Gregory Leo Nagel

Outside and Inside Hired CEOs: A Performance Surprise

We investigate the association between financial performance and CEO hiring source: internal promotion or external firm. This analysis includes all U.S. CEOs in established public firms from 1986 to 2005. The results show that in large firms, internal hires provide significantly higher median performance, equal chance of the highest performance, and lesser chance of low performance. Over our time period of study, external hires’ performance, relative to internal hires, has decreased significantly. Further, in 10 circumstances where it is commonly thought that external hires would excel, it is the inside hires who either excel or deliver performance comparable to external hires. In the aggregate, internally promoted CEOs are associated with at least 25.4% greater total financial performance than external hires. Overall, the results 1) reveal a deviation from boards’ expectations, and 2) are consistent with Merton’s (1987) observation that correction of an anomaly like this can only occur after a period of time sufficient for its statistical documentation.

The Effect of CEO Hiring Source on Total Cash Flow

We examine the financial performance that boards of large U.S. firms realize by their decision to hire a new CEO from within the firm versus externally. Using a structural self-selection modeling approach, we find, for boards that promote internally, greater total cash flows than would have been obtained from the passed over external candidate (a marginal gain). On the other hand, for boards that hire externally, we find less total cash flow than would have been obtained from the passed over internal candidate (a marginal loss). This marginal loss is primarily explained by our addressing two concerns involving method and measure. First, we include all CEOs regardless of tenure to avoid (survival) bias. Second, we account for cash expenses not included in operating income, such as the expense of ongoing operations that will be discontinued and the cost of restructuring; these expenses are primarily associated with externally hired CEOs. Our analysis suggests boards do not account for the marginal loss we document in their decision to externally hire a CEO. Further, associated with search firms’ rising revenues and greater pay for placing an outside CEO, we find an increasing frequency of external hiring and increased marginal losses, especially among S&P 500-size firms where search firms are primarily employed.

The Likely Effect of CEO Hiring Source on Total Cash Flow

We examine the financial performance that firms realize by the decision to hire a new CEO from within the firm versus externally. Using a structural self-selection modeling approach, we find, for boards that hire externally, less total cash flow on average than would have been obtained from the passed over internal candidate (a marginal loss). A marginal gain is found for boards that promote internally. The marginal loss we find when hiring externally is not likely explained by theories based on maximizing firm value. Our results are consistent with behavioral theories involving overconfidence or with agency explanations.

The Real Asset Anomaly: A Critical Long View of Capital Markets and Institutions from Realized Returns of Corporate Assets in Over 50 Years

Abstract Our chapter raises serious questions about the long-term efficiency of stock prices in relation to the realized returns of the underlying corporate real assets. In our large-scale calculations that cover horizons of 10, 20, 30, 40, and 50 years, returns on corporate real assets suffer a long-term decline, and have been below the yields of 10-year Treasury bonds since 1973. Real assets that received more external financing from capital markets and institutions actually report even lower realized long-term returns. The decline in realized returns cannot be attributed to declining risks as the volatilities of realized returns have been increasing over time. These surprising results may stimulate fresh debate on the roles and long-term performance of capital markets and institutions.

The Financial Outcome of Hiring a CEO from Outside the Firm

We investigate the financial result of boards’ choices to promote a new CEO from within the firm or hire externally, at large U.S. public firms between 1986 and 2005. This choice theoretically maximizes profits. Additionally, choosing a new CEO from outside the firm influences labor market demand and compensation for top executives. We use the structural self-selection modeling method to determine the performance (total cash flow) boards would have obtained by choosing the passed-over type of hire. The method accounts for boards that self-select their hiring source (inside or outside) to maximize profits. The model uses instrument variables that affect the decision to hire externally but are uncorrelated to firm performance. Standard methods are used to address any remaining concerns related to endogeneity, firm fixed effects, and truncation bias. Extensive robustness tests are run. Results are verified by using advanced matching estimators. Our results show that an economically significant gain is realized, on average, by hiring internally relative to what would have been obtained by hiring externally, whereas an economically significant loss is realized by hiring externally. This result is a) robust to analysis method, performance measure, and model specification, b) holds regardless of the time period, for both S&P 500-size and Forbes 800-size firms, and c) is not significantly changed by removing interim CEOs. Ours tests suggest the loss obtained when hiring externally is not attributable to weak governance or greater risk taking by outside hires to obtain superior performance. Instead, our results suggest that boards are unknowingly missing critical information about external candidates, which results in their decision to hire externally and a subsequent loss of profits. Our result can help explain the major trends in corporate governance and CEO compensation since 1934.

A Critical Long View of Capital Markets and Institutions: Realized Returns from Corporate Assets, 1950-2003

It is often taken for granted that: 1) capital markets and institutions allocate funds to firms where realized returns on real assets are highest; 2) the net gains to the economy from investments by corporations have improved in the last 30-50 years due to innovations and better risk management techniques in the financial markets; and 3) the agency cost-reducing role of markets and institutions ensures that real assets funded with external funds would earn higher returns. However, corporate real assets are long lived, and realized returns have to be tracked over a long period to verify these assertions. We perform large-scale calculations of the realized returns on real assets to all firms available in the Compustat database for periods of 10, 20, 30, 40, and 50 years. Our methodology relies only on cash flow between the firms and all their fund providers. In particular, we focus on capital markets, institutions and non interest bearing liability holders. It circumvents the potential problem in using market expectations of future cash flows if markets are inefficient over long periods as suggested by Shiller (1981). We found several new and surprising results. Returns on real assets by corporations derived from actual cash flow over long periods are, on the whole, lower than expected by the fund providers. They suffer a long-term decline, and have been below the yields of 10 year Treasury bonds since 1973. Real assets that received more external financing (from capital markets and institutions) actually report even lower realized long-term returns. These unexpected results may stimulate fresh debate on the roles and long-term performance of capital markets and institutions.