Research

Who are you? How professional background affects CEO pay

CEOs are in the spotlight today. In a time of economic hardship, their outsized salaries make them targets of criticism and resentment. When their companies succeed, CEOs are celebrated, but when firms fail, these executives are saddled with blame. Cláudia Custódio, assistant professor in the W. P. Carey School's Finance Department, is trying to discover the real truths about chief executive officers -- what in their backgrounds led them to their positions, why they receive such handsome salaries, and how they contribute to the success of their organizations.

2012-09-25

CEOs are in the spotlight today. In a time of economic hardship, their outsized salaries make them targets of criticism and resentment. When their companies succeed, CEOs are celebrated, but when firms fail, these executives are saddled with blame.

Cláudia Custódio, assistant professor in the W. P. Carey School's Finance Department, is trying to discover the real truths about chief executive officers -- what in their backgrounds led them to their positions, why they receive such handsome salaries, and how they contribute to the success of their organizations. In a series of research projects, Custódio and her collaborators have been able to shed light on a difficult and controversial subject.

"The causes and effects are very tough to disentangle," she says. "To be able to answer these questions accurately is a challenge."

A premium for generalist CEOs

A native of Portugal, Custódio joined the W. P. Carey School faculty in 2010 after receiving her doctorate earlier that year from the London School of Economics. She tackled the issue of CEO compensation in a forthcoming article, "Generalists versus Specialists: Lifetime Work Experience and CEO Pay," to be published in the Journal of Financial Economics.

With co-authors Miguel A. Ferreira of the Universidade Nova de Lisboa and Pedro P. Matos of the University of Virginia, Custódio analyzed the backgrounds and pay of the CEOs of S&P 1500 firms from 1993 through 2007. The researchers found that CEOs who had general managerial backgrounds received almost 20 percent higher pay than CEOs whose experience was concentrated in a firm or industry. In dollar terms, the generalist CEOs made about a million dollars a year more than the specialists. If we consider that the average tenure of a CEO in a firm is 8 years, generalist CEOs make 8 million dollars more than a specialist during this time.

"These numbers were not only statistically significant, but they are also economically significant," Custódio says. "This is an important amount of money we are talking about."

The researchers identified CEOs as generalists or specialists by going over resumes, which had been compiled and coded in a database. "It's difficult to define general human capital," she says. "We considered things like the number of past industries a CEO worked in, the number of different firms, experience in a conglomerate," she says. "Then we put these together in an index. It was a tough job to put it all together with the compensation data."

With such a significant premium being offered for broad managerial experience, generalist CEOs can look to profit in the market, Custódio believes. In the Journal of Financial Economics article, she and her co-authors conclude, "Overall, we show that measurable CEO characteristics, in particular skills gathered through work experience, have significant explanatory power for CEO pay. We provide direct evidence of the growing importance of general managerial skills versus firm-specific skills in the market for CEOs."

Earning their pay in negotiations

In another paper, now being revised for publication in a major journal, Custódio and co-author Daniel Metzger of the Stockholm School of Economics attempt to identify the value that a skilled CEO can bring to a company.

"There has been a debate in the finance literature about whether CEOs can actually add value to a firm," Custódio says. "It's a way of asking the question, 'Why are these guys paid so much?'"

One answer, the researchers determined, is the ability of some CEOs to execute advantageous mergers and acquisitions. In the paper, "How Do CEOs Matter? The Effect of Industry Expertise on Acquisition Returns," Custódio and Metzger conclude that when a CEO has experience in the industry of a target firm, the acquiring company can expect greater announcement returns from a merger or acquisition.

"Using U.S. data on 4,844 announcements of acquisitions from 1990 to 2008 in the U.S., we find that the stock market reacts more favorably to diversifying mergers when the bidding CEO has prior work experience in the target industry," the researchers write.

The fact that a CEO with industry experience is capable of generating abnormal high returns for the acquiring company is an important finding, Custódio believes. She points out that much of the academic literature on mergers and acquisitions has found that most acquiring firms see no gain or negative returns when companies combine, while all of the gains in the transaction usually go to the firm being acquired.

Custódio and Metzger also tackled the question of how a CEO could generate these high returns. "Intuitively, we would expect him to be better able to run the business, which he already knows and so could probably generate more synergies," Custódio says. "But this is not what we find."

In their examination of the finances behind mergers and acquisitions, the researchers found that the expert CEOs generated profits for their firm in the initial deal. "He is better able to negotiate," Custódio says. "The industry expert CEO is able to extract a larger fraction of the surplus that is being created by the merging of two companies. We argue that this is consistent with him having better negotiating ability due to his industry experience."

Speaking the language of finance

In a working paper, "Financial Expert CEOs: Corporate Policies, CEO Choice, and the Firm Life Cycle," Custódio and Metzger study a specific type of CEO -- one whose expertise is in finance.

"The financial expert CEO is someone who is running a non-financial company but has worked in the financial industry or who has been in a financial role before," Custódio says. "He may have been a CFO before becoming a CEO."

The researchers set out to determine if financial expert CEOs tend to work at certain kinds of firms. They studied more than 4,000 CEOs, cataloging both their level of experience in finance and the characteristics of the firms they headed.

"What we first find is that the financial expert CEOs tend to be matched with firms that are at a more mature stage," Custódio says. "The financial expert is more focused on lowering the cost of capital, holding less cash, and paying dividends, which tend to be the priorities of these firms."

The researchers also studied the behavior of these CEOs and found that their actions fit with the needs of a mature company, which favors financial stability over growth.

"We find that financial expert CEOs tend to hold more leverage," Custódio says. "They pay out more to their shareholders: they do more share repurchases, and they pay out more dividends. It seems that they are able to lower cash balances. There is evidence that when the firm needs to raise capital, they can just go and do it, even when credit market conditions are bad."

The researchers also found that analysts' forecasts about firms headed by financial expert CEOs tended to be consistent with each other. There was little disagreement among analysts about the direction of these companies.

According to Custódio, this finding provides a clue to the effectiveness of these CEOs. "We believe it shows that they are better able to communicate with financial markets," she says. "Maybe it is because they speak the same language. It is consistent with the idea that they communicate their message more clearly."

Custódio believes more research is needed to fully understand the role CEOs play in firms and the value they can bring to an organization.

"We observe that the financial experts go to more mature firms, and we know that more mature firms pay more dividends," she says. "Should we conclude it is the financial expert CEO who is responsible for these dividend payouts or is it just because the firm is at a certain growth stage?"

To find the answers to these and other questions, researchers need first to determine the correct methodologies and then undertake extensive studies, according to Custódio. "We still have a long way to go in this area," she says.

Bottom line:

• The role of CEOs is an important area for academic researchers. CEOs receive huge pay packages and are widely seen as responsible for their firms' success or failure.
• CEOs who come to their positions with general management background receive higher compensation than CEOs with experience in a specific firm, according to the research of Assistant Professor Claudia Custódio. These generalist CEOs make on average 19 percent more than their specialist counterparts -- about $1 million a year.
• CEOs who have extensive experience in a particular industry deliver big gains for their firm when the company undertakes a merger or acquisition with a firm in that industry. Custódio's research found that CEOs with industry experience tend to be effective negotiators when the terms of deals are bargained.
• CEOs who have a background in finance tend to work for more mature firms, Custódio discovered. These executives are able to deliver higher dividends, while holding less cash and more debt -- all priorities of mature firms looking for financial stability instead of growth.

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