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Review of Quantitative Finance and Accounting

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23.05.2018 | Original Research

Does CEO managerial ability matter? Evidence from corporate investment efficiency

verfasst von: Huiqi Gan

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2019

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Abstract

This study investigates how higher ability CEOs behave differently from lower ability CEOs in making investment decisions and, particularly, whether CEO managerial ability contributes to improved investment efficiency. I show evidence that more able CEOs make more efficient investment decisions. Specifically, talented CEOs increase (decrease) capital expenditures, acquisition expenditures, and total investments when their firms operate in settings more prone to under-investment (over-investment). These results suggest that high managerial ability helps with overcoming the two sources of investment inefficiency: over- and under-investment. I also find that the positive impact of CEO managerial ability on investment efficiency generally persists across different levels of board monitoring, whereas it gets weaker as the CEOs are overly exposed to equity risk. Robustness tests of using alternative measures of CEO managerial ability and controlling for potential endogeneity issues generate consistent results. Overall, the findings suggest that higher managerial ability leads to more efficient investment decision-making.

Vorheriger Artikel Debt rollover-induced local volatility model

Nächster Artikel Relative option liquidity and price efficiency

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Upper echelons theory (Hambrick and Mason 1984) states that behavioral factors are influential in complex decisions in a corporate context. Generally speaking, strategic decisions and organizational outcomes are predicted, to some degree, by CEO managerial characteristics (Hambrick and Mason 1984).

Demerjian et al. (2012) confirm the validity of the measure of managerial ability and demonstrate that it contains less noise and better captures the manager-specific component of ability. In addition, they show that their proposed measures outperform existing ability measures, including past abnormal performance, CEO tenure, and media mentions. However, as Demerjian et al. (2012) acknowledge in their study, the managerial ability measures still have some limitations. For example, there could be measurement errors in some accounting variables that are used in the process of estimating firms’ efficiency scores and managerial efficiency scores; the regression processes may omit some factors that affect firm efficiency and managerial ability due to unavailable data; and residuals, which are used as the measure of managerial ability, may contain some factors that are not attributable to managerial ability.

The managerial ability measure developed by Demerjian et al. (2012) reflects managerial efficiency and productivity, which undoubtedly result from CEOs’ past (and unobservable) experiences, psychological traits, values, etc. In this sense, this measure is a summary proxy for CEO managerial ability that directly speaks to the research question and setting of this study. I acknowledge the merits of alternative managerial quality measures used by other studies, such as Chemmanur et al. (2001) and Chemmanur and Paeglis (2005), which use composite measures for managerial quality by taking management team size, knowledge and education, tenure, CEO dominance, and reputation into account. However, given that this study investigates how managerial ability impacts investment efficiency, these measures can be incomplete and less direct compared to the ability (efficiency) measure developed by Demerjian et al. (2012).

This managerial ability dataset is constructed according to the methodology in Demerjian et al. (2012). It is available on the website http://faculty.washington.edu/pdemerj/data.html.

I exclude the cash and leverage variables in Model (2) because the OVERI variable captures information about cash and leverage.

Before running regressions, I calculate variance inflation factors (VIF, hereafter) for the independent variables. The mean VIF is 1.50, and the independent variable with the highest VIF is capital structure (KSTRUCTURE), 2.79.

I require at least 20 observations for each year and industry.

The more positive (negative) the residuals, the greater is the magnitude of over-investment (under-investment).

These cross-section analyses serves two goals. First, they can further examine whether the different degrees of managerial ability’s impacts on improving investment efficiency are consistent with this study’s hypotheses. Second, they can provide evidence as to whether the positive effects of high managerial ability on investment efficiency still holds after controlling for CEOs’ various incentives and boards’ monitoring levels.

The calculation of delta and vega follows Core and Guay (1999, 2002) and Coles et al. (2006).

There is one exception: the above-median group using inside director ownership as the proxy. For firms that have CEOs with above-median inside director ownership, the effects of CEO managerial ability on improving investment efficiency are not significant (or very marginal).

I thank an anonymous reviewer for this suggestion.

As another robustness test, the average ability score of a CEO prior to joining the current firm is also employed as an alternative independent variable of interest to test Model (2). To construct this measure, I require the sample to have 1) CEO turnover and 2) the CEO’s ability data from both the current firm and the prior firm. These restrictions reduce sample size to 498 observations. The regression results (not tabulated) have not shown significant, even though the signs of the coefficients are generally consistent with those in Table 4. The insignificant results can be due to small sample size.

Using the average ability ranking of a CEO over the sample years when he/she is the CEO of the firm as an alternative independent variable of interest generates consistent evidence (untabulated): CEOs with higher average ability rankings tend to reduce (increase) total investments and capital expenditures when firms are likely to over-invest (under-invest).

The two instrumental variables have passed the overidentification and underidentification tests.

Although the study employs several ways to mitigate potential endogeneity problems in this research setting (e.g., using lagged models, robustness tests controlling firm- and year-fixed effects, and using 2SLS regressions with instrumental variables), endogeneity issues may still exist. For example, there might still be omitted variables affecting managerial ability and investment relation or firms’ hiring and investment policies. I acknowledge this as one of the limitations of this study.

Meanwhile, prior literature maintains that tenure also indicates a potential entrenchment problem. The longer a CEO remains in that position, the more likely the CEO is to be entrenched (e.g., Mace 1971; Finkelstein and Hambrick 1989; Hill and Phan 1991).

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Titel: Does CEO managerial ability matter? Evidence from corporate investment efficiency
verfasst von: Huiqi Gan
Publikationsdatum: 23.05.2018
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2019
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-018-0737-2

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