Evidence of CEO Adaptability to Industry Shocks

The following post comes to us from Wayne Guay, Daniel Taylor, and Jason Xiao, all of the Department of Accounting at the University of Pennsylvania.

Prior turnover literature documents various signals of poor performance, such as stock returns and earnings, that lead a board of directors to terminate the CEO, but does not explore the underlying causes of the CEO’s poor performance. In many cases, terminated CEOs have been successful earlier in their tenure as CEO. At some point, however, the board decides that the existing CEO’s skills do not fit with the current leadership needs of the firm, and so switches to a new CEO. The question of why these previously successful CEOs are released (apart from retirements or voluntary departures) remains largely unanswered.

In our paper, Adapt or Perish: Evidence of CEO Adaptability to Strategic Industry Shocks, which was recently made publicly available on SSRN, we conjecture that a previously successful CEO may not be able to adapt when the firms within her industry change their business strategy, or more precisely, that strategic shocks within the industry increase the probability that the CEO will suffer from an adaptability problem. If strategic industry shocks alter a firm’s leadership needs, and the board perceives the CEO cannot adapt their skills to fit those needs, then the CEO is more likely to be terminated. For example, assume a CEO has a set of skills that leads them to prefer to conduct manufacturing activities domestically. When faced with competitive forces that dictate a different strategy, some CEOs may be able to adapt successfully to manage foreign manufacturing operations. Other CEOs, however, may have difficulty adjusting their skills to fit the current strategic needs of the firm. If this is the case, the latter type of CEO will face a higher probability of being terminated when the firm’s industry competitors change their strategies. We note that it is certainly the case that all CEOs can adapt to some degree to changing business conditions. The interesting question then, is whether one can identify the types of shocks, if any, that cause CEO adaptability problems.

The notion of CEO adaptability has not been discussed in the prior turnover or corporate governance literature. A related literature on manager “style” argues that CEOs have individual-specific preferences regarding investing, financing, and organizational practices that they carry with them over time and from firm to firm (e.g., Bertrand and Schoar, 2003). An interesting question raised by this research is whether CEOs are set in their styles, or whether they can adapt their styles to fit the needs of the firm at specific points in time. In other words, are CEO styles simply preferences, or do they instead reflect constraints on the CEO’s ability to effectively manage certain types of firms or within certain types of business environments? Another related literature argues that CEOs differ in terms of their “generalist” and “specialist” skill sets. We expect that generalist/specialist skills may differentially affect the ability of a CEO to adapt to industry-level shocks, but that the direction of this effect is unclear, ex ante.

In this paper, we analyze the relation between turnover and various shocks to the industry’s operating environment. Specifically, we use industry-level as proxies for exogenous changes in the business environment for the firms within that industry. If the board perceives the CEO cannot adapt to the change in industry strategy, and thus anticipates weakened future performance, directors will be more likely to fire the CEO than if they believe the CEO can adapt to the shock. Specifically, a firing in response to an exogenous industry shock suggests that the board anticipates a decrease in future performance large enough to warrant bearing the switching cost of replacing the CEO. If the board instead anticipates that the CEO will be able to adapt, such that the predicted decrease in future performance does not exceed the replacement cost of firing the CEO, she will be retained. Thus, for industry shocks where the board expects CEOs cannot (can) adapt, we predict a positive (no) relation between the industry shock and turnover (although we also recognize that the board’s ability to fire a CEO will be influenced by governance-related frictions).

We begin our analysis by estimating a base model of turnover using determinants common in the prior turnover literature. We find results consistent with those of prior studies and, in particular, we observe the well-documented negative relations between stock-price performance and turnover, and between managerial entrenchment and turnover. We then include various measures of industry shocks in the turnover model to begin our exploration of the types of changes in industry strategy that pose adaptability problems for CEOs. Some of our shock measures, such as shocks to investment, R&D, and advertising are loosely based on the key corporate practices examined by Bertrand and Schoar (2003) in their analysis of CEO “styles”. Other shocks, such as changes in industry competition, growth options, and the extent of globalization, are selected based on our own conjectures about innovations in corporate strategies that might cause CEO adaptation difficulties.

We find evidence of positive relations between CEO turnover and shocks to industry growth, investment, competition, and globalization, suggesting that CEOs in our sample are, on average, perceived to have difficulty adapting to these types of shocks. We also find that industry shocks influence the board’s decision to terminate the CEO due to poor firm performance. Specifically, we consider the possibility that boards use observed changes in industry strategy to infer whether current-period underperformance of their firms reflect potential CEO adaptability problems. For example, consider a CEO that is suffering from current-period poor performance. In deciding whether to terminate the CEO, the board will attempt to determine whether the CEO’s poor performance is expected to be transitory, or instead, to persist into the future. We conjecture that if the poor performance is contemporaneous with shocks to industry strategies that are known to give CEOs adaptability problems, the board is more likely to terminate the CEO. Consistent with this hypothesis, we find that recent underperformers are more likely to be terminated following industry shocks, suggesting that when boards observe such shocks, they put greater weight on current-period performance in the turnover decisions. Further, we find that industry shocks attenuate the weight placed on prior period returns in the turnover decision. Overall these performance-related results suggest that industry shocks raise a red flag for boards regarding the adaptability of their CEO, and lead them to increase the weight on current stock returns and decrease the weight on prior returns when making turnover decisions.

Extending these main results, we conduct several tests that document cross-sectional variation in the relation between industry shocks and turnover. Using several proxies for governance, we show that CEO entrenchment attenuates the effects of the industry shocks on turnover by shielding managers against dismissal in response to a shock. Specifically, we find that the likelihood that a CEO will be terminated following an industry shock is higher when activist investors hold a greater proportion of shares, and is lower when the CEO has longer tenure and when the CEO is also the Chairman of the Board. These results suggest that CEO entrenchment can create frictions that make it more difficult for a board to terminate inadaptable CEOs.

A CEO’s employment background and generalist/specialist skill set also appears to influence adaptability. We gather data on whether the CEO’s prior position was at a different firm and/or in a different industry, as well as the CEO’s “general managerial ability” index value constructed by Custodio et al. (2013). We find that CEOs hired from outside the firm, and CEOs with greater general managerial ability are more adaptable in that they are less likely to be terminated following industry shocks. Interestingly, CEOs that are hired from outside the industry appear to be less adaptable than those hired from within the industry, suggesting that CEOs are better able to handle industry shocks when they have more experience managing firms within their own industry. We also find that CEOs with higher pay in excess of standard economic and governance/agency determinants are less likely to be terminated following industry shocks. To the extent that we have effectively controlled for other determinant of pay, this suggests that adaptable CEOs command a pay premium in the labor market relative to their peers.

As a validation check of the results noted above, we examine whether future operating performance is lower in cases where the CEO is predicted to be terminated by the board, but is not in realization. That is, our analysis suggests that strategic industry shocks combined with poor performance increases the probability that a CEO will be terminated, but that in some cases, such CEOs are not terminated because of entrenchment-related frictions. In cases where the CEO is predicted to be terminated, but is not, we find that their respective firms do in fact experience lower future operating performance.

Finally, we examine turnover of top management beyond the CEO. Specifically, we re-estimate our main specifications, but replace CEO turnover with turnover of the non-CEO top-five executives (specifically, the four highest paid executives excluding the CEO). This analysis allows us to explore the adaptability of non-CEO executives to strategic industry shocks, and whether these executives have difficulty adapting to the same types of industry changes as do CEOs. We find that non-CEO executives are more likely to be terminated follow strategic changes in industry growth, investment, competition, globalization, and customer development (interestingly, the customer development result was not found for CEOs). We also provide some evidence that non-CEO executives are less likely to be terminated when the CEO is terminated following certain industry shocks. These results suggest that adaptability varies with the role that the executive plays within the organization, and that other executives may be turned over in response to changing leadership needs even if the CEO is not.

Our findings contribute to the literature on CEO “style” by suggesting that beyond just reflecting a preference, style may impede a CEO’s ability to adapt to changes in the business environment. Further, CEO adaptability may provide an explanation for the puzzling results documented in prior literature that CEOs are fired in response to exogenous circumstances beyond their control (e.g., Jenter and Kanaan (2012)). Finally, our results highlight various aspects of CEO entrenchment that can attenuate the board’s ability to terminate CEOs that are unable to adapt to changing industry conditions.

The full paper is available for download here.

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