Human Capital, Management Quality, and Firm Performance

The following post comes to us from Thomas Chemmanur and Lei Kong, both of the Department of Finance at Boston College, and Karthik Krishnan of the Finance Group at Northeastern University.

The quality of the top management team of a firm is an important determinant of its performance. This is an obvious statement to many. Yet, there is little evidence that relates top management team quality to firm performance in a causal manner. Part of the challenge in doing so stems from assigning a measure to the quality of the top management team. There are, after all, various aspects of top managers that contribute to their performance, including their education, their connections and prior experience. Another reason that relating management quality to firm performance is hard is that one can argue that the best managers can simply select into the best firms to work in. This makes making causal statements extremely hard in this context. As a result, while one can point toward anecdotal evidence relating good managers to good performance (e.g., Steve Jobs of Apple), systematic evidence is lacking in the academic literature on this issue. The relation between management quality and firm performance is important in more than just an academic context. For instance, analysts frequently cite top management quality as a reason to invest in a stock. Thus, one needs to ask what they mean by “quality,” and does it really impact the future performance of the firm.

In our paper entitled, Human Capital, Management Quality, and Firm Performance, which was recently made publicly available on SSRN, we attempt to tease out the causal relation between top management quality and firm performance. The basic theoretical setting in this paper is as follows. The quality of a firm’s management team may affect its future performance if higher quality managers select better projects (characterized by a larger NPV for any given scale) and implement them more ably. This means that firms with higher quality management teams can be expected to have better future operating performance. Further, since, in a symmetric information setting, the market value of a firm will be the present value of future cash flows to stockholders, firms with higher ability management teams will also be characterized by higher market values. If we assume that the stock market does not fully incorporate the effect of higher operating cash flows instantaneously but only gradually over time (as these cash flows are realized), then firms with higher ability management teams will also be characterized by greater future stock return. Further, given that the setting predicts a larger scale of investment for firms managed by higher quality management teams, we expect to see greater extent of capital and R&D investments by these firms.

We overcome the various empirical hurdles described above by, first, creating a management team quality index from various measures used previously in the literature, such as top management team size, fraction of top managers with MBAs, the fraction of employment- and education-based connections of the top management team, prior experience of the members of the top management team, and prior directorships of the members of the top management team. These measures are adjusted for firm size. We create a comprehensive index of management quality based on common factor analysis using the above-mentioned measures of management quality.

We overcome the second hurdle related to endogeneity by using Vietnam War period draft deferment rules for graduate education. In particular, after the start of the Vietnam War and until 1968, draft rules allowed draft deferment for a person who gets admitted to a graduate degree. This led to many individuals getting a higher education for reasons unrelated to their intrinsic quality and provides an exogenous variation in the human capital of managers. This instrument is also ideal for our analysis, since within the sample period in our data (1999 to 2010), individuals who graduated during the 1960s were of the typical age for top managers in corporations in the U.S. Using this instrument, we find a causal relationship between our management quality index and a firm’s long-run future operating performance, market to book ratio, and long-run future stock-returns. Consistent with the notion that higher management quality firms have a larger optimal scale of investment, we find a positive effect of management quality on capital and R&D investments as well as on changes in these investments.

Further, if management quality is an important driver of firm performance due to the ability of the top management team, we would expect this relationship to be stronger for firms in R&D intensive industries, where knowledge and human capital of top managers is more important; and for firms in more competitive industries, where management quality can be more important in giving the firm an edge over competitors. Consistent with this notion, we find that the relationship between our management quality factor and future operating performance, current market valuation, and future stock returns are stronger for firms in R&D intensive and more competitive industries. Finally, our results indicate that the positive relationship between management quality and firm performance is more important during recessions, when managerial ability in selecting better projects and implementing them ably is important; and for firms in financially constrained industries, where managerial ability in selecting and implementing projects more efficiently is important. Overall, our results indicate that management team quality is indeed an important driver of value for firms.

This paper contributes to the literature by analyzing the relationship between various measures of the management quality of a firm and its long-run future operating performance, current stock market valuation, and long-run stock returns. Moreover, this is the first paper to establish a causal relationship between management quality and operating performance, stock market valuation, and long-run stock returns. By doing so, we are able to identify a new determinant of firm performance that has not received significant attention in the literature.

The full paper is available for download here.

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