Is Your CEO a Debt Junkie? | BTalk

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Anil Makhija, Ohio State University

(Episode 424; 9 minutes 20) A word of warning --- if your CEO is steam rolling a highly leveraged approach to business it might be as much to do with his/her personal traits as it is to do with sound business thinking.

On BTalk today I talk to Anil Makhija from the Fisher College of Business at the Ohio State University. Anil has co-authored a report "What Does CEOs' Personal Leverage Tell Us About Corporate Leverage?"

Their conclusion is that there is a strong relationship between personal and business leverage decisions. Is this a warning to companies that their corporate governance is too weak and key decisions are being made unilaterally by the CEO.

• Transcript

Phil Dobbie: Hello. I'm Phil Dobbie. Welcome to BTalk. Today: the way your CEO runs his or her personal finances probably says a lot about the way your company is run.

If your CEO borrows a lot of money to finance his or her house, will your CEO run your business the same way and borrow heavily? Can you be a debt junkie in your social life and in your work life, in other words? Well, let's ask Anil Makhija from the Fisher College of Business at the Ohio State University. He's the author, or co-author I should say, of a paper that asks what the CEO's personal leverage tells us about corporate leverage. Now you've looked at the CEOs of the top 1,500 listed companies in America for this. So I'm presuming, otherwise there'd be no story here, that you did find a connection. So is that what you found? That there was a connection between personal debt and company debt?

Anil Makhija: Yes, indeed we did. In this study that I did with Henrik Cronqvist and with Scott Yonker, what we did is we examined the personal leverage of CEOs based on how they financed their primary residence.

Dobbie: Right. Now every CEO of course is going to have a home loan of some sort. But were you looking say, well, if you've got a heavy debt with your home loan ... you've got a big house in other words, you're likely to incur heavier debts in your work as well?

Makhija: We figured that the primary residence is the major financing personal decision, because that's probably the largest physical asset that the CEO might own on his personal side. And so that might be an indicator about how they view leverage, at least in their personal domain.

Dobbie: Right. Now this is a big decision for a business. Just how much they're getting into debt, how much they leverage. And the fact that this relationship with how much the CEO is borrowing in their personal life just shows how much unilateral decision-making the CEO has. I find that a bit of a worry for a business.

Makhija: Well, you're right on. Because of all the decisions that a firm makes, I think pretty close to the top would be the capital structure of financing decision. Now you might realise that a priori, one would have thought that people that take on a lot of personal debt, if indeed they had the ability to affect corporate debt in a personal way, they might actually do it in the opposite direction.

Dobbie: Yes.

Makhija: Kind of a hedging. Because if you are indebted too much personally, you would want to do hedging by not putting the corporation at risk. In a way you don't want bankruptcy in both places.

Dobbie: No, that's right. You want to keep. If the company goes down you still want to keep your job. You still want to keep your house in other words, or vice versa.

Makhija: Exactly. Exactly. However, you might argue that individuals have certain very strong traits.

Dobbie: Yes.

Makhija: And so that might be the competing way to view this. And as it turns out that the evidence supports this competing view. That is, the personal trait carries over to the professional side as well.

Dobbie: Now how quickly does this kick in? Did you look and see if a CEO comes into a new role, a new business, do they ...

Makhija: Yes.

Dobbie: It can happen quickly, can it?

Makhija: Oh, yes. Fairly quickly, you would think. Remember we did the study in two ways. First we took this 1,500 --- Standard and Poor's 1,500 CEOs --- which of course represents the largest corporations in the USA. And we did a cross-sectional study across them. But then separately we also examined what happens when a firm changes a CEO. Because now we have the opportunity to see the personal indebtedness on the mortgage side of the CEO and what the firm had. And then look at what happens when a new CEO comes in. We find that this change shows up within a year.

Dobbie: Right. Now all of this was done before the global financial crisis, wasn't it? The year 2004 was the time scale on this, so companies since then have been scrambling to deleverage. I'd assume some of the CEOs might have learned their lesson by now.

Makhija: Well, there is another aspect related to what you just said that is worth highlighting. And that is so far we talked as if it is the CEO that imprints his personal choice or her personal choice on the corporation. But it's very possible that firms themselves may have preselected the CEOs that they thought would deliver the capital structure of finances that they wanted.

Dobbie: Right.

Makhija: So when we look back at that financial crisis, I think we want to be a little careful. It may not be that the CEO drove the firm to those levels of excessive leverage. It could well have been that the firms were very happy to hire the people that would have delivered that leverage.

Dobbie: Right. So what you're saying is when you're interviewing for a CEO, ask them to bring along a photograph of their house and a copy of the bank statement. Is that the idea?

Makhija: This is of course an indicator. And if anything, all we are suggesting is we are trying to capture the debt tolerance of an individual that, as you can understand, is very difficult to capture. I imagine that when they interview for a CEO they really look around, you know, the person very carefully. And whether they use this directly as a measure or not, I presume that they are looking for many such features to figure out what are the proclivities of this individual.

Dobbie: Nice. So your research raises another interesting question, doesn't it? You know, what was the cause of it? Was it because, as you say, perhaps they appointed the CEO who's going to take them down the path that they already decided? Or has the CEO come into the job and steamrolled a little bit? And said look, you know, if we want to grow quickly we're going to take more risks. And if it's the latter, then that says something about a governance in these top companies, doesn't it?

Makhija: Well, as you know life is always complicated because it turns out that we have evidence on both sides.

Dobbie: Right.

Makhija: We found a certain amount of evidence that CEOs are able to imprint their personal preferences on the firm. And we know that because when we examine firms that have weaker corporate governance, we find that the CEO has a greater ability to act. The relationship between personal and corporate leverage is stronger when the corporate governance is weak. And we can get into how we measure that. But generally the notion being that if the CEO is able to imprint his preferences in terms of financing, we have evidence of that. But we also find that when firms hire a new CEO, the personal leverage of the new CEO tends to be correlated with the personal leverage of the retiring or the previous CEOs.

Dobbie: Right.

Makhija: So that means that the firms are in a way choosing people of a similar type.

Dobbie: So if you were buying shares on these top 1,500 companies ... maybe this is something else you should be looking at. Looking at the personal behaviours of the CEO to find out how much risk this business is likely to incur. It's another thing to look at if you're playing the share market, isn't it?

Makhija: Well, definitely it's going to tell you a very important aspect of the firm, which is the kind of financial risk this firm is going to have. And I know that investors care a lot about the nature of risk for the firm that they want to put in their personal portfolios. This certainly provides one more indicator. Because, you know, the people who make the decision, the CEO for example, shows here to have a role in the financial risk of the firm.

Dobbie: Now this was 2004 you were looking at. I wonder how many of those CEOs with their huge mortgages are still living in the same house these days. That's another piece of research perhaps. Anil, thank you very much for your time today.

Makhija: You're most welcome.