Introduction

Globally, most companies will, at some point in their history, face a turnaround situation in which they experience a severe decline in performance. Such decline tends to have a tremendous impact on a company’s resources and poses a substantial challenge to successful turnaround management. Exceptional leadership is critical in such situations, as it usually takes sound decisions to reverse a firm’s performance trajectory and get it out of dire straits. Previous research highlights the importance of a CEO’s accurate attribution and understanding of the severity of the decline to achieve a successful turnaround. However, there has been a very limited understanding of the types of CEOs that either benefit or harm distressed firms and thus little guidance to boards of directors—and CEOs themselves—on the kinds of executive characteristics that tend to benefit or harm their troubled firms.

Our study, published in Journal of Management Studies, assesses a key characteristic found across organizational C-suites—overconfidence—and its performance implications in times of crisis.

CEO Overconfidence

Among the proclivities that prevail at the CEO post, CEO overconfidence is certainly one of the most prominent. CEO overconfidence is a psychological characteristic that leads individuals to overestimate their abilities. This tendency involves overestimating the general outcome of uncertain events and placing excessive reliance on one’s predictions. As such, CEO overconfidence has, for example, been found to lead to higher takeover premiums, weaker lending standards, or value-destroying mergers. Overconfident CEOs are usually more likely to make optimistic forecasts and to resist corrective feedback. On a more positive note, however, CEO overconfidence has also been associated with riskier investments into innovation projects. In turnaround situations, however, CEO overconfidence seems to have both positive and negative effects on firm performance, depending on whether the overconfident CEO is the incumbent CEO who led the firm into crisis or a successor hired to reverse organizational decline.

Data and Main Takeaways

The sample of the study consist of S&P 1500 firms who experienced a turnaround situation between 1992 and 2012. Financial firms are excluded for comparability. Following prior literature, CEO overconfidence is proxied based on their option-exercising behavior and their press portrayal. Performance is assessed in terms of return-on-equity (ROE) and the market-to-book ratio (MTB).

When the incumbent CEO who led the firm into crisis is overconfident, their leadership can seriously interfere with the firm’s turnaround success. Overconfident CEOs, fueled by an inflated ego from their overestimated abilities (and pre-decline success) tend to encounter particular difficulties when their high performance expectations collide with the harsh reality of a decline. As such, they may be more likely to attribute failure externally and downplay the severity of the decline, thus engaging in coping mechanisms to justify the decline instead of taking the steps necessary to achieve a successful turnaround.

Moreover, when the overconfident incumbent CEO also serves as the board chair, a situation known as CEO duality, the negative effects of the CEO’s overconfidence on their company’s turnaround performance are intensified. CEO duality grants the CEO more power and control, enabling them to significantly influence board decisions and reduce monitoring effectiveness. In other words, CEO duality enables an overconfident incumbent CEO to limit board opposition against their misguided situational assessments. This can further diminish the company’s prospects of a successful turnaround.

Replacing an overconfident incumbent CEO thus seems to be beneficial for firms’ turnaround performance, particularly when the overconfident incumbent CEO also serves as board chair—even if the company hired an “average” successor as a replacement.

Yet whereas overconfident incumbent CEOs thus appear to harm their firms’ turnaround performance, hiring an overconfident successor can actually be a good choice to reverse organizational decline. Particularly, the analyses suggest that overconfident successor CEOs do have a positive impact on their firms’ turnaround prospects, compared to their less-overconfident counterparts. Indeed, although overconfident successor CEOs appeared to acknowledge challenges in managing the turnaround, they also tended to communicate a concrete roadmap and ambitious vision for recovery. Non-overconfident successors, in contrast, tended to communicate a more cautious or vague roadmap focused more on disciplined management and, in the end, were associated with inferior turnaround performance.

Implications

CEO overconfidence can thus either facilitate the disaster or accelerate recovery, depending on whether it is an overconfident incumbent or an overconfident successor CEO responsible to turn a struggling firm around. These effects are of high economic importance since the fate of firms can be inherently tied to their success in achieving performance turnaround. As such, it appears crucial for corporate boards to be vigilant for potential biases in their CEOs’ assessment of organizational decline—and to take their fiduciary responsibilities very seriously in the oversight, replacement, and/or selection of a new CEO in troubling times.