The relation between CEO tenure and firm value is hump-shaped
To inform the question of whether there exists an optimal CEO tenure, in our study we bridge this gap in the literature in two ways. First, by looking at firm value, a comprehensive and forward-looking measure that captures the realized and expected net benefits of CEOs’ actions to shareholders (see box for more details on the specific measure of company value). Second, we provide evidence on the determinants of the CEO tenure-firm value association. We base our empirical predictions on key assumptions and findings from the theoretical literature in management and economics. The most explicit theory of CEO tenure and firm performance is Donald Hambrick and Gregory Fukutomi’s descriptive model of a CEO’s “seasons”. In their seminal work, Hambrick and Fukutomi argue that CEOs will contribute to firm performance positively over time as they increase their task knowledge and become more capable of making value-enhancing decisions. However, Hambrick and Fukutomi also argue that, the longer they stay in office, the more powerful CEOs become, ultimately making them less able to learn, and less engaged, leading to declining firm performance. Overall, they predict that the CEO tenure-firm value relationship is hump-shaped, with firm value first increasing and eventually declining in CEO tenure.
Our study is the first to provide systematic evidence of a hump-shaped CEO tenure-firm value relation, consistent with the predictions of Hambrick and Fukutomi’s descriptive model of a CEO’s seasons. For the average S&P 1500 firm, we find that the relation between CEO tenure and firm value increases for more than the first decade of a CEO’s tenure and starts to decline after about 14 years. We use several empirical tests to confirm that the hump shape is statistically significant and that it best fits the data. One major issue in empirical corporate finance and governance research is “endogeneity” which hampers any causal interpretation of results. In our setting, endogeneity concerns primarily arise because CEOs and companies are not matched randomly, but for reasons mostly unobservable to researchers. Similarly, many reasons for contract termination are unknown. These unobservable, and thus omitted, variables may result in biased estimation results. To mitigate such endogeneity concerns, we examine the stock market reaction following the announcement of sudden, unexpected CEO deaths between 1950-2017. Since these CEO deaths are exogenous to firm and market conditions, they allow us to observe how the market assessed the anticipated value contribution of these CEOs at the time of their deaths. We found that the market reacted more positively if the CEO had been in office for a longer period at the time of their death, independent of the CEO’s age and various observable CEO and firm characteristics. These results indicate that a CEO’s contribution to firm value declines in tenure and, at some point, even turns negative.