CEO-Firm Match Quality and Firm Performance
65 Pages Posted: 9 Jun 2015
Date Written: June 8, 2015
Much of the empirical research on CEO pay is based on agency theory and has studied the incentives executives have to make decisions that benefit shareholders. This study takes a different look at CEO success by focusing on the quality of the match between the CEO and the firm’s needs. Compared to lower quality matches, highly productive matches are characterized by executives that have long tenures as CEOs and better per period firm performance over their time as CEO. A simple modification of a widely used Bayesian model of learning (DeGroot 1970) is proposed where the board of directors dismiss a CEO when they conclude the probability true firm-CEO match quality falls below a critical match quality threshold is greater than a threshold probability. This separation decision rule means CEOs are positively selected on match quality. The empirical results confirm this prediction; a statistically and economically significant relationship between the total time an executive serves as CEO (completed tenure) and monthly stock returns is found. We also find that stock returns in period t are correlated with completed tenure for CEOs that survive to period t. These results suggests investors are making valid judgments about firm-CEO match quality and boards of directors are making CEO retention decisions as they learn about CEO productivity in the firm. The results are inconsistent with models that predict long tenured CEOs become entrenched in their positions at the expense of shareholders.
Keywords: CEO entrenchment, firm performance, agency theory, match quality
JEL Classification: J41, J44, M51, D21, D83, G14
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