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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

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

slide2
CEO Turnover Happens a LotCEO turnover rate increased from 6% to 10.1% in world’s 2500 largest firms 1995-2002

Source: CNET news.com

slide3
It’s Costly to Find Mr./Ms. RightThe number of search firms in North America tripled 1990-2000, hitting revenues of $8.7 billion in 2000

Source: Kennedy Information LLC

slide4
More outsiders hired for the top positionThe percentage of outsider succession doubled in 800 large companies 1990-2000

Source: Watson Wyatt Worldwide

but does this searching effort pay off
But does this searching effort pay off?
  • “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
what s new in this study
What’s new in this study?
  • 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
why china
Why 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
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?
slide9

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

findings
Findings
  • 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
outline of the talk
Outline of the Talk
  • Introduction
  • Theory and Hypotheses
  • China’s context
  • Data
  • Empirical Strategy
  • Results
  • Conclusion and Discussion
theory hypotheses i ceo selection
Theory & Hypotheses I: 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
Theory & Hypotheses II: 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
theory hypotheses iii post turnover performance
Theory & Hypotheses III: 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
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
Outline of the Talk
  • Introduction
  • Theory and Hypotheses
  • China’s context
  • Data
  • Empirical Strategy
  • Results
  • Conclusion and Discussion
slide17
Data
  • 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
slide20

Proportion of Insider and Outsider CEOs after turnover

Turnover rate: 85%

Outside Succession ratio: 70%

slide21

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
Outline of the Talk
  • Introduction
  • Theory and Hypotheses
  • China’s context
  • Data
  • Empirical Strategy
  • Results
  • Conclusion and Discussion
two steps of the estimation
Two Steps of the Estimation
  • 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
CEO Selection Estimation
  • 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
Productivity Estimation
  • 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
Empirical Strategy – Challenges
  • 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
empirical strategy control for selection
Empirical Strategy – control for selection
  • 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”
empirical strategy control for unobserved shocks
Empirical Strategy – control for unobserved shocks
  • 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
Outline of the Talk
  • Introduction
  • Theory and Hypotheses
  • China’s context
  • Data
  • Empirical Strategy
  • Results
  • Conclusion and Discussion
slide30

Result on CEO Selection 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

slide34
Total Factor Productivity before and after turnoverTFP goes up in outsider-succession firms, and goes down in insider-succession firms
slide35
Results on post-turnover performance –Outsider CEOs improves productivity more, esp. in state-owned firms

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

slide36

When do outsiders do better? – 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

When do outsiders do better? – 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

industry analysis outsider ceos do better in low tech industries
Industry AnalysisOutsider CEOs do better in low-tech industries

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

conclusion and caveats
Conclusion and Caveats
  • 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)