As an investor, you're probably very aware of changes in company management. A new CEO could signal anything from a shift in company strategy, to the continuation of a legacy, or even a desperate attempt to regain profitability.
So how do you respond to a new CEO? One thing you probably don't do, which you should, is to reconsider the company's cost of financing.
The relationship between borrowing and CEOs
A comprehensive study of S&P 1500 firms between 1987 and 2010 found that a new CEO has a distinct effect on a company's borrowing costs. On average, a new CEO faces loan and bond yield spreads that are over 0.20% higher than CEOs who have been at the helm for three years.
In other words, when a new CEO steps in, borrowing costs go up -- but just for a few years, until lenders and the market get acquainted with the firm's new leader.
Funny enough, the reason for appointing a new CEO doesn't matter. Whether it's because of problems with the previous one, a planned succession, or something altogether different, new CEOs consistently face higher borrowing costs than their longer-tenured peers.
What does vary, of course, is the magnitude of those cost changes. When a new CEO isn't as well known, borrowing costs go up even more.
In particular, younger CEOs, external hires, and those who weren't an "heir apparent" all see higher costs than older CEOs, internal hires, and those who were being groomed for succession.
Another important factor: new CEOs who had a relationship with the firm's lenders prior to being appointed don't see their costs rise as much.
The implications for financial management
So what does all that mean?
Because firms face higher borrowing costs when a new CEO comes on board, you should expect that financial policies will be adjusted accordingly. Firms with new CEOs generally don't issue as much external debt, take less external financing for business activities like acquisitions, and carry higher cash balances than those with longer-tenured CEOs.
This is an important consideration for you as an investor, especially if you're looking at a company that relies heavily on debt or which is trying to expand aggressively.
Facing higher financing costs means that a firm might face a higher bar in taking on new projects, or it could have fewer options for getting out of a thorny financial situation. The returns to externally financed projects might be lower, or acquisitions might be passed over until costs go back down.
Higher cash balances can also affect the bottom line. It makes sense for companies to keep more cash on hand when borrowing becomes relatively expensive, but it could also mean a less productive use of capital.
Finally, there's an important implication here for short-term outcomes and comparability to other firms.
We tend to be hard on CEOs at the best of times, what with the market's fixation on quarterly earnings. Remember, then, that with a new CEO, massive productivity or profitability won't come instantly. Aside from the usual headwinds, higher borrowing costs will put a damper on these measures.
Taken together, this also means that performance might not look quite so stellar in the moment -- and that it could look relatively bad compared to the competition. Whether it's a structural problem with the company or a temporary problem with the transition is an important distinction to make, and these clues about borrowing costs will help you make it.
Thus, if he or she looks good otherwise, give a new CEO some time -- because change, it seems, doesn't come cheap.