In our paper, Looking in the Rear View Mirror: The Effect of Managers’ Professional Experience on Corporate Cash Holdings, which was recently made publicly available on SSRN, we study the role of managers’ professional experience in financial decision making, focusing on one of the most debated corporate policies in recent years – cash savings.
We focus our analysis on corporate cash policies because firms hold unprecedented, increasing levels of cash. In 1980, firms held $234.6 billion (in 2011 dollars) in cash, amounting to 12% of assets. By 2011, the amount of cash grew to $1,500 billion, or 22% of assets. The predominant approach to understanding corporate cash holdings is the precautionary savings motive. According to this motive, firms hold liquid assets to hedge against future states of nature in which adverse cash flow shocks, coupled with external finance frictions, may lead to underinvestment or default. While prior research shows that the precautionary savings motive explains much of the cash policy of firms, some suggest that managers are overly conservative in their decision to hold high levels of cash.
Motivated by psychological evidence, which shows that past experience affects individual decision-making, we argue that managers may behave conservatively because they experienced financial difficulties in their professional career. To test this hypothesis, we collect detailed data on managers’ employment histories and construct four measures of experience at firms that faced financial difficulties. These measures capture financial constraints and adverse shocks to cash flows and stock returns. To separate firm and CEO effects, the measures are based on prior employment at other firms.
The results support the importance of professional experiences in shaping the financial decision-making of the CEO. We find that CEOs who were previously employed at a firm that experienced financial difficulties have a cash-to-assets ratio that is 3.1 to 4.4 percentage points higher compared to firms whose CEOs did not experience financial difficulties.
A potential concern with our analysis is that firms may choose the CEO because she has experience running financially troubled firms, in which case the positive relation between cash holdings and professional experience may capture a selection effect as opposed to a treatment effect. Our empirical design allows us to address this identification challenge in three ways. First, we control for firm characteristics, such as financial constraints, that may lead the firm to prefer a manager that experienced financial difficulties. Second, we redefine our measures to include only professional experience in non-CEO roles, because a CEO is less likely to be appointed to run a conservative cash policy based on non-CEO experience. Third, we estimate the effect of professional experience around a subset of CEO turnovers that represent natural causes (death or illness), planned retirements, or scheduled succession plans. This identification strategy addresses the challenge that some CEO turnovers may be caused by poor performance or financing difficulties, which may confound our empirical inference. Our empirical results persist across the different tests.
We consider two possible views. On the one hand, experiencing financial difficulties may push managers, who are on average overconfident and tend to underestimate risk, to optimally increase their cash holdings. Alternatively, it may push them to become overly conservative and hold too much cash. We separate these views by studying how experience is related to corporate governance and the value of cash.
Our results suggest that the effect of professional experiences on firms’ cash holdings is stronger at poorly governed firms. Moreover, we find that CEOs’ experience of financial difficulties implies a reduction of 10.6 to 18.2 cents in the value of an added dollar of cash. These findings collectively support the view that prior experience of financial difficulties pushes managers to be overly conservative and hold more cash than needed.
We also recreate our measures of professional experience for CFOs and find that after controlling for CEO experience, CFO experience is associated with an additional increase of 1.2 to 1.8 percentage points in cash.
Overall, our article demonstrates the importance of managers’ professional experience in corporate decision-making and identifies a set of experiences involving financial difficulties that influences the efficacy and value of corporate cash holdings.
The full paper is available for download here.