discussion of ownership structure, firm performance and top executive change: an analysis of uk...

DISCUSSIONOFOWNERSHIP STRUCTURE, FIRMPERFORMANCE AND TOP EXECUTIVE CHANGE: AN

ANALYSIS OF UK FIRMS

Steven Young*

Effective internal monitoring dictates that the likelihood of top managementturnover increases when firm performance declines. Evidence from the USbroadly supports the existence of an inverse relation between firmperformance and senior executive change. But is the same true in the UK?Dahya, Lonie and Powell (DLP) (1998) report important findings relating toexecutive turnover in a sample of UK firms during the period 1989 to 1992. Inaddition to confirming US evidence that turnover and firm performance arenegatively related, this comprehensive study also contributes to the literatureby illustrating that managerial stock ownership represents a potentiallyimportant intervening variable in the performance-turnover relation.Consistent with the findings of Denis, Denis and Sarin (DDS) (1997) thepaper documents a negative association between senior executive turnoverand the extent of their stock ownership. In other words, ownership by topmanagement canmake their timely removal less likely. A particularly strikingconclusion is that a significant degree of entrenchment can occur at relativelylow ownership levels (e.g., one per cent).

In the following discussion, I first consider the research method employed.Next I discuss the empirical findings. Finally, I offer some suggestions for fu-ture work. Many of my comments relate to the general literature on executiveturnover and should not, therefore, be interpreted as criticisms specific to thepresent paper.

METHOD

Sample Selection

From an initial sample of 2,643 London Stock Exchange firms, DLP examinedtopmanagement changes in 105 firms over a 48-month period from 1 January,

Journal of Business Finance&Accounting, 25(9) & (10), November/December 1998, 0306-686X

ß Blackwell Publishers Ltd. 1998, 108 Cowley Road, Oxford OX4 1JF, UKand 350Main Street, Malden, MA 02148, USA. 1119

* The author is ESRC Management Research Fellow, Department of Accounting and Finance,Lancaster University. This discussion has benefited from the helpful comments of Jorge Farinha,Ken Peasnell and Peter Pope.

Address for correspondence: Steven Young, Department of Accounting and Finance, TheManagement School, Lancaster University, Lancaster LA1 4YX.e-mail: [email protected].

1989 to 31 December, 1992. This turnover sample was then combined with166 firms that did not experience a change in their senior management teamduring the sample period. Data for the 271 firms in the final sample were thencollected for the eight-year period 1987^1994, resulting in a final sample of2,128 firm-year observations.1 Firm-years in which a topmanagement changeoccurred were coded one, while all non-change firm-years were coded zero.For the full sample, therefore, the dependent variable is a vector of 2,128observations consisting of 105 ones and 2,023 zeros.

This sampling approach raises several issues. First, pooling observations forthe turnover and non-turnover firms over an eight-year period tends to dis-guise the fact that the study only examines 105 actual turnover events. For ex-ample, consider the analysis of turnover rates, partitioned by ownership level,in Table 3. With an average number of annual observations per firm of ap-proximately eight, the 29 firm-year observations in the >25^30% categorytranslates into less than four cases of managerial turnover. Similarly, the 61(69) firm-year observations in the >20^25% (>30%) category contain ap-proximately eight (nine) turnover events. While the turnover rates based onthese frequencies remain valid and informative, the sparse nature of the datasuggests a degree of caution may be necessary when comparing rates for thedifferent ownership partitions.

Secondly, pooling time-series and cross-sectional data also means that theobservations are no longer completely independent, thereby biasing the stan-dard errors of the estimated coefficients. Finally, since all turnover cases aresampled during the period 1989^1992, none of the observations from 1987,1988, 1993 or 1994 add any additional information on managerial changes.The benefit of including these additional `non-event' firm-years in the ana-lyses reported in Tables 3^6 is not clearly elucidated. The cost, however, islikely to be a reduction in power due to the additional noise introduced bythese observations. All else equal, therefore, the results reported by DLP mayactually understate both the magnitude of the performance-turnover associa-tion, and the intervening effect of managerial ownership.

Classification of Executive Changes

Consistent with prior research, DLP dichotomise top management turnoverinto routine and non-routine categories: routine changes are defined as thosearising from normal succession and retirement, while non-routine changes arethose associated with (a) poor performance, (b) personal considerations, and(c) factors other than retirement. The success of such an approach dependscrucially on one's ability to assign turnover events to the correct category.Several factors suggest that some degree of misclassification may haveoccurred in the present study. For example, findings in Table 1 indicate that85% of executives in the non-routine subset are aged between 60 and 65,compared with only 32% in the routine subset. Assuming that the probability

1120 YOUNG

ß Blackwell Publishers Ltd 1998

of retirement increases with an executive's age, these findings suggest that aproportion of the turnover events classified as non-routine might, in fact, beof a more routine nature. Further, of the 105 turnover events included in thesample, 64% are classified as non-routine. Given that executive dismissals area relatively rare corporate event (Furtado and Karan, 1990), the highincidence of non-routine changes in the present sample could be interpretedas evidence of a misclassification problem.2

Finally, results presented in Table 5 indicate that routine turnover is asso-ciated with poor stock price performance in the period prior to the change.While the effect is substantially lower than that documented for the non-rou-tine group, these findings contrast with the evidence reported byMurphy andZimmerman (1993) and Weisbach (1988) that retirement-related top man-agement changes are not generally preceded by poor performance.3 One pos-sible explanation is that some non-routine changes have been incorrectlyclassified as routine. Some suggestions for improving classification accuracyin future work are presented in the final section of this discussion.

Supply-side Effects

A potential weakness of this and similar studies that examine the associationbetween firm performance and executive turnover is that the focus isexclusively demand-side orientated. As a result, any possible supply-sideeffects are ignored. Thus, while senior executives may be pushed when firmperformance declines, they may also voluntarily jump in an attempt topreserve the value of their human capital.4 This is particularly pertinent tostudies that focus on the intervening effect of stock ownership, since one mightexpect an executive's decision to voluntarily leave the firm to be affected bythe magnitude of his ownership stake. For example, voluntary exit forexecutives with high ownership stakes might be more difficult because theyhave a larger proportion of their total wealth directly tied to the firm. Thus,what might, from a demand-side perspective, appear to be evidence ofmanagerial entrenchment, could, from a supply-side perspective, simplyreflect the difficulty of voluntary exit.

RESULTS

Incentive-Alignment versus Entrenchment Effects

As DLP discuss, higher levels of managerial ownership can have twocontrasting effects. On the one hand, high ownership can be beneficial becauseit better aligns managers' interests with those of shareholders. On the otherhand, high ownership can serve to entrench managers, making their removalmore difficult when their performance falls below some pre-determined level.

DISCUSSIONOFOWNERSHIP, PERFORMANCE AND EXECUTIVE CHANGE 1121


Prior work suggests that incentive-alignment effects tend to dominate over thelow ownership range (e.g., less than five per cent: Morck et al., 1988), whileentrenchment effects begin to bite beyond this level (DDS; and Morck et al.,1988). The results presented by DLP are consistent with the entrenchmenteffect of managerial ownership. More importantly, they conclude that theseentrenchment effects can occur at extremely low ownership levels (e.g., oneper cent). This is a striking result, because it implies that the range over whichthe incentive-alignment effects of managerial ownership operate is extremelysmall.

The results of DLP for the UK and DDS for the US contrast with the con-clusion reached by Gilson (1989) that large managerial stockholdings do notappear to prevent control changes when firms' financial performance has de-teriorated significantly. A potential explanation for these differences is thatGilson's sample contains significantly worse performers. Specifically, Gilson'sfirms are those with three-year cumulative unadjusted stock returns in the bot-tom five per cent of all NYSE and AMEX firms. This in turn raises the possi-bility that the extent of managerial entrenchment in poorly performing firmsmay depend to a large extent on just how bad one chooses to define `poor per-formance'. For example, while relatively low levels of stock ownership mightbe sufficient to insulate managers from dismissal when results fall below aver-age in the short term, even significant ownership stakesmight not be enough toprotect managers in the event of truly awful, long term performance.

Declining Performance for the Non-routine Sub-sample

Table 8 indicates that firm performance (measured as either ROCE oroperating profit) declines even further for the non-routine sub-sample in thepost-turnover period. Several interpretations of this result are possible. First,consistent with supply-side arguments, this finding could support thesuggestion that some of these executives jumped in anticipation of worseningfuture performance. Second, a significant drop in post-turnover reportedperformance could be evidence of big-bath accounting choices by theincoming CEO. Third, this finding could be interpreted as evidence that thedismissal was, with the benefit of hindsight, the wrong decision and thatinstead the firm would have been better served by retaining the executive.Research aimed at distinguishing between these competing explanationswould represent a useful contribution to the literature.

Comparison of Results for the Routine and Non-routine Sub-samples

Defining non-routine changes in terms of poor performance and/or the lack ofmarket expectation of the event creates an inherent bias in the empirical tests.For example, the fact that a number of the non-routine changes have beenspecifically linked to poor performance means that, ex ante, one is much more

1122 YOUNG


likely to document evidence of an association between performance andturnover for this subset of firms. Similarly, since the degree of marketanticipation of non-routine turnover is by definition lower, one would expectto observe larger share price revisions for these firms, relative to those observedfor the routine subset. These inherent biases suggest caution when comparingresults for the routine and non-routine sub-samples.

FUTUREWORK

Classification of Turnover Events

Topmanagement turnover represents an extreme governance event on whichDLP shed some important new insights. As discussed above, however, theextent of the insights afforded by this and similar work on executive change isrestricted to some degree by the relatively opaque nature of the turnoverevent. Specifically, prior work has encountered difficulties in distinguishingbetween forced departures and routine succession. Progress on this issue doesappear possible, however. For example, future studies could exploit recentimprovements in disclosure quality (particularly in relation to executivecontracts and remuneration) to develop a more accurate classification ofturnover type. This might include (i) performing a detailed analysis of thecircumstances surrounding each turnover event and (ii) analysing thesubsequent career path of the departing executive:

à Researchers could collect data on the following issues in relation to (i):Wasan immediate replacement made? Was the replacement characterized bythe normal succession pattern (Vancil, 1987) or was there evidence that itwas largely unplanned?Was the change associated with other senior execu-tive departures? Was there any severance pay associated with the depar-ture? Did the change occur before the end of the executive's contract? Wasthe departing executive explicitly thanked in the subsequent annual reportfor his contribution to the firm during his period of tenure?Was his length oftenure less than the average for the industry?

à Similarly, researchers could collect data on the following issues in relationto (ii): Did the departing executive remain with the firm in some other ca-pacity? Did he take another executive position? If so, was it with a higher orlower profile firm and was his compensation higher or lower?

While the costs of such an approach would be non-trivial given the time- andlabour-intensive nature of the associated data collection task, it is likely thatsuch costs would be far outweighed by the benefits associated with a moreaccurate classification of turnover types.



Costs and Benefits ofManagerial Entrenchment

There is a tendency to assume that insulating managers from external pressureautomatically threatens shareholder value. While this may be the case in somesituations, a degree of managerial entrenchment might, in other circumstances,be efficient. For example, DeAngelo and DeAngelo (1985) argue thatentrenchment might be efficient if it encourages managers to invest in firm-specific human capital whose returns might otherwise be appropriable if controlwere transferred to another management team. Similarly, insulating topmanagers from some degree of external pressure may help overcome anytendency they may have to fixate on short-term performance measures at theexpense of long-term shareholder value-maximization (Bizjak et al., 1993; andStein, 1989).However, current understanding regarding if,when, andhowmuchmanagerial entrenchment is optimal is extremely limited. Additional researchdirected at modelling the costs and benefits of managerial entrenchment istherefore warranted, as is empirical evidence on the magnitude of these costsand benefits.

Empirical Specification

Equity ownership forms only one part of a potentially complex governance mixthat might include some or all of the following mechanisms: the product market,the market for corporate control, the managerial labour market, capitalstructure, the board of directors, executive remuneration, etc.. Differentmechanisms interact with one another, either as complements, as in the case ofexecutive remuneration and outside directors (Greenbury, 1995), or assubstitutes, as in the case of boards of directors and hostile takeovers (Shivdasani,1993). Further, while certain mechanisms are exogenously determined (e.g.,competition in the product and labour markets), managers are free to chooseothers (e.g., managerial ownership and board composition). In equilibrium,firms are expected to adopt the governance mix that maximizes firm value,conditional on their particular circumstances. Interactions between alternativegovernance instruments, combined with the endogenous nature of some of thesemechanisms, suggests that a single equation approach to modelling therelationship between firm performance and executive turnover might lead tomisspecified empirical tests. A more appropriate empirical specification wouldbe one that allowed for inherent variation in firm performance and managerialownership levels. To this end, future research could use a system of equations toexamine the association between firm performance, top management turnover,andmanagerial ownership.

LowTurnover Rates

Finally, an obvious question raised by the extant literature on topmanagement change is: why do firms take so long to dismiss apparently poorly

1124 YOUNG


performing managers? In particular, it is instructive to contrast the lowturnover rates documented for senior personnel in the corporate sector withthose observed in other domains (e.g., politics and sport). The papers byDLP for the UK and DDS for the US help shed some light on this issue ö itcould be that many senior managers are partially insulated from such extremeforms of discipline as a result of their direct ownership stake in theorganization. However, this is unlikely to be the full story. For example, thelow turnover frequency may reflect the fact that measures short of outrightdismissal (e.g., pay adjustments, early retirement, etc.) are the preferredmethod for correcting performance problems in the corporate sector. Theapparent reluctance to dismiss senior managers may also be a manifestationof the company's investment in firm-specific human capital (Furtado andRozeff, 1987).5 Further research on these and other possible reasons whyCEOs of poorly performing firms are not replaced in a more timely fashionwould be particularly informative, together with evidence on whether suchbehaviour is optimal in terms of shareholder-wealth maximization.

NOTES

1 Share price data were unavailable for 40 firm-years.2 An alternative explanation for the high frequency of non-routine changes is selection bias. For

example, DLP exclude all management changes that are accompanied by additional publicannouncements by the firm in the seven day period commencing three days prior to, and end-ing three days after, the date on which the management change was reported in the FinancialTimes. If announcements of routine senior executive retirements are more likely to be made inconjuction with the release of other corporate information (e.g., earnings announcements,etc.), then this sampling approach will tend to exclude a larger proportion of routine changes.

3 The systematic improvement in post-turnaround ROCE documented in Table 8 for the rou-tine turnover group is also interesting since it suggests that operating performance is routinelyimproved by the normal succession process. This finding is consistent with Weisbach's (1995)conjecture that boards might be limited in their ability to force senior managers out, so thatnormal retirement provisions provide an opportunity to correct managerial mistakes. Weis-bach (1995) presents evidence that such corrections regularly take place after turnover, sug-gesting that mandatory retirement provisions are one of the mechanisms helping to controlagency problems with the CEO.

4 Kaplan and Reishus (1990) present evidence of a reduction in the value of directors' humancapital in the event of poor firm performance. The incentive to jump will be especially strongwhere poor corporate performance is considered to be the result of factors beyond the control ofsenior executives, or when worsening future performance is anticipated.

5 To the extent that firm-specific human capital declines as one moves down the organisationalhierarchy, we might expect to observe higher dismissal rates among lower level employees.Indeed, it is possible that a degree of insulation from dismissal may serve as an additional andimportant non-pecuniary benefit associated with promotion up the organizational ladder.

REFERENCES

Bizjak, J.M., J.A. Brickley and J.L. Coles (1993), `Stock-based Incentive Compensation and In-vestment Behaviour', Journal of Accounting and Economics, Vol. 16, pp. 349^72.

Dahya, J., A.A. Lonie and D.M. Power (1998), `Ownership Structure, Firm Performance andTop Executive Change: An Analysis of UK Firms', Journal of Business, Finance & Accounting,



this issue.DeAngelo, H. and L. E. DeAngelo (1985), `Managerial Ownership of Voting Rights: A Study of

Public Corporations withDual Classes of Common Stock', Journal of Financial Economics, Vol.14, pp. 33^71.

Denis, D.J., D.K. Denis and A. Sarin (1997), Òwnership Structure and Top Executive Turn-over', Journal of Financial Economics, Vol. 45, pp. 193^221.

Furtado, E.P.H. andV.Karan (1990), `Causes, Consequences, and ShareholderWealth Effects ofManagerial Turnover: A Review of the Empirical Evidence', Financial Management, pp. 60^75.

________________________ and M.S. Rozeff (1987), `The Wealth Effects of Company Initiated ManagementChanges', Journal of Financial Economics, Vol. 18, pp. 147^60.

Gilson, S. (1989), `Managerial Turnover and Financial Distress', Journal of Financial Economics,Vol. 25, pp. 241^62.

GreenburyReport (1995),Directors'Remuneration:Report of AStudyGroupChaired by SirRichardGreen-bury (Gee, London).

Kaplan, S. and D. Reishus (1990), Òutside Directors and Corporate Performance', Journal of Fi-nancial Economics, Vol. 27, pp. 389^410.

Morck, R., A. Shleifer and R. Vishny (1988), `Management Ownership and Market Valuation:An Empirical Analysis', Journal of Financial Economics, Vol. 14, pp. 293^315.

Murphy, K. and J. Zimmerman (1993), `Financial Performance Surrounding CEO Turnover',Journal of Accounting and Economics, Vol. 16, 273^316.

Shivdasani, A. (1993), `Board Composition, Ownership Structure, and Hostile Takeovers', Jour-nal of Accounting and Economics, Vol. 16, pp. 167^98.

Stein, J. C., (1989), Èfficient Capital Markets, Inefficient Firms: A Model of Myopic CorporateBehavior', Quarterly Journal of Economics, Vol. 104, pp. 655^69.

Vancil, R. (1987), Passing the Batton: Managing the Process of CEO Succession (Harvard BusinessSchool Press, Boston, MA).

Weisbach, M. (1995), `CEO Turnover and the Firm's Investment Decisions', Journal of FinancialEconomics, Vol. 37, pp. 159^88.

________________________ (1988), Òutside Directors and CEOTurnover', Journal of Financial Economics, Vol. 20, pp.431^60.

1126 YOUNG


discussion of ownership structure, firm performance and top executive change: an analysis of uk...

Documents