CEO Tenure and Firm Value

Peter Limbach is Professor of Corporate Finance and Governance at the University of Bielefeld. This post is based on a recent paper, forthcoming in The Accounting Review, by Mr. Limbach; Francois Brochet, Associate Professor of Accounting at Boston University Questrom School of Business; Markus Schmid, Professor of Corporate Finance at the University of St.Gallen; and Meik Scholz-Daneshgari, Karlsruhe Institute of Technology.

Among academics and practitioners, there is an ongoing debate over whether CEOs stay in office too long. Empirically, a mosaic of evidence suggests that corporate outcomes – such as earnings management (Ali and Zhang, 2015), firm-customer and firm-employee relationships (Luo et al., 2014), innovation (Wu et al., 2005), net investments (Pan et al., 2016), and profitability (Henderson et al., 2006) – vary over the CEO’s time in office. Yet, this body of evidence does not provide a clear answer to a fundamental question: How does firm value vary over a CEO’s tenure?

To inform the question of whether there exists an optimal CEO tenure, we bridge this gap in the literature in two ways. First, by looking at firm value, a comprehensive and forward-looking measure that captures the realized and expected net benefits of CEOs’ actions to shareholders. Specifically, we measure firm value using Total q from Peters and Taylor (2017), who propose an adjustment to Tobin’s q that incorporates intangible assets into the denominator by capitalizing R&D and a portion of SG&A expenses. Second, by providing evidence on the determinants of the CEO tenure-firm value association.

We base our empirical predictions on key assumptions and findings from the theoretical literature in management and economics. The most explicit theory of CEO tenure and firm performance is Hambrick and Fukutomi’s (1991) descriptive model of a CEO’s “seasons”. Hambrick and Fukutomi (1991) argue that CEOs will contribute to firm performance positively over time as they increase their task knowledge and become more capable of making value-enhancing decisions. However, Hambrick and Fukutomi (1991) also argue that, the longer they stay in office, CEOs become more powerful, less able to learn, and less engaged, which all lead to declining firm performance. Overall, they predict that “performance very early and very late in the tenure will be lower” (p. 732).

Examining S&P 1500 firms between 1992 and 2017, our study is the first to provide systematic evidence of a hump-shaped CEO tenure-firm value relation. Specifically, for the average S&P 1500 firm, we find that the relation between CEO tenure and firm value is increasing over more than the first decade of a CEO’s tenure and starts to decline after about 14 years. We use several empirical tests to confirm that the hump shape is statistically significant and that it best fits the data. We obtain similar results based on a semi-parametric estimation that does not assume a functional form. To mitigate endogeneity concerns arising from endogenous CEO-firm matching and past performance, we additionally examine the stock market reaction to announcements of sudden, unexpected CEO deaths taking place in the period 1950-2017. These CEO deaths are exogenous to firm and market conditions. We find that abnormal returns are negative (positive) if low-tenure (high-tenure) CEOs die unexpectedly and generally become more positive over a CEO’s tenure, indicating a declining, and at some point negative, contribution to firm value.

In the second part of the paper, we build on extant theoretical and empirical work to derive and empirically test cross-sectional predictions concerning the time-varying association between CEO tenure and firm value. Hambrick and Fukutomi (1991) posit that this association is likely to vary substantially across CEOs, firms, and other external conditions. Our cross-sectional predictions focus on plausible sources of deterioration of the match between the firm and the CEO. Our evidence suggests that the dynamics of CEO-firm match quality are a first-order driver of the CEO tenure-firm value association, as explained by firm characteristics (i.e., dynamism), CEO characteristics (i.e., adaptability), and labor market characteristics that affect the optimal matching between firms and CEOs.

In particular, we document the following three patterns. First, firm value peaks earlier during a CEO’s tenure in dynamic environments (for example, in industries with higher R&D expenditures or more globalization), whereas in more stable environments, firm value either peaks later during a CEO’s tenure or is positively associated with CEO tenure. Second, firm value peaks earlier during a CEO’s tenure for CEOs who are less adaptable to change, namely specialist CEOs with relatively low general managerial skills and relatively older CEOs, while it peaks later for generalist CEOs and increases over tenure if CEOs are younger. These two patterns raise the question of why boards would not just promptly replace CEOs when they have reached their peak? We predict that firms facing greater labor market frictions have a harder time attracting and retaining talented CEOs (who thus may negotiate more favorable terms that increase replacement costs). Consistently, we find that firm value peaks earlier for CEOs of firms that are subject to greater labor market frictions, such as firms with more local peers that have a larger market capitalization.

Our study has important implications both for the academic literature and for policy considerations. For example, our evidence extends the literature that examines CEOs’ impact on firm value and performance (e.g., Bertrand and Schoar, 2003, Bennedsen et al., 2020), which has primarily focused on heterogeneity across CEOs. Our study highlights the heterogeneity of CEOs’ impact on the same firm over time. We show that CEOs’ contribution to firm value during their tenure depends on their characteristics. For instance, we find adaptable CEOs to be associated with value creation for 25-30% longer tenure relative to less adaptable ones. Collectively, our results shed light on the dynamics of CEO-firm matching and its cross-sectional determinants, and we provide the most comprehensive evidence to date on the drivers of CEOs’ “seasons”.

The evidence we provide adds to the longstanding debate about CEO term limits. Our results suggest that periodic CEO turnover can be valuable for shareholders because even successful CEOs, who were good initial matches for their firms, may be associated with declining firm value over the later course of their tenure. However, our findings do not support a fixed policy of CEO term limits or general voting recommendations against high-tenure CEOs by proxy advisors given that the tenure-firm value relation differs considerably across firms and CEOs. Furthermore, while we find an average turning point of approximately 14 years, it should be noted that many CEOs end their tenure before that “peak”. Hence, it is possible that CEO tenure be too short in some cases.

The complete paper is available for download here.

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