When Are Powerful CEOs Beneficial?

In our paper, CEOs and the Product Market: When Are Powerful CEOs Beneficial?, which was recently made publicly available on SSRN, we explore what the central factors are that influence when and how powerful CEOs may add value and how the benefits and costs of CEO power vary with industry conditions. In an ideal world, shareholders would grant an optimal level of power, weighing various costs and benefits specific to the firm’s characteristics and the business conditions in which it operates. We hypothesize that the optimal amount of power changes based on product market conditions.

Most recent research has shown that CEO power is negatively associated with firm value and is associated with negative outcomes for the firm. Articles have suggested that powerful CEOs may be bad news for shareholders (e.g., Bebchuk, Cremers, and Peyer 2011; Landier, Sauvagnat, Sraer, and Thesmar 2013). Morse, Nanda, and Seru (2011) provide evidence that powerful CEOs may have more favorable incentive contracts. Khanna, Kim, and Lu (forthcoming) show that CEO power arising from personal decisions can increase the likelihood of fraud within corporations.

With all these negative outcomes associated with CEO power, why are there still powerful CEOs? In this paper, we hypothesize that CEO power may create value for firms when they need to respond quickly to a rapidly changing and competitive product market. The central idea we examine is whether management undertakes efficiency-enhancing measures and value-increasing business decisions to stay abreast, or get ahead, of the competition when product markets are rapidly changing, and more competitive. Thus, efficient reactions to product market conditions are important necessary conditions for being successful in challenging and rapidly changing product markets. Efficiently implementing such corporate activities normally requires the CEO to have sufficient power to lead the firm and management team. In these circumstances, whether a CEO can efficiently lead the management team to react to the changes in product market conditions is crucial for firm performance.

We consider three key measures of a firm’s product market environment. The first one is “fluidity,” which is a text-based measure of product market fluidity from Hoberg, Phillips and Prabhala (2014). It captures changes in the products of rival firms and how these changes relate to a firm’s current product offerings. The second one is a measure of the changes to demand that a firm faces in its external product market. We use the changes in product shipments for downstream industries to capture demand shocks for the upstream industry. The third one is a text-based measure of product market concentration following Hoberg and Phillips (2010). It captures changes in the competition a firm faces in the product market in each year.

Our measures of CEO power have both “soft” and explicit components that capture the CEO’s ability to influence and direct corporate behavior. We capture “soft” influence by the CEO’s internal connections to non-CEO executives and directors in the firm, following previous studies (e.g., Morse, Nanda, and Seru, 2011; Khanna, Kim, and Lu, forthcoming). We use the fraction of top four non-CEO executives and non-CEO directors appointed during the current CEO’s tenure. Following previous studies (e.g., Adams, Almeida, and Ferreira, 2005; Hermalin and Weisbach, 1988; Morse, Nanda, and Seru, 2011), we use as indicators for explicit influence whether the CEO chairs the board, is a founder, and has served for longer than six years (sample median) as a CEO.

Our results show that the impact of CEO power on firm value measured by Tobin’s q depends on product market conditions. We find that unconditional measures of CEO power show a negative relation with firm value. However, the interaction terms between CEO power variables and our measures of product market conditions are significantly positive, suggesting that the product markets with high fluidity, demand shocks and competition make CEO power more beneficial in enhancing firm value. We document the benefits of CEO power in changing and competitive industries, both within-firm after controlling for firm fixed effects and cross-firm and industry after using CEO-firm pair between regressions or controlling for industry fixed effects. We find the economic effect of CEO power in these situations is also large. In the rapidly changing, challenging product markets, having a CEO with the overall highest power index versus the overall lowest power index results in an increase of 24.5% in Tobin’s q. We also find that CEO power is strongly positively related to capital expenditures and advertising expenditures in product markets that are rapidly changing and more competitive.

We further find that except for CEO tenure, all other components of CEO power become more beneficial in enhancing firm value in more rapidly changing, competitive product markets. We further examine the potential sources of CEO “soft” power. Besides having the chief financial officer (CFO) and greater fractions of directors appointed during the CEO’s tenure on the audit and advising committees can enhance firm value in product markets with high fluidity. Having the CFO and other key executives, as well as greater fractions of directors appointed during the CEO’s tenure on the audit and compensation committees, are also associated with higher firm value in competitive product markets.

Finally, we recognize that CEO power may be endogenous as Hermalin and Weisbach (1998) model and show that our results are robust to instrumenting CEO power with exogenous executive and director deaths.

Our results contribute to the literature studying CEOs by helping understand the two-sided nature of CEO power. They add to our understanding of the dynamic nature of assigning power to CEOs. In rapidly changing product markets that have high competition, CEO power has a positive relation to firm value. We thus add to Adams, Almeida, and Ferreira (2005) who find that powerful CEOs are associated with the best and the worst performing firms. Our results are consistent with a firm’s product market being a central factor that influences the optimal amount of power that should be delegated to the CEO.

The full paper is available for download here.