Outsider vs. Insider: Where should the firms look for their next CEO? Evidence From China

1. Outsider vs. Insider: Where should the firms look for their next CEO? Evidence From China Feng Helen Liang Haas School of BusinessOct 2005

2. Outline of the Talk • Introduction • Theory and Literature • China’s context • Data • Empirical Strategy • Results • Conclusion and Discussion

3. Should firms hire outsider or promote insider CEO? • CEO turnover happens a lot • Firms face the tradeoff between hiring an insider and an outsider when choosing a new CEO: • An internal new CEO  • knows the organization better • but might be constrained by the social networks • An external new CEO  • Has less knowledge of the organization • buts not constrained by the social ties • May bring new resources

4. Why China? • Rapid economic development • Restructure state-owned sector by: • Changing ownership – have not been very effective • Improving governance structure • Better board monitoring • Hire Better managers • We are interested in: • How applicable is the theory in the development setting? • Do managers matter in the same way as in a market economy?

5. 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?

6. Theory & Hypotheses I: CEO Selection • CEO Selection: outsider vs. insider • Poor pre-turnover performance  hire outsider to turn around • Strategy discontinuity  outsider • Strategy maintenance  insider • Dalton and Kesner 1985, Weisbach 1988 • Smaller firms less costly to hire outsiders • Less tacit org knowledge to learn • Fewer insider candidates available • Chung et al 1987 • This need not hold for SOEs in China • Less technology complexity  outsider • H1. A firm is more likely to choose an outsider CEO when the firm: • Is small • Does not have R&D department • Has poor pre-turnover performance

7. Theory & Hypotheses II: post-turnover performance: within the firm • Implicit contract and entrenchment: • 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 2003) • Thus they might sacrifice shareholder’s interests via: • Suboptimal labor allocation • Buy peace with higher wages • An external manager can’t capture such rents after turnover  Outsider CEOs could allocate human resource more efficiently than insiders do • It’s costly to hire an outsider, because • External turnover hurts lower-level manager incentives (Chan1996) • 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

8. Theory & Hypotheses II: post-turnover performance: outside of the firm • Outsiders might bring valuable external resources • Ties with government regulatory agents, banks • Ties with clients and suppliers (Peng & Luo2000) • Especially important in an uncertain institutional environment to • Obtain financing for investment • Secure supply, timely delivery, and customer loyalty • Safeguard contract • 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

9. 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 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

10. Data • Collected by the Chinese Academy of Social Science (CASS), with the scholars in University of Michigan, UCSD, and Oxford University • Panel firm data on operation activities plus manager survey • 94-99 panel data cover 800 enterprises in four provinces (Sichuan, Jiangsu, Jilin, and Shanxi) and in 36 industries: • production input and output, cost and revenue, incentives, and employment. • 55% SOEs, 45% NSOEs • 4800 firm-year observations • Managerial Survey covers: • The new manager’s characteristics, the old manager’s status at turnover, ownership, incentive, government regulation, etc. • Retrospective data for a balanced sample  could introduce survival bias

11. Descriptive Statistics

12. CEO turnover by year

13. Proportion of Insider and Outsider CEOs after turnover

14. Compensation, Age, and Education of Insider and Outsider CEOs: Mean and Difference *** p<0.01, ** p<0.05, * p<0.10

15. TFP plus firm fixed effects – before and after turnover

16. TFP residual before and after turnover

17. 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, • ß’X = constant + ß1*ln FirmSizei,1994 + ß2*R&D i + ß3* ROA i,1994 + CONTROL i,1994+ εi • Control variables: industry dummy, province dummy,

18. Productivity Estimation • Translog production function to estimate productivity: Yit = Ait F(Zit) • lnF(Zit) = ρ1* lnKit + ρ2* lnLit + ρ3* lnMit + ρ4* lnKit lnKit + ρ5* lnLit lnLit+ ρ6* lnMit lnMit + ρ7* lnKit lnLit + ρ8* lnKit lnMit + ρ9* lnLit lnMit • Ait = exp (η1* NewCEOit + η2* OUTSIDERit + θ*Wit + αi + γt + υit + ωit + ξit) • Wit = {OUTSIDERit *Labor it, OUTSIDERit * College Graduate Ratio it, OUTSIDERit from Government, OUTSIDERit from industry, OUTSIDERit*Government financing, OUTSIDERit *Customer Credit} • Firm fixed effect, year dummies, and interaction of province & year  take out time invariant firm effects, time trend, and region-year shocks • Controls: CEO age, education, tenure in the firm

19. Empirical Strategy – challenges • Two challenges: • Unobserved contemporaneous shocks ωit • observable to managers and may influence manager turnover and output simultaneously • e.g. technology shock, demand fluctuation • Selection • Firms choosing external CEOs are different from those promoting internal CEOs

20. 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 function is used here. • 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.

21. Empirical Strategy – control for selection • Selection of CEO • Firms choosing external CEOs are different from those promoting internal CEOs • Propensity score matching (Rosenbaum-Rubin1984) based on 1994 condition, nearest neighbor matching result reported • Selection bias is reduced if • What we see is what determined the selection – observables are sufficient statistics of probability of treatment • Matched sample covariates are “balanced”

22. Result on CEO Selection based on firm initial condition in 1994 Outsider succession is more likely in smaller firms, without R&D dept, and poorer pre-turnover performance, but not significant Dependent Variable: 1 if the new CEO is an outsider *** p<0.01, ** p<0.05, * p<0.10

23. Covariate Imbalance after matching

24. Results on post-turnover performance -- Hyp1Outsider CEOs improves productivity more, esp. in state-owned firms *** p<0.01, ** p<0.05, * p<0.10

25. Proxy for human capitalCollege graduate as a ratio of total employment

26. When do outsiders do better? – Hyp2: Total labor 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

27. When do outsiders do better? – Hyp3: Linkage to Gov. and industryOutsider CEOs linkage to government matters, but not necessarily through better use of GOV funding *** p<0.01, ** p<0.05, * p<0.10

28. Conclusion and Caveats • Outsider new CEOs increase productivity by 2-3%, more evident in state-owned enterprises, where the manager’s pursuit of side goals are presumably more pervasive • An outsider improves productivity via better allocation or utilization of labor, though he might not be better at using skilled labor • An outsider might improve productivity via external connection with the government and other firms. • Caveats