Risk and CEO turnover☆
Introduction
A key aspect of corporate governance is embodied in the decision rights granted to a firm's board of directors to hire, compensate, and fire the chief executive officer (CEO). These decision rights are manifested in comprehensive incentive schemes that include both a formal compensation contract and an option, exercisable at a board's discretion, to fire and replace incumbent CEOs. A vast literature examines the design of executive compensation contracts, including a number of papers focused in particular on the important role that firm performance risk plays in optimal contract design via the pay-performance-sensitivity (PPS) aspect of CEOs’ compensation contracts.1 While there also exists a significant empirical research stream that investigates relations between CEO turnover and realized firm performance, little attention has been directed toward isolating key channels through which firm performance risk can directly impact CEO turnover decisions.2 In this paper, we extend the extant literature by establishing fundamental connections between firm performance risk and CEO turnover.3
The central focus of our analysis is on the role played by performance risk in impacting a board's ability to learn about a CEO's unknown talent. This focus on interactions between performance risk and learning processes of boards introduces a different perspective on risk from that typical in the executive compensation literature. The archetypical compensation setting is concerned with designing optimal incentives for executives to take actions that benefit shareholders. In this setting, performance risk represents noise with respect to observing an executive's actions, and risk-averse executives must be paid a risk premium for bearing performance risk, regardless of the source of the risk. In contrast to the role of firm performance in the provision of incentives, CEO turnover decisions instead utilize firm performance to learn about a CEO's unobservable talent. A key element in a board of director's decision to retain or dismiss an incumbent CEO is the board's assessment of the CEO's talent relative to the assessed talent of potential replacement CEOs. This learning perspective shifts the focus from the impact of performance risk on the risk premium demanded by risk-averse executives to the role played by performance risk in facilitating or impeding a board's ability to learn about CEO talent from realized performance.4
The fundamental insight of our paper is that the impact of performance risk on the ability of boards to learn about CEO talent from firm performance depends crucially on the underlying sources of the risk. The idea is that if volatility in performance outcomes is driven primarily by unobservable CEO talent, firm performance is diagnostic about such talent, allowing boards to accurately assess CEO talent and to replace low talent incumbents. However, if volatility in performance outcomes is driven by factors unrelated to CEO talent (e.g., noise, economy-wide effects, etc.), then a board's ability to infer CEO talent from performance is more limited, making it difficult to cleanly distinguish an incumbent's talent level from the assessed talent of potential replacement CEOs.
To isolate these two fundamental economic forces, we first analyze a simple, two-period model with symmetric learning about unknown CEO talent. We derive the optimal firing rule as a function of two sources of risk: risk deriving from uncertainty about a CEO's unobservable talent level and risk deriving from sources outside the CEO's control. The model produces three empirical implications concerning the relation between performance risk and CEO turnover. First, the probability of CEO turnover is increasing in the variance of the distribution over CEO talent. When uncertainty over CEO talent increases relative to other sources of variability, firm performance becomes relatively more diagnostic about CEO talent, increasing the board's ability to detect low talent incumbents and exercise their firing option when warranted. Second, the probability of CEO turnover is decreasing in volatility unrelated to talent and beyond the CEO's control. Such volatility represents noise from the perspective of learning about a CEO's talent from observed performance. More noise increases the difficulty of distinguishing the talent of incumbents from those of potential rookie CEOs, increasing the board's reluctance to incur the costs of exercising their firing option. Third, the sensitivity of CEO turnover to observed performance is increasing in the variance of the distribution of CEO talent and decreasing in volatility unrelated to talent.
Turning to our empirical analysis, we use stock returns as our empirical measure of firm performance and decompose return volatility into its idiosyncratic and systematic components. We posit that idiosyncratic volatility reflects information arrival related to the impact of CEO talent on firm performance, while systematic volatility captures aspects of return variability unrelated to CEO talent and beyond the CEO's control. We predict that these distinct aspects of volatility have opposite effects on CEO turnover given their differential implications for the process of learning about CEO talent. Consistent with this prediction, we provide robust empirical evidence that the likelihood of CEO turnover is increasing in idiosyncratic risk and decreasing in systematic risk, after controlling for firm performance.
We also predict and show that turnover-performance-sensitivity increases in idiosyncratic risk and decreases in systematic risk, consistent with the information content of performance with respect to learning about CEO's talent increasing in idiosyncratic risk and decreasing in systematic risk.5 This result stands in stark contrast to the extant executive compensation literature in which higher performance risk from any source is generally expected to decrease pay-performance-sensitivity due to risk-aversion considerations. In our turnover setting, risk impacts the learning process and can either increase or decrease turnover-performance-sensitivity depending on the underlying source of the volatility.
It is instructive to contrast our analysis of risk and CEO turnover with the Jin (2002) analysis of risk and CEO pay-performance-sensitivity. Analogous to our study, Jin (2002) decomposes the volatility of stock returns into idiosyncratic and systematic components. Using data on executive compensation contracts, he shows that idiosyncratic risk is negatively related to pay-performance-sensitivity, but he finds little relation between systematic risk and incentive level. These results are consistent with the Jin (2002) model in which all (unhedged) sources of performance volatility represent risk that the CEO must be compensated for bearing, resulting in the classic trade-off between CEO incentives and the cost of CEOs’ bearing risk. In contrast, in our setting, higher volatility driven by factors related to CEO talent (i.e., idiosyncratic risk) makes firm performance more diagnostic about talent, where volatility unrelated to CEO talent (i.e., systematic risk) is noise from a learning perspective. Thus, our paper complements Jin (2002) by exploring the impact of performance volatility in a different, but interrelated context, revealing distinct channels through which performance risk impacts contracting relations between boards and CEOs.
In Section 6, we complete our empirical analysis by exploring interrelations between the firing option and CEO compensation. First, we show that for retained CEOs, pay-performance-sensitivity is decreasing in the probability of turnover. This is consistent with the insight from our model that when the probability of turnover is high, the CEO faces high-powered implicit incentives and so requires less explicit incentives. We also show that for CEOs who are retained, subsequent pay levels are also a decreasing function of the probability of turnover, suggesting that the retained CEO could be forced to take a pay cut as turnover pressure increases. This is consistent with Gao, Harford, and Li (2008), who show that pay cuts can be a short-term substitute for dismissal.
Finally, it is important to relate our paper with Jenter and Kanaan, 2008, Kaplan and Minton, 2006, who show that the systematic component of returns significantly influences the likelihood of CEO turnover, contrary to the received theory of relative performance evaluation.6 In contrast, we investigate how both idiosyncratic and systematic return volatility impacts CEO turnover. We do incorporate the Jenter and Kanaan, 2008, Kaplan and Minton, 2006 results in our empirical analyses by including the systematic component of returns in our analyses to mitigate potential model misspecification (and replicate their results). However, we are not aware of any theory connecting systematic return volatility to violations of relative performance evaluation. It is important to stress that our analysis requires only that systematic return volatility impede ability to learn about talent from performance, and we provide evidence consistent with this story, including that the likelihood of turnover is decreasing in systematic risk, after controlling for idiosyncratic and systematic returns.
The paper is organized as follows. In Section 2, we analyze a two-period model and develop empirical implications. Section 3 describes the data underlying our empirical analyses and provides descriptive statistics. Section 4 presents our empirical analyses about the relations between CEO turnover and distinct components of risk, and Section 5 presents our results on the relation between turnover-performance-sensitivity and risk. Section 6 examines the implications of CEO turnover decisions for CEO compensation contracts, and Section 7 summarizes and concludes.
Section snippets
Basic assumptions and model setup
CEOs are endowed with a given level of talent. The CEO and the firm have common knowledge about the distribution over CEO talent, but neither party knows the actual level of CEO talent (see also Gibbons and Murphy, 1992, Holmstrom, 1999, Hermalin and Weisbach, 2008). CEOs are ex ante identical, with all market participants holding identical prior beliefs over talent. The firm operates for two periods, t=1, 2. A contract is signed between the firm and the CEO at the beginning of period one. The
Data and construction of the forced turnover sample
Identifying whether a CEO turnover event is forced is not straightforward as involuntary turnovers are often presented as retirements. Classification thus requires hand collection of data from multiple sources, in particular, press releases. We follow the classification scheme devised by Parrino (1997) to classify turnovers into forced and routine.14
Empirical relations between CEO turnover and risk
In this section, we present in Table 2 the main analysis of our predictions that CEO turnover probability is increasing in Risk_Idiosyncratic and decreasing in Risk_Peer, after controlling for firm performance. In Table 3 we examine whether the impact of the two components of risk on turnover varies with two CEO characteristics: CEO tenure and company founder status. In all specifications, we include a number of key control variables and year dummies (all variables are defined in detail in
The empirical relation between performance risk and turnover-performance-sensitivity
In this section, we investigate the prediction (Empirical Implication 3 in Section 2) that the sensitivity of turnover to performance is increasing in idiosyncratic risk, consistent with higher levels of idiosyncratic risk implying higher information content of performance with respect to talent, and decreasing in systematic risk, consistent with higher levels of systematic risk implying lower information content. The results of our analyses are in Table 4, Table 5.
Table 4 presents the main
Implications of CEO turnover on CEO compensation contracts
The model in Section 2 simultaneously solves for the optimal firing rule and the optimal CEO compensation contract. In this final empirical section, we study interrelations between the firing option and CEO compensation. First, we explore the extent to which the threat of turnover creates implicit incentives that reduce the explicit pay-performance-sensitivity in CEOs’ compensation contracts. Second, we explore how the probability of turnover impacts the future pay levels of CEOs when they are
Summary and conclusions
In this paper, we investigate the role played by performance risk in impacting a board's ability to learn about a CEO's unknown talent. A key element in a board of director's decision to retain or dismiss an incumbent CEO is the board's assessment of the CEO's talent. The fundamental insight of our paper is that the impact of performance risk on the ability of boards to learn about CEO talent from firm performance depends crucially on the underlying sources of the risk. If volatility in
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We would like to thank an anonymous referee, Jeff Abarbanell, Ryan Ball, Henry Cao, Qi Chen, Eliezer Fich, Raffi Indjejikian, Alan Jagolinzer, Dirk Jenter, Bjorn Jorgensen, Matthias Kahl, Michael Lemmon (Western Finance Association discussant), Ed Maydew, Karl Muller, Bill Schwert (the editor), Doug Shackelford, Harold Zhang, and seminar participants at University of North Carolina (UNC) at Chapel Hill, Hong Kong University of Science and Technology, University of British Columbia, Boston University, Tel Aviv University, University of Texas at Dallas, Wharton School of the University of Pennsylvania, Harvard Business School, Danish Center for Accounting and Finance, Duke-UNC Accounting Fall Camp, and Western Finance Association for their thoughtful suggestions and comments. All errors are ours.