Investors require higher returns from firms with CEOs who have general managerial ability compared with those CEOs with specific abilities. These higher expected returns are more pronounced in firms with high human capital that belong to M&A-intensive industries and that have complex operations, a high number of agency problems, and a high number of antitakeover provisions.
The author finds that firms led by generalist CEOs have greater cost of equity by 14 bps than those led by CEOs with specific-to-industry managerial skills. An increase of one standard deviation in general managerial ability results in an 8 bp increase in the cost of equity capital.
The CEO with broad managerial experience possesses transferable skills, has incentives to take greater risks, poses a greater risk of his or her interests not being aligned with those of the shareholders, and will be more costly to retain. Investors will require a higher return for the increased risks associated with the generalist.
How Is This Research Useful to Practitioners?
When faced with a CEO hiring decision or succession planning, boards may want to consider costs beyond the higher pay and benefits associated with a generalist CEO. Indirect costs include the higher cost of equity capital, greater agency costs, a higher discount rate when analyzing investment opportunities, and the risk of losing key talent. Having a generalist CEO versus a specialist affects the firm’s long-term financing and investment decisions.
Although the author finds that the cost-of-equity effect increases significantly with firms that are in an M&A-intensive industry and have high organization capital, complex operations, a high number of agency problems, and a high number of antitakeover provisions, he does not suggest that a generalist CEO does not add value. Certain firms and industries may require general managerial skills. The author has not made any inferences as to the benefits associated with the additional costs of being led by a CEO with broad abilities.
How Did the Author Conduct This Research?
The author examines whether an investor’s required rate of return varies between generalist CEO–led firms and similar firms with specialist CEOs. Using ordinary least-squares regression and controlling for common determinants of cost of equity as well as industry and year effects, he finds that CEO general managerial ability significantly affects the implied cost of equity capital.
The CEO general managerial ability index (Gen-Index) the author uses is borrowed from Custódio, Ferreira, and Matos (Journal of Financial Economics 2013) and incorporates the number of CEO positions held, the number of firms worked for, the number of industries worked in, CEO positions held at other companies, and prior experience in a conglomerate firm. A higher score on the Gen-Index indicates higher CEO human capital or greater generalized managerial ability. The author hypothesizes that the easy transferability of these skills to other firms serves as incentive for the CEO to take higher risks, leading to increased agency issues and to investors requiring a higher rate of return.
The author uses the average of three widely applied cost-of-equity estimations. These measures do not rely on historical prices but are forward-looking to better represent the investors’ expectations. Data for the 12,431 firm-year sample of S&P 1500 firms are from the Institutional Brokers Earnings Services historical earnings file and the Compustat annual file and cover the period 1993–2006.
The author suggests that the indirect costs of having a CEO with general skills and experiences should be considered in CEO selection. This suggestion generates questions about how to measure those costs and the added benefits of a CEO with broad experience. How much value does a generalist CEO add for a firm involved in mergers and acquisitions, for a complex organization, or for a firm looking to reorganize? Which industries benefit most from a general-ability CEO? The author’s conclusion that significant costs are associated with a general-ability CEO warrants further research to identify and quantify those costs.