In a CEO Transition, Some Assets Are Lost in the Shuffle

Incoming CEOs do a second-rate job of handling the investments of their predecessors. Is it because their reputation isn’t on the line or is something else at play?
In a CEO Transition, Some Assets Are Lost in the Shuffle

The essentials

How well do newly hired chief executives manage the assets they inherit from outgoing CEOs? Research by Mark Huson and Heather Wier, both of the University of Alberta, found a significant reduction in the relation between return-on-assets and SG&A (selling, general, and administration) expenditures when the managing CEO was not the investing CEO. These results were driven by “non-routine” turnovers, particularly when the replacement CEO came from outside the firm. There are two possible reasons: One, with little of their reputation at stake, newly-hired CEOs from the outside may find it easier than inside hires to dissociate themselves from decisions of their predecessors. Two, firms select outside successors in part because their style differs from that of departing CEOs. Huson presented their findings at a Queen’s School of Business research seminar.

Much as an incoming CEO wants to believe the old adage that “a new broom sweeps clean,” it’s never that simple. New chief executives inherit (or are saddled with) so-called legacy assets generated by his or her predecessor. 

You could understand why a new CEO would make a half-hearted attempt at managing these legacy assets. After all, successors do not bear the reputational costs associated with investments made by an incumbent chief executive. But that’s bad news for shareholders who look askance at unrealized value.

“Whether investments made by outgoing CEOs harm or benefit shareholders depends in part on how well incoming CEOs manage investments that they did not make,” says Mark Huson, professor of finance at University of Alberta. 

Huson teamed up with University of Alberta colleague Heather Wier, professor of accounting, to examine how well newly hired CEOs manage the assets they inherit from their predecessors. He spoke about their research at a Queen’s School of Business seminar in April 2014. 

For raw data, Huson and Wier pulled information from Execucomp relating to CEO transitions between 1992 and 2011. As a marker for legacy assets, they used selling, general, and administrative (SG&A) expenditures. SG&A includes expenses such as marketing and brand development costs, distribution channel management, engineering expenses, information technology, and employee training. “The breadth of the SG&A category permits CEOs to make expenditures that are correlated with their own human capital,” says Huson. As well, “SG&A is a major category of expenditures that is on average 31 percent of the value of the firm’s total assets.”

The proof is in the poor return on assets

Once they crunched the numbers, Huson and Wier found a significant reduction in the relation between return-on-assets (ROA) and SG&A expenditures when the managing CEO was not the investing CEO. These results were driven by “non-routine” turnovers, particularly when the replacement CEO came from outside the firm.

“The normally positive and significant relation between lagged SG&A expenditures and current ROA disappears in the first years of a newly appointed outside successor,” says Huson. “This result does not appear to be driven by poor investments on the part of the outgoing CEO or by general difficulties in transition management experienced by the new CEO.”

One possible explanation may have to do with outside successors’ greater ease in dissociating themselves from decisions made by the former CEO compared to inside successors who are invested in the firm’s strategy choices. 

But Huson and Wier also found evidence suggesting incoming CEOs from the inside “may actually manage legacy SG&A better than the CEO who made the expenditures” in the first place. This would suggest that firms select outside successors in part because their style differs from that of the outgoing CEO.

These results should cause boards of directors to rethink how they manage the transition between chief executives. They are, however, fighting competing forces. Many CEOs nearing retirement have a subtle incentive to curtail investment and discretionary expenditures to increase their earnings-based bonuses. To fight this value-destroying tendency, some boards alter executive compensation packages to actually encourage discretionary expenditures by lame duck CEOs. 

While this is probably a correct course of action in most cases, Huson says, board members should weigh the likelihood of an outside replacement being hired before encouraging investment by outgoing CEOs. Boards should also consider the impact of legacy assets on the performance of new CEOs when determining CEO compensation in the first few years of their tenure.

Alan Morantz

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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