4/19/2014

The Vicious Cycle of CEO Pet Projects

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s+b Blogs Posted: February 13, 2014

Matt Palmquist Matt Palmquist is a freelance business journalist based in Oakland, Calif.

Recent Research

The Vicious Cycle of CEO Pet Projects

This article was originally published by Booz & Company

http://www.strategy-business.com/blog/The-Vicious-Cycle-of-CEO-Pet-Projects

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4/19/2014
eventually investing just as unwisely.

The Vicious Cycle of CEO Pet Projects

Bottom Line: I ncoming leaders follow a predictable pattern of disinvesting from their predecessors flops and

CEOs are stuck in a cycle: They remedy the headaches left by their predecessors only to then create messes of their own. Thats the striking conclusion of a new study that reveals a distinct and deleterious CEO cycle of investment at large publicly traded U.S. firms. In the first years after CEOs take office, they concentrate on shedding the poorly performing assets associated with the previous regime. But over time, their increasing control of the board leads them into the same trap. They overinvest in pet projects that detract from shareholder value, and then refuse to abandon them because of personal or career interests. The authors studied 5,420 CEOs at 2,991 S&P 1500 firms between 1980 and 2009. They found that during the first three years of a CEOs tenure, as the new administration disinvested from old projects, the annual Is to Apples Unleashing investment ratethe(Tacit) ratio of expenditures and acquisitions capital stockwas 6 to 8 percentage points Knowledge Is 3.2 percentage points Meteoric Rise Creativity lower, and the asset growth rate was lower, than in the rest of his or her term. As time wore on, CEOs upped their spending significantly Devastating in an effort to spur growth, but shareholders paid Drop? the price. The average companys annual investment rates increased by 40 percent from the first to the eighth year of a CEOs tenure, and the number of acquisitions made by the firm doubled during the same period. But the markets reaction to acquisition announcements decreased sharply over the CEOs term and became negative during later years. The large disinvestment rate in the initial period is aimed primarily at ventures instigated by the previous CEO that ranked in the bottom 10 percent of a firms business unit performance, the authors found. But familiar habits are tough to break: When the former CEO stuck around on the board, or when the incoming CEO had had a role in the outgoing management team, firms were much less likely to disinvest underperforming assets. Notably, this investment cycle persisted irrespective of the reason the previous CEO leftwhether he or she was fired because the firm was struggling, stepped down because of illness, or retired. And the pattern held regardless of whether the CEO was hired internally or externally, how long he or she spent in the position, and the industry conditions faced by the firm. Overall, the cyclical behavior of investment is a general phenomenon in publicly traded corporations, the authors write. And it might be one reason that private equity partnerships can afford to pay large premiums for public companies and still bring high returns to their investors, the authors note. With so much inefficiency in public companies investment patterns, private firms can identify which pet projects should be defunded or overhauled. The results also imply that consistent turnover at the top, viewed in many quarters as a sign of a company in crisis, might actually be a good thing.

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Consistent turnover at the top, viewed by some as a sign of crisis, might actually be a good thing.
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Source: CEO Investment Cycles, by Yihui Pan (University of Utah), Tracy Yue Wang (University of Minnesota), and Michael S. Weisbach (Ohio State University), Fisher College of Business Working Paper Series, Aug. 2013

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