DECLINE, TURNAROUND, AND MANAGERIAL OWNERSHIP
John D. Francis, Hagan School of Business, Iona College
Eleni Mariola, Hagan School of Business, Iona College
ABSTRACT
This paper investigates the effect of managerial ownership and turnover on the probability of a turnaround for companies that experience decline in their profitability. We also examine whether CEO turnover determines the type of retrenchment strategy chosen so as to hasten the turnaround process. In addition, we test the impact of environmental munificence, size, financial slack, methods of retrenchment and corporate productivity on the probability of turnaround. Our empirical results suggest that financial slack and productivity are the most important determinants of a turnaround. Equity ownership by management and the board of directors does not appear to have an impact on turnaround contrary to our hypothesis.
Key words: turnaround strategies, governance, agency theory
I.Introduction
The management literature has long sought to explain the issues of organizational decline and turnaround. Reduced corporate profitability, particularly during periods of general economic contraction, leads to a series of dysfunctional consequences, which include shrinking resources, poor morale, skeptical stakeholders, conflict, turnover, and time constraints (Lohrke and Bedeian, 1998; Hambrick and D’Aveni, 1988). Corporate responses range from denial of the problem, reliance on stringent internal controls, reduction of scale and scope of operations, to the dissolution of the organization (Schendel and Patton, 1976).
With the broad domain of issues and implications associated with decline and turnaround process, the ability to formulate appropriate strategic responses is of prime consideration for management researchers and practitioners. Despite the extensive investigations of the critical questions in the turnaround efforts, the strategic management literature offers limited guidance for reversing firm decline (Lohrke and Bedeian, 1998). In fact several primary issues remain unsettled. For example, what is the relative effect of the environment and decline, and firm actions on organizational turnaround? Also, what types of organizational action are required for turnaround? Specifically, is firm retrenchment a necessary strategy for turnaround situations? What organizational resources enable a firm to achieve improved performance? Finally, does managerial ownership affect retrenchment strategies and corporate turnaround? Recently, Barker, Mone, Mueller and Freeman (1998) and Castrogiovanni and Bruton (2000) reexamined the factors associated with turnaround and concluded that the debate concerning retrenchment and other factors that lead to turnaround is still open and in need for further research. Arogyaswamy, Barker, and Yasai-Ardekani (1995) in review of the decline and turnaround literature argue that decline and turnaround are closely linked as successful turnaround attempts must both manage the decline and change the firm's strategy, and internal processes to secure newer resources to deal with the causes of decline.
Our study extends previous research attempts by examining a broad range of internal and external factors that impact on decline and turnaround. In particular, we focus on the effects of the environment, the nature of the decline, the corporate financial characteristics, the retrenchment policies and the corporate governance issues on whether the company achieves a turnaround or not. Moreover, the study uses a broad array of factors considering the whole turnaround process, with factors included in the study from before decline occurs, during the decline, and the resulting performance. These factors are examined in the context of firms that managed successful turnaround and those that did not, using declining firms from a wide range of industries in order to develop generalizable findings.
In Section II, we develop our empirical hypotheses. Section III reviews the empirical methodology and describes the data. Section IV summarizes the results, and Section V concludes.
II.Theory and Hypotheses
Past studies have suggested numerous factors that are important influences on turnaround including, environmental characteristics, such as industry growth, government regulations, and financial institutions (Gopinath, 1995), and deliberate tactics, such as improving operational efficiency or changing the firm’s competitive strategy (Barker and Duhaime, 1997; Hambrick and Schecter, 1983; Winn, 1997). Studies of declining firms tend to examine three basic areas: (1) sources of decline, (2) organizational responses to decline, and (3) effects of decline on other organizational activities (Lohrke and Bedeian, 1998; Whetten, 1987). Primarily, researchers who have analyzed organizational decline have grappled with unresolved issues concerning the appropriateness of a firm’s actions to effect turnaround (Castrogiovanni and Bruton, 2000; Hambrick and Schecter, 1983; Robbins and Pearce, 1992; Pant, 1991).
One of the earlier studies on corporate turnaround by Schendel, Patton and Riggs (1976) indicated that downturns in performance were a result of unfavorable environmental shifts combined with organizational inefficiency or inappropriate competitive strategies. The authors maintained that it took an organizational crisis for a firm to seriously address decline. Other researchers have also argued that environmental factors such as industry conditions, government regulations, external stakeholders, such as financial institutions limit the choices of management to effect turnaround (Hubbard & Kosnik, 1996; Gopinath, 1995). Others have argued that the decline situation itself influences organizational outcomes. For example, in Chowdhury & Lang’s (1993) study, they found that firms experiencing crisis decline situations were more successful in their turnarounds than those experiencing more gradual decline.
Most of the research in this area has focused on the actions management must take in overcoming organizational decline (Arogyaswamy, et al, 1995: Barker & Mone, 1994; Bonnici & Fredenberger, 1994; Robbins & Pearce, 1992). It was in this vein that Pant (1991) addressed the issue of decline and turnaround using the industry structure-conduct-performance paradigm. Drawing her conclusions based on a sample of firms from a variety of industries in the 1970s, she argued that industry characteristics did not significantly explain turnaround, but that deliberate management action was required.
Hofer (1980) provided a contingency theory for turnaround strategies where he compared operational and strategic actions, in order to achieve a fit with prevailing environmental conditions. Hambrick & Schecter (1983) tested this theoretical distinction on a group of strategic business units and found that operational actions consisting primarily of reductions in assets and costs or withdrawal from selective products and markets, influenced firm turnaround. Similarly, several authors have found that improved financial performance is related to efficiency-enhancing measures such as cost cutting or asset retrenchment (Ramanujam, 1984; Thietart, 1988). These findings led to an emphasis on the importance of retrenchment strategies for turnaround to the point where Robbins & Pearce (1992) argued that retrenchment is a necessary element of any turnaround strategy.
The issues concerning retrenchment have become a debated topic in the literature. Barker & Mone (1994) suggested there is little evidence for supporting the retrenchment assertion. Instead turnaround is a response to steep decline and that the actual performance of retrenching firms is not significantly better than that of non-retrenching firms. Similarly, Castrogiovanni & Bruton (2000) contend that retrenchment strategies are not generalizable to all firms because they were not beneficial to a sample of acquired firms that were in need of turnaround.
Other organizational responses to decline have also been investigated in the literature. Barker & Duhaime (1997) examined strategic and entrepreneurial responses to organizational decline and found that organizations belonging to declining industries are more likely to pursue strategic change. Studies focusing on firm actions in the turnaround process have also investigated firm activities such as environmental scanning, management or change styles, and organizational structures (Armenakis, Fredenberger, Giles, Cherones, Field, & Holley, 1996; Grinyer, Mayes, & McKiernan, 1990).
Overall, previous research considers a broad array of environmental and decline characteristics, organizational resources and organizational actions as important influences on performance turnarounds. The literature offers limited guidance on the importance of different factors within the turnaround process and many of the studies have been industry specific and not generalizable. Furthermore, this guidance has not only been inconsistent, but at times contradictory (Lohrke and Bedeian, 1998). This, of course, is one of the causes of our failure to generate a comprehensive theory of firm turnaround and one of the reasons why continued research in this area is needed.
In researching the influence of several factors on organizational turnaround, we mainly utilize the structure-conduct-performance paradigm and resource-based theory (Barnett, Greve, and Park; 1994; Barney, 1991) to investigate the extent to which different situational and firm variables influence improved corporate performance after a decline. We view decline as a result of erosion of productive resources. Therefore, in order to manage a turnaround, managers must focus on stemming the erosion of resources, effectively use the existing resources and concurrently replace and/or add to resources.
The starting point for testing the factors that influence turnaround lies in the external environment. Obviously, the environment is an important situational element since it has a strong impact on a firm’s strategic direction, the process by which strategic direction is shaped and the way firm’s resources are secured (Hamel and Prahalad, 1994). The strategy literature is replete with conceptualizations of the environment and its effect on organizations. For example, Dess and Beard (1984) categorized the external environment along three dimensions-- munificence, dynamism and complexity, with each dimension comprised of a cluster of attributes influencing the organization in a unique way. Of these categories, environmental munificence (the environment’s capacity to accommodate firms) has particular relevance to organizational decline and turnaround (Arogyaswamy et al., 1995). It has long been acknowledged in the organizational ecology literature that low environmental munificence makes it difficult for organizations to survive (Hannan and Freeman, 1977).
Other research indicates that environmental munificence is positively associated with the number of strategic options available to firms and their chances of survival (Brittain and Freeman, 1980). Similarly, Goll and Rasheed (1997) have found that munificence affects firm performance. Alternatively, Covin and Slevin (1989) suggest hostile environments are characterized by precarious industry settings, intense competition, harsh, overwhelming business climates, and the relative lack of exploitable opportunities. It is likely that firms in munificent environments would find it easier to turnaround, amidst strategic actions taken, due to higher demand for products, more available resources and lower competition. Therefore, based on these arguments the following hypothesis is offered:
Hypothesis 1:Environmental munificence will influence the turnaround outcome of declining firms positively.
Another situational variable important in the turnaround process is the nature of the decline itself. One aspect of corporate decline concerns its severity or depth. Robbins and Pearce (1992) maintain that the severity of decline gauges the magnitude of the threat facing the organization. From a resource-based perspective, a severe decline would indicate more critical problems with the ongoing use of valuable resources and competencies. It is likely that firms experiencing severe declines find it more difficult to achieve turnaround than firms experiencing less severity.
A second decline variable concerns how gradual or rapid the decline occurred. This factor indicates how quickly the firm’s resources are depleted. D'Aveni (1989) proposes that there are patterns to decline in terms of how resources deteriorate, and classified these patterns as either sudden, gradual, or lingering. A sudden decline is characterized by moving from a perceived situation of organizational health to one of poor performance and instability in a short period of time. Firms experiencing this decline condition would have a shorter time frame to garner resources and implement effective actions to stem the decline.
Overall, we suggest that the speed at which the decline occurred, combined with its severity, create a very urgent situation. Firms finding themselves in these situations have a harder time taking effective organizational actions due to the magnitude of the problem, the state of the firm’s resources and the time constraints involved. Therefore, it is expected that firms in urgent decline situations have more difficulty achieving turnaround. In light of these arguments, the following hypothesis is offered:
Hypothesis 2:The higher the urgency of the decline the lower the probability of a turnaround
Resource-based literature suggests that internal resources define durable competitive advantage. For declining firms, a key question is which resources stand out as enabling a firm to overcome its performance declines? The turnaround literature suggests that there are several firm characteristics that enhance a firm’s ability to deal with decline. Usually these characteristics are discussed in terms of their ability to buffer the effects of the decline and the urgency of the situation. Under the auspices of resource based theory, buffering characteristics enable a firm time to respond appropriately to decline and provide it with capabilities and resources to achieve a successful turnaround.
For example, the size of the organization can be seen as a firm characteristic that affects the eventual turnaround result (Singh and Lumsden, 1990; Haveman, 1993). The relationship between size and consequence of a declining situation has been debated in the literature. Large firms are more insulated (Hannan and Freeman, 1984) and possess the stability to overcome adverse economic situations because of broader institutional systems (Haveman, 1992). In following the logic of Thompson (1967), these characteristics can buffer an organization’s core from the effects of the environment.
Others argue that large firms are likely to have tortuous internal procedures and multiple relationships with stakeholders, which may slow down their ability to respond quickly (Meyer and Zucker, 1989). Therefore, according to the behavioral perspective (Hambrick and D’Aveni, 1988), the presence of size-related inertia in large firms would negatively affect their ability to enact turnaround strategies.
Arguments from both research streams have received support in the turnaround literature. Barker and Mone (1998) find no support for the positive influence of size on turnaround. However, Zajac and Kraatz (1993) and Haveman (1993) find that larger organizations tend to respond better to declining performance and turbulent environments, respectively. We contend that size of the firm plays an important positive role in determining turnaround outcomes and consider it an important tangible resource of the firm and a means for the organization to buffer itself from the effects of the decline situation. Large firms have greater resources and more options for initiating turnaround strategies, such as the divestment of under performing assets, reduction of salary expenses or the closing of ineffective operations. We expect to see therefore:
Hypothesis 3:Larger firms being associated with successful turnaround strategies
Another buffering characteristic that enables a firm to respond appropriately to decline is the availability of slack resources. Firms with immediately available (or unavailable) resources at the time of the turnaround attempt would be less (or more) constrained in their ability to initiate appropriate remedial measures (Hambrick and D’Aveni, 1988; Barker and Mone, 1998). It has been suggested that the presence of slack resources, such as cash, inventory, or access to credit, can provide a firm with the cushion necessary to implement a recovery strategy (Barker and Duhaime, 1997). Mainly slack resources help a firm absorb the effects of performance downturns or variability (Bourgeois, 1985) and provide a base of resources to take effective actions. Therefore,
Hypothesis 4:Firms with more slack resources during decline have a better chance of surviving and staging a turnaround.
One of the attributes relating to the resource capabilities of the firm is their use, specifically the productivity of its human and capital resources. Shetty and Butler (1990) suggest that firm productivity is an encompassing construct and evidence of a firm’s overall competitiveness and effectiveness. Although firm productivity could be related to past cost reduction activities, it is a result of other additional firm level factors such as existing market share or sales growth (Arogyaswamy et al., 1995; Barker and Duhaime, 1997; Winn, 1997). A declining firm that has relatively efficient operations is utilizing its resources more productively and economically, enabling it to focus on other primary causes of decline. We hypothesize that:
Hypothesis 5: The higher the firm productivity, the higher the probability of a turnaround
Prior research on corporate governance reports that the components of CEO compensation are an indicator of the influence he enjoys relative to the board of directors. Agency theory proposes that managers' compensation packages should be designed to provide incentives for them to pursue firm value-increasing projects, and Jensen and Murphy (1990) suggest that political forces operating within the firm can influence the CEO performance/compensation relation. Moreover, Berger, Ofek, and Yermack (1997) report that the degree of CEO entrenchment affects firm leverage levels, and that entrenched CEOs take on less debt. They study several measures of entrenchment including managerial equity ownership, fixed compensation (proxied by salary and bonus), and CEO tenure. Following these authors we utilize cash salary and bonus as a proxy for fixed compensation in our analysis, and propose that the percentage of salary and bonus relative to total compensation is an informative indicator of managerial entrenchment. However, if CEO compensation is comprised primarily of stock options and other profit-sharing arrangements, then compensation is sensitive to performance, and this may be indicative of the relatively limited influence that he exerts within the firm.
Hypothesis 6: The lower the percentage of salary to total compensation, the higher the
probability of turnaround.
We use the number of years of employment with the firm as a proxy for tenure. Prior research reports an association between CEO tenure and CEO influence/power within the firm (Harrison, Torres, and Kukalis (1988)). The longer he holds office, the more the CEO becomes experienced with the firm's operations, establishes a power base, and becomes entrenched within the firm. In such a case, the expectation is that poor performance by a CEO who has a long tenure with the firm, will not necessarily lead to his dismissal. It is proposed that managerial power increases at a decreasing rate the longer the CEO stays in office, and accordingly, tenure is measured as the natural logarithm of the number of years of CEO employment with the firm.