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Should Firms Look to an Insider or an Outsider When Hiring a New CEO? Evidence from China. Feng Helen Liang Haas School of Business, UC Berkeley April 21, 2006. CEO Turnover Happens a Lot CEO turnover rate increased from 6% to 10.1% in world’s 2500 largest firms 1995-2002.

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Should firms look to an insider or an outsider when hiring a new ceo evidence from china l.jpg

Should Firms Look to an Insider or an Outsider When Hiring a New CEO? Evidence from China

Feng Helen Liang

Haas School of Business, UC BerkeleyApril 21, 2006


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CEO Turnover Happens a Lot New CEO? Evidence from ChinaCEO turnover rate increased from 6% to 10.1% in world’s 2500 largest firms 1995-2002

Source: CNET news.com


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It’s Costly to Find Mr./Ms. Right New CEO? Evidence from ChinaThe number of search firms in North America tripled 1990-2000, hitting revenues of $8.7 billion in 2000

Source: Kennedy Information LLC


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More outsiders hired for the top position New CEO? Evidence from ChinaThe percentage of outsider succession doubled in 800 large companies 1990-2000

Source: Watson Wyatt Worldwide


But does this searching effort pay off l.jpg
But does this searching effort pay off? New CEO? Evidence from China

  • “Outsiders are hired to shake up the firm, but they are a high-risk gamble.”

  • “Outsiders generate rapid results.”

  • “But they lose momentum later because of lack of internal support network.”

    --Booz Allen Hamilton Annual Study of CEO Succession

  • Empirical studies found little systematic relations between successor type and performance, due to

    • Mean reversion

    • Noisy dependant variables: stock price (Huson et al 2004)

    • Selection


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What’s new in this study? New CEO? Evidence from China

  • A rich data set on Chinese firms

    • Details on CEO background and firm operation

    • Control for selection between outsiders and insiders

  • Productivity: a more accurate performance measure

  • Developing country setup


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Why China? New CEO? Evidence from China

  • Rapid economic development

  • World manufacturing center

  • Restructure in the state-owned sector  widespread managerial turnover


This research asks two questions about ceo turnover and firm performance l.jpg
This research asks two questions about CEO turnover and firm performance:

  • RESEARCH QUESTIONS:

    • When do firms hire an outsider over an insider in choosing a new CEO?

    • Are outsider CEOs better at improving productivity than insiders? What are the channels?


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What I found -- performance:Total Factor Productivity before and after turnoverTFP goes up in outsider-succession firms, and goes down in insider-succession firms


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Findings performance:

  • Firms that hire outsiders do better:

    • Total factor productivity improves 2-3% more

  • Significant in large state-owned firms, but not in private firms

  • Managers’ ties with government and other firms help to improve productivity


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Outline of the Talk performance:

  • Introduction

  • Theory and Hypotheses

  • China’s context

  • Data

  • Empirical Strategy

  • Results

  • Conclusion and Discussion


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Theory & Hypotheses I: performance:CEO Selection

  • Difference between an outsider and an insider

  • Smaller firms less costly to hire outsiders

    • Less tacit org knowledge to learn (Chung et al 1987)

    • Fewer insider candidates available

    • External turnover hurts middle-level managers’ incentives (Chan1996)

  • Less technology complexity  outsider

  • Poor pre-turnover performance  hire outsider to turn around

    • Strategy discontinuity  outsider

    • Strategy maintenance  insider

    • (Dalton and Kesner 1985, Weisbach 1988)

  • H1. A firm is more likely to choose an outsider CEO when the firm:

    • Is small

    • Does not have a R&D department

    • Has poor pre-turnover performance


  • Theory hypotheses ii post turnover performance l.jpg
    Theory & Hypotheses II: performance:post-turnover performance

    • Implicit contract:

      • Incumbent managers are bound by an implicit contract with the workers and could entrench themselves with manager specific investment

        (Shleifer & Summers 1988, Shleifer & Vishny 1989, Bertrand & Mullainathan 2003)

      • Thus they might sacrifice shareholder’s interests via:

        • Suboptimal labor allocation

        • Buy peace with higher wages

      • An outsider can’t capture such rents after turnover  Outsider CEOs could allocate human resource more efficiently than insiders do

    • H2. Everything else equal, an outsider CEO is more likely to improve firm productivity, esp. when the firm

      • Has a large employment, and

      • Higher proportion of skilled labor


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    Theory & Hypotheses III: performance:post-turnover performance

    • Outsiders might bring valuable external resources

      • Ties with government regulatory agents, banks

      • Ties with clients and suppliers (Peng & Luo 2000)

      • Especially important in an uncertain institutional environment to

        • Obtain financing for investment

        • Secure supply, timely delivery, and customer loyalty

        • Safeguard contract

      • But such ties could be detrimental to firm performance (Bartel & Harrison 2005)

      • H3. Everything else equal, an outsider CEO is more likely to improve firm productivity, esp. when the firm

        • Has higher proportion of investment funding from the government and state-owned banks and

        • Has a larger amount of revenue in the form of customer credit


    I address the research questions in the context of china s reform l.jpg
    I address the research questions in the context of China’s reform

    • WHY CHINA? – Restructure in State-owned sector and CEO turnover

      • The Reform started in 1978

      • Before 1992  Gradualism

        • Productivity improved during 1980-1990

        • Li 1997, Groves, Hong, McMillan and Naughton 1994, 1995

      • Starting from 1992, the government gave more autonomy to the managers

        • The 14th Congress of the Chinese Communist Party decided to build a “socialist market economy”

        • Before 1992, most firms suffer labor redundancy and low productivity

        • They are forced to restructure, downsize, and improve productivity

      • Our data covers CEO characteristics and firm performance 1994-1999

        • How did managers do in those firms?

      • Variation in firm ownership: State-owned and non state-owned enterprises may have different mechanisms


    Outline of the talk16 l.jpg
    Outline of the Talk reform

    • Introduction

    • Theory and Hypotheses

    • China’s context

    • Data

    • Empirical Strategy

    • Results

    • Conclusion and Discussion


    Slide17 l.jpg
    Data reform

    • Collected by the Chinese Academy of Social Science (CASS), with the researchers in University of Michigan, UC San Diego, and Oxford University (Li 1997, Groves et. al. 1994,1995)

    • Firm operation and manages’ characteristics

      • Firm Operation:

        • 800 firms in 1994 -1999

        • Four provinces and in 36 industries:

        • production input and output, cost and revenue, wages, etc

        • 55% SOEs, 45% NSOEs

        • 4800 firm-year observations

      • Managers’ characteristics:

        • The new manager’s characteristics, the old manager’s status upon turnover, incentive, relation with government, etc

    • Limitation: Retrospective data in a balanced sample  survival bias




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    Proportion of Insider and Outsider CEOs after turnover reform

    Turnover rate: 85%

    Outside Succession ratio: 70%


    Slide21 l.jpg

    Compensation, Age, and Education of Insider and Outsider CEOs: Mean and Difference

    Insider and Outsider Successors Look Similar

    *** p<0.01, ** p<0.05, * p<0.10


    Outline of the talk22 l.jpg
    Outline of the Talk CEOs: Mean and Difference

    • Introduction

    • Theory and Hypotheses

    • China’s context

    • Data

    • Empirical Strategy

    • Results

    • Conclusion and Discussion


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    Two Steps of the Estimation CEOs: Mean and Difference

    • Selection of CEO

      • A Logit model

      • Matching using the selection estimation results

    • Post-turnover performance

      • Total Factor Productivity estimation using the matched sample

      • Control for unobservables


    Ceo selection estimation l.jpg
    CEO Selection Estimation CEOs: Mean and Difference

    • Conditional on turnover, the choice between insider and outsider successor is estimated with a logit model:

    • Pr(OUTSIDERi = 1 | CEO turnover) =

      Where X include

    • Independent Variable:

      • Firm Size in 1994

      • Return on Asset in 1994

      • R&D Department dummy

    • Control variable: industry dummy, province dummy, ownership


    Productivity estimation l.jpg
    Productivity Estimation CEOs: Mean and Difference

    • Translog production function to estimate productivity:

      Yit = Ait * F(Zit)

    • Where F(Zit) is a translog productivity function including labor hour, capital, and material

    • Dependant Variable: Yit -- Output

    • Ait include:

    • Independent Variables:

      • New CEO dummy

      • OUTSIDER dummy (+)

      • OUTSIDER dummy interactive terms with employment, College Graduate Ratio (+)

      • OUTSIDER from Government or Industry dummy (+)

      • OUTSIDER from Gov or Industry dummy interactive terms with Gov financing and Custom Credit (+)

    • Control Variables:

      • Firm fixed effect, year dummy

      • CEO age, education, and tenure at the firm


    Empirical strategy challenges l.jpg
    Empirical Strategy – Challenges CEOs: Mean and Difference

    • Two challenges:

      • Selection

        • Firms choosing external CEOs are different from those promoting internal CEOs

      • Unobserved contemporaneous shocks ωit

        • observable to managers but not to the researcher

        • influence turnover and output simultaneously

        • e.g. technology shock, demand fluctuation

        • not captured by firm fixed effects and year dummies


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    Empirical Strategy – control for selection CEOs: Mean and Difference

    • Construct a control group

      • Treatment group: firms that hired outsiders

      • Control group: firms that hired insiders but have the same probability of hiring an outsider

    • Method

      • Propensity score estimated with initial conditions (Rosenbaum-Rubin1984)

      • Nearest neighbor matching: logit estimation with higher order terms and input variables

  • Selection bias is reduced if

    • What we see is what determined the selection – observables are sufficient statistics of the probability of treatment

    • Matched sample covariates are “balanced”


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    Empirical Strategy – control for unobserved shocks CEOs: Mean and Difference

    • Unobserved shocks (Olley-Pakes 1996, Levinsohn-Petrin 2003):

      • Proxy for the shocks with a proxy variable (investment or intermediate input) and a state variable (capital)

        • ωit = h(INVit, Kit)

        • h(.) is a non-parametric estimator; a third order polynomial function is used

      • ωit is identified if:

        • Investment and intermediate inputs (energy consumption) change monotonically with ωit

        • Lit Mit respond to ωit immediately, while Kitresponds after a lag


    Outline of the talk29 l.jpg
    Outline of the Talk CEOs: Mean and Difference

    • Introduction

    • Theory and Hypotheses

    • China’s context

    • Data

    • Empirical Strategy

    • Results

    • Conclusion and Discussion


    Slide30 l.jpg

    Result on CEO Selection CEOs: Mean and Difference based on firm initial conditions in 1994 Outsider succession is more likely in smaller firms without R&D dept, and with poor pre-turnover performanceDependent Variable: 1 if the new CEO is an outsider

    *** p<0.01, ** p<0.05, * p<0.10


    Distribution of roa in matched sample l.jpg
    Distribution of ROA in matched sample CEOs: Mean and Difference




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    Total Factor Productivity before and after turnover CEOs: Mean and Difference TFP goes up in outsider-succession firms, and goes down in insider-succession firms


    Slide35 l.jpg
    Results on post-turnover performance – CEOs: Mean and Difference Outsider CEOs improves productivity more, esp. in state-owned firms

    *** p<0.01, ** p<0.05, * p<0.10


    Slide36 l.jpg

    When do outsiders do better? – CEOs: Mean and Difference Total employment and skilled laborOutsider CEOs improves productivity more, esp. in firms w/ larger employment, but not necessarily w/ more skilled labor

    *** p<0.01, ** p<0.05, * p<0.10


    Slide37 l.jpg

    When do outsiders do better? – CEOs: Mean and Difference Linkage to government and industryOutsider CEOs linkage to government and industry matters, but not necessarily through better use of GOV funding and customer credit

    *** p<0.01, ** p<0.05, * p<0.10


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    Industry Analysis CEOs: Mean and Difference Outsider CEOs do better in low-tech industries

    *** p<0.01, ** p<0.05, * p<0.10


    Conclusion and caveats l.jpg
    Conclusion and Caveats CEOs: Mean and Difference

    • Firms that hire outsiders increase productivity by 2-3% more

      • More evident in state-owned enterprises, where the manager’s pursuit of side goals might be more pervasive

    • An outsider might improve productivity via better allocation of labor, though not of skilled labor

    • An outsider might improve productivity via external connection with the government and other firms

    • Caveats

      • Matching: I assume observed variables provide sufficient info for matching

      • Survival bias: good firms survived outside succession, bad firms exit

      • Productivity versus profit (ROA)