to infer the generality of managerial skills and their value impact (Kaplan, Klebanov, and Sorensen, 2012; Custodio, Ferreira, and Matos, 2013).

Third, our study highlights the importance of managing the management risk in a firm. Practices such as managerial succession planning and transparency in managerial policies can significantly reduce the firm’s perceived default risk. Since 2009, the U.S. Securities and Exchange Commission has required that corporate boards significantly address the succession related issues as leadership voids or uncertainty could adversely affect companies. Our findings support SEC’s concern and suggest that creditors clearly care about management risk.

The full paper is available for download here.