Good and Bad CEOs

Dirk Jenter is a Professor of Finance at London School of Economics and Political Science, Egor Matveyev is a Senior Lecturer and Research Scientist in Finance at Massachusetts Institute of Technology, and Lukas Roth is an Associate Professor of Finance at University of Alberta. This post is based on their recent paper.

How important are individual CEOs for firm performance and value? CEOs are not randomly allocated to firms – e.g., better firms are likely to attract better CEOs – and their turnover is likely to be correlated with other changes that affect productivity. This makes it difficult to assess whether variation in performance is due to differences in leadership.

To make progress on this question, our paper “Good and Bad CEOs” analyzes changes in firm value, performance, and behavior caused by deaths of incumbent CEOs. This allows us to measure the contribution of the deceased CEO relative to that of their successor. Unlike other CEO turnovers, most CEO deaths are randomly allocated to firms and are not a decision made by the board of directors. Hence, any effects of CEO deaths on firms should be due to scarce CEO talent, changes in the division of value between shareholders and CEOs, or frictions in the matching of CEOs to firms.

Analyzing 449 CEO deaths in publicly traded US firms between 1980 and 2012, we find striking heterogeneity in the shareholder value effects of CEO deaths. While the average stock price reaction to CEO deaths is small, we document large negative reactions to many deaths and large positive ones to many others. In 10% of cases, stock prices drop by at least 13% in the four days around announcements, while in another 10% of cases, stock prices rise by at least 11%.

The large losses associated with many CEO deaths suggest that these firms are worth more under the incumbent than the successor, and that a large part of the value created accrues to shareholders. The large stock price gains associated with other deaths show that their shareholders prefer the expected successor. If board governance worked well, this should never happen, as firms should always be matched with their value-maximizing CEO. In reality, however, shareholders welcome a surprising number of CEO deaths.

The heterogeneity in stock price reactions is in part explained by CEO and firm characteristics, such as CEO age, tenure, and firm size. Stock prices tend to fall when the deceased CEOs are young, but they tend to rise when CEOs are old, and especially old and long-tenured. Deaths of young founder CEOs cause the most negative stock price reactions, and deaths of old founder CEOs the most positive ones, consistent with founder CEOs being more influential but also more difficult to remove. However, CEO and firm characteristics combined explain only a small fraction of the variation in stock price reactions, indicating that shareholders use other information (such as observations of CEO actions) to assess CEOs.

We also explore the operational effects of CEO deaths. The initial stock price reactions suggest that shareholders expect large negative effects in some firms and large positive ones in others. Consistent with the stock price reactions, there are no significant changes in average operating performance, but there is unusually wide dispersion – some deaths improve operating performance and others worsen it. There are also unusually large changes in sales growth, dividend payments, and cash holdings, indicating that the new CEOs change operating policies.

Finally, we show that the stock price reactions to CEO deaths have predictive power for subsequent operating performance and firm failures. Stock price reactions in the bottom third of the sample predict decreases in operating profitability, increases in operating expenses, and unusually many firm failures (defined as going bankrupt, being delisted, or liquidated). Stock price reactions in the top third predict the opposite. Hence, investor reactions to CEO deaths offer valuable insights into the quality of the terminated CEO-firm match.

In sum, our results show that many CEOs have first-order effects on their firms and, crucially, that these effects are highly heterogenous. If there were a large supply of capable CEOs of all types, and if firms could frictionlessly match with their preferred CEO at all times, a CEO death would cause firms to quickly hire a similar replacement, with minimal effects. Our results show that this is not a good description of reality for many firms. Instead, they suggest that the supply of executive talent is limited, the matching process far from frictionless, and the resulting match quality highly heterogeneous.

Our findings also have implications for interpreting CEO pay. Its rapid rise since the 1980s has led to a contentious debate about whether pay levels can be justified by CEOs’ contributions to firm value. Our evidence adds to both sides of this debate: The stock price declines associated with many CEO deaths suggest that their firms are worth more under the incumbent, and that these CEOs are not extracting all the value they generate. On the other hand, the stock price gains associated with many other deaths suggest that those CEOs lower shareholder value, either because they are not the right match or because they are overpaid.

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