Managerial Legacies, Entrenchment, and Strategic Inertia

In the paper, Managerial Legacies, Entrenchment, and Strategic Inertia, forthcoming in the Journal of Finance, my co-author, Catherine Casamatta, and I explore a firm’s decision to replace a poorly performing CEO with a new CEO in a context where strategic decisions have a long-term impact on the firm’s cash flows. Such a legacy implies that a new CEO’s performance is partially affected by something he bears no responsibility for, namely the previous CEO’s choice of firm strategy. This renders the incentive problem of a new CEO more severe than it would be for the incumbent CEO. As a result the firm will not always wish to fire the CEO even if he performs poorly – the incumbent is entrenched. In contrast to much of the literature on CEO turnover, which views entrenchment as a result of weak boards, we argue that entrenchment may be optimal for shareholders.

We then study the board’s decision to change strategy and CEO. Strategy change and managerial turnover are closely associated, and the (endogenous) cost of managerial turnover makes it more expensive for the firm to change strategy. This leads to ‘strategic inertia’ in the firm’s decision. These results arise purely from managerial incentive problems and in spite of the fact that all managers in our model are ex ante identical. We thus challenge the view that managerial style, i.e., an innate manager specific skill, is required to explain the observation that managers in practice are associated with certain types of strategies.

Last, we explore how manager’s ability to implement strategies affects the decision to change managers and strategies. We show that weakening a strategy’s legacy potential weakens entrenchment and strategic inertia. Finally, we distinguish between internal and external replacements and show that when the legacy potential is weakened, an internal successor may be preferred over an external one.

The model highlights a new potential determinant of managerial turnover, namely the legacy potential of strategic choices. It allows us to derive numerous empirical predictions to enrich empirical studies on managerial turnover, and to distinguish our theory from others. We predict that managerial turnover after poor performance is less likely when legacy potential is strong and reputation concerns are important. Moreover, we are able to link managerial turnover to strategy change, and CEO pay. The model predicts a higher (incentive and average) pay for newly hired CEOs replacing poorly performing predecessors. Finally, it allows us to distinguish internal and external successions: internal successions should be positively correlated with strategy continuity, while external successions should be correlated with strategy change.

Although this paper focuses on the board’s decision to replace a CEO and/or a firm’s strategy, we believe that the underlying economic mechanism that we identify has many other interesting applications. One such application would be to look more carefully at the relationship between a CEO and top management just below the CEO level. On the one hand, lower tier executives may have an interest to please the CEO they are working for. On the other hand, if things go wrong, those managers who did not associate themselves too closely with the outgoing CEO may be in a better position to succeed him. Our approach may thus provide a framework to study career concerns in a more realistic setting where career progression is not just a function of a simple performance measure.

The full paper is available for download here.