Picking Winners: Managerial Ability and Capital Allocation in Internal Capital Markets

• Applicants: Professor Dr. Daniel Hoang; Professor Dr. Martin Ruckes
• Subject Area: Accounting and Finance
• Term: from 2016 to 2023
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 313770560

Theoretical arguments and evidence from CFO surveys (Graham, Harvey and Puri, 2015; Gatzer, Hoang and Ruckes, 2014) suggest that heterogeneity in divisional managers' ability (human capital) may lead to profound differences in the allocation of resources in internal capital markets. Top management's assessment of divisional managers' managerial ability (e.g., by using realized returns of past projects as signals) allows for value-enhancing capital allocations across divisions. Firms pick winners (Stein, 2003) and move financial resources to divisions with the best managers. The research project empirically examines this hypothesized relationship between capital allocation and managerial ability.The effect of managerial ability on capital allocation depends also on information asymmetries and governance structures. The conjectured positive association between ability and capital allocation should be stronger in settings in which headquarters is faced with high information asymmetries about investment opportunities of its divisions (e.g., in pure conglomerates). Then, top management may put more weight on additional human-capital-related signals because information asymmetries render assessing intrinsic investment opportunities of divisions expensive. Likewise, we hypothesize that under weak governance the association between ability and capital allocation is less pronounced. Finally, capital investment may also depend on how well top management can assess managerial ability. Top management should allocate more capital to projects if it is able to properly assess divisional managers' ability. Therefore, the project examines whether intertemporal learning about managerial ability affects investment outcomes. We expect newly hired managers to receive less capital than seasoned managers, and this gap should narrow over time as information asymmetries about ability diminish. This hypothesis suggests that frictions in the internal labor market have a significant impact on corporate investment policies. To conduct the empirical tests, the project builds a unique database using biographical data of divisional managers at S&P 500 firms for the period of 2000-2014. For identification of causal effect, the study exploits exogenous shocks (e.g., exogenous manager turnovers, negative media reports) and instrumental variables (e.g., non-compete regulation).

• DFG Programme: Research Grants