The chief executive officer (CEO) and the top management team are typically viewed as critical to the success or failure of companies. As it is not uncommon for top executives to make value-destroying decisions, the role of internal control mechanisms, such as oversight by a board of directors (BoD), is to safeguard the interests of shareholders by replacing poorly performing incumbent CEOs with new ones.
But does it pay to fire underperforming CEOs? Doing so can cost shareholders a bundle in severance packages and golden parachute payments. When CEOs at Hewlett-Packard, Bank of New York Mellon, Yahoo!, Kellogg’s, and United Airlines were asked to step down, they walked away with severance packages of tens of millions of dollars. In the S&P 500, CEOs are entitled to receive an average of $22 million in the event they are fired.
The corporate investment decisions of CEO successors offer fundamental insights into the corporate performance-resuscitating role of CEO replacements and whether they improve corporate decision making. Recent research has highlighted the importance of corporate investment decisions in CEO careers, with poor investment results a key reason for forced CEO exits. This is not surprising in view of the paramount importance of corporate investment for the operating and stock performance of a listed company as well as for the whole economy (in 2017, U.S. companies invested more than $4 trillion in growth). To address this question, research has focused on Mergers and Acquisitions (M&A) – the most important form of corporate investment with clearly measurable outcomes – and has documented that poorly performing bidders (those that undertake value destroying M&A) are more likely to be fired.
Yet, two important questions remain: Do new CEOs beat their predecessors’ record of firm performance through superior M&A and other investments? And can monitoring mechanisms linked to the firm’s corporate governance and ownership structure improve the firm’s investment performance through superior CEO hiring decisions?
In our recent article, Does Firing a CEO Pay Off?, we find remarkable improvement in corporate investment performance following termination of a CEO. More specifically, while the average M&A deal of a departed CEO typically brings about a 0.88 percent abnormal reduction in the market value of the acquiring firm (the firm undertaking the investment) around the deal announcement, the average deal of a successor CEO tends to increase shareholder wealth by 1.59 percent. To put this into perspective, in the five years after a CEO firing, an average-sized firm generates a staggering $273 million in shareholder value through M&A, which is $390 million better than under a predecessor CEO. Since this gain is 10 times greater than the implied cost associated with firing a CEO, dismissing an underperforming CEO seems good for shareholder interests.
Our findings also suggest that the benefit from replacing a CEO persists beyond the period surrounding the deal announcement, since CEO successors’ M&A seems to create significant long-term shareholder value. We also document that CEO successors create sizable shareholder value by reversing prior investments through selling assets and discontinuing certain operations while adopting more efficient organic (CAPEX and R&D) and inorganic (M&A) investment strategies.
So what drives the significant improvement in firm performance after CEO firing? Our findings show that strong internal and external monitoring mechanisms as well as managerial experience are instrumental in how successful new CEOs perform. The stronger the corporate governance (measured by the degree of board independence) and the higher the hedge fund ownership in the acquiring firm, the greater the improvement in investment performance. This seems consistent with the view that good corporate governance can facilitate superior CEO hiring decisions and that external monitoring by hedge funds not only prompts CEO turnover but also considerably improves CEO hiring decisions. CEO characteristics are also important. For instance, management experience seems particularly important to a CEO’s success and thus deserves special attention in considering a CEO replacement.
The general conclusion from this new research is that, although the cost can be substantial, corporate boards should not think twice before replacing underperforming CEOs at publicly traded companies and should reduce that cost by aligning executive pay policies with performance.
This post comes to us from professors George Alexandridis at Henley Business School’s ICMA Centre, John A. Doukas at Old Dominion University’s Strome College of Business and a research associate (honorary) at the Judge Business School, University of Cambridge, and Christos Mavis at the University of Surrey’s Surrey Business School. It is based on their recent paper, “Does Firing a CEO Pay Off?,” available here.