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.