Most CEOs invest and divest assets based on a cycle that starts directly after they are appointed, according to research released in August by the US National Bureau of Economic Research.
The research examined the investments and divestments of 5,420 US CEOs that took office in 2,991 companies between 1980 and 2009.
It found that divestments (including asset sales or discontinued operations) were fairly common in the early years of a CEO’s tenure and decrease over time, while investments (including acquisitions and capital expenditures) are low in the early years and increase over time.
The peak of disinvestment occurred in the year after turnover occurred, with the probability of a company undergoing a divestment at that time being 21%, then falling to 13.7% in year eight. The total investment rate (investment over net value of the firm’s property, plants and equipment at the start of the year) increased from 53% in the year turnover occurred to 75% in year eight.
The first few years of a CEO’s tenure affected investment and disinvestment the most, according to the research. In the first three years after a CEO starts, the investment rate tended to be 6% to 8% lower than during later years in office and the probability that the company would divest was 3.2% higher.
The research found that the effect of the CEO investment cycle was of the same magnitude as external factors affecting investment such as business cycle, financial constraints or political uncertainty. The effect of being a CEO in the first three years of tenure was approximately the same as being a CEO in a recession or in a company facing financial constraints. It has more than twice the effect of being a CEO in an election year.
The cycle held regardless of the reason for CEO turnover. It also held regardless of industry conditions and whether an insider or outsider was appointed.
The paper hypothesised that the high level of divestments after CEO turnover occurred because the new CEO is incentivised to divest poorly performing assets that the previous CEO had paid for and was unwilling to abandon. The new CEO would not feel the embarrassment of being involved in the investment decisions they plan to divest.
Yet once this divestment is done, the CEO is incentivised to increase investment, as CEO pay and prestige is often connected to the size of a company. The longer the CEO spends with the company, the more powerful they become and the stronger their hold on the Board, such that the Board is more unlikely to oppose inefficient investments.
The research also mentioned alternate theories: that when a CEO starts, they divest the assets that do not suit their skill base and then invest in assets that do, and that a CEO’s expertise increases with tenure, leading for more opportunities for investment.
If the paper’s hypothesis and not the alternate theories were true, the paper concluded that:
- The quality of the divestments made after turnover should generally be poor;
- If the CEO was recruited from the old management team, or the former CEO and management were on the Board, the new CEO will be less likely to divest;
- It should not make a difference to the level of divestment after CEO turnover if the companies’ assets are all in one area or the CEO’s skills match the companies’ assets;
- The CEO’s power over the Board should be more important than their tenure alone; and
- The quality of investments made over a CEO’s tenure should remain static or decrease.
It then tested these statements, finding:
- Data suggests that only substantially underperforming segments established by previous management are divested at an abnormally high rate following CEO turnover, ruling out the divestment to suit skills argument.
- The probability was lower that a company divests assets after turnover if the former CEO remains as chairman or executives from the previous leadership remain on the Board.
- There was no significant difference in the investment cycle for firms that only had one line of business versus those with multiple lines of business, even if they hired company insiders that had all the necessary skill sets to manage current assets.
- The level of investment is correlated with the percentage of Directors that have been appointed since the CEO was appointed (an indicator of CEO power, as the CEO can try to influence appointments). If the data is controlled for the percentage of Directors appointed, the CEO tenure’s effect on investment disappears, suggesting that CEO tenure affects investment through progressively acquired control over the Board.
- The stock market reaction in the first three days after an investment announcement was 20 points better in the first three years of a CEO’s tenure than in later years. 39% of deals made in the CEO’s first three years had negative returns, while 58% of deals made after the first three years had negative returns.
Egan Associates Viewpoint
It would seem prudent to consider the investment cycle when designing at risk remuneration policy. Given the inherent incentives to invest efficiently are different at varying stages of a CEO’s role, incentive plans that remain static over a CEO’s time at a company may not deliver optimal shareholder benefits.
Boards should consider whether at risk reward should vary with the CEO investment cycle – both encouraging new CEOs to invest and ensuring long-serving CEOs are making value accretive acquisitions.