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

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

3. 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. 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. 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. 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. 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. 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. 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 14 th 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. 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. 11 Descriptive Statistics VariableNMeanStd. Dev.MinMax Asset (in thousand Yuan)4680169,803.9561508.780812,700,000 Profit (in thousand Yuan)468018,555.4451797.94-24,5791,522,228 Return on Asset (ROA)46800.1270.101-0.250.73 Number of Employees46801,8833131.9911545,182 Output (in thousand Yuan)4680135,745.50502519.91611.73E+07 Capital (in thousand Yuan)466267,917.10248407.8856161252 Investment (in thousand Yuan, book value)45485,914.31827043.90925,809 Total annual labor hours (in 10,000 hours)4241486.0283441.086090720 Material (in thousand Yuan)453671,223.2524337797584509

12. 12 CEO turnover by year

13. 13 Proportion of Insider and Outsider CEOs after turnover CEO Turnover occurred during 94-99 No CEO turnover 94-99 Sum Insider New CEO Outsider New CEO State-owned Enterprises 10024486430 Non State-owned Enterprise 9722231350 Sum197466117780

14. 14 Compensation, Age, and Education of Insider and Outsider CEOs: Mean and Difference CEO Relative Salary Pay-for- performance sensitivity Level CEO Age in 2000 CEO Education level Mean of Inside New CEO (#obs) 3.081 (45) 1.103 (83) 46.340 (197) 3.464 (220) Mean of Outside New CEO (#obs) 2.486 (109) 1.003 (54) 46.779 (466) 3.248 (560) Difference.595***-.903-.439***.215*** *** p<0.01, ** p<0.05, * p<0.10

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

16. 16 TFP residual before and after turnover

17. 17 CEO Selection Estimation  Conditional on turnover, the choice between insider and outsider successor is estimated with a logit model:  Pr(OUTSIDER i = 1 | CEO turnover) =  Where,  ß’X = constant + ß1*ln Firm Size i,1994 + ß2*R&D i + ß3* ROA i,1994 + CONTROL i,1994 + ε i  Control variables: industry dummy, province dummy,

18. 18 Productivity Estimation Translog production function to estimate productivity: Y it = A it F(Z it ) 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 = {OUTSIDER it *Labor it, OUTSIDER it * College Graduate Ratio it, OUTSIDER it from Government, OUTSIDER it from industry, OUTSIDER it *Government financing, OUTSIDER it *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. 19 Empirical Strategy – challenges Two challenges:  Unobserved contemporaneous shocks ω it 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. 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) ω it = h ( INV it, K it ) h(.) is a non-parametric estimator. A third order function is used here.  ω it is identified if: Investment and intermediate inputs (energy consumption) change monotonically with ω it L it M it respond to ω it immediately, while K it responds after a lag.

21. 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. 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 Baseline ModelLogit coefficientsMarginal EffectsX Log Employment-.2114*-.2207-.04487.0967 R&D Department dummy -.5825**-.5517*-.1180*.2482 Return to Asset-1.1915-1.3938-.2830.1182 Non SOE dummy-.5559**-.4451-.0957.1684 Industry dummy YY Province dummy YY Higher order termsNY N653564 LR chi-square57.6849.30 *** p<0.01, ** p<0.05, * p<0.10

23. 23 Covariate Imbalance after matching Treated (outsider=1) Control (outsider=0) VariableObsMeanStd.Err. Ob s MeanStd.Err.difference 2sample t-test statistic s P>|t| Log (output) 38710.70090.058212410.84300.10490.14211.200.2319 Log (capital) 38710.05410.060912410.3410.11720.28692.270.0237 Log (labor hours) 3874.46570.10711244.72460.19570.25891.180.2383 Log (material) 3879.94370.067612410.08920.11070.14551.080.2813 Log (coal) 3518.01340.09121097.92500.1834-0.0884-0.460.6470 Log (investment) 3567.83450.06771188.03080.12740.19641.420.1570 Log (employment) 3877.02790.04551247.22220.08660.19432.060.0395 R&D dummy 3870.20930.02071240.28230.04060.07301.690.0918 Labor/capital 3870.02200.00071240.02140.0011-0.0006-0.420.6772 Return to Assets (ROA) 3870.11740.00411240.11490.0060-0.0025-0.320.7516

24. 24 Results on post-turnover performance -- Hyp1 Outsider CEOs improves productivity more, esp. in state-owned firms After Propensity score matching Fixed EffectFixed Effect with Olley Pakes proxies Pooled SampleState-OwnedNon State-Owned New CEO dummy-0.0064-0.0142-0.0208-0.0290 Outsider dummy0.01190.02350.0375**-0.0289 No. of obs.268423442037307 No. of enterprises45544938663 *** p<0.01, ** p<0.05, * p<0.10

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

26. 26 When do outsiders do better? – Hyp2: Total labor and skilled labor Outsider CEOs improves productivity more, esp. in firms w/ larger employment, but not necessarily w/ more skilled labor Fixed Effect with Olley-Pakes proxies New CEO dummy-0.01420.2127-0.0157 Outsider dummy0.0235-0.3082*0.0125 Outsider * log(labor)0.0460** Log(employment)-0.0631 Outsider*ratio of college-grad 0.1497 Ratio of College-grad0.0170 No. of obs.2344 No. of enterprises449 *** p<0.01, ** p<0.05, * p<0.10

27. 27 When do outsiders do better? – Hyp3: Linkage to Gov. and industry Outsider CEOs linkage to government matters, but not necessarily through better use of GOV funding Fixed Effect with Olley-Pakes proxies New CEO dummy-0.0224-0.01830.0803 Outsider from Gov0.0353*0.0399**-0.1136 Outsider from Industry 0.0372**0.0300*-0.0479 Outsider from Gov* Gov Funding -0.0338 Outsider from Firm* Gov Funding 0.0400 Outsider from Gov* Accounts Receivables 0.0087 Outsider from Firm* Accounts Receivables 0.0162 No. of obs.234423342337 No. of enterprises449447448 *** p<0.01, ** p<0.05, * p<0.10

28. 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