The Effect of CEO Hiring Source on Total Cash Flow

Abstract

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.

Keywords: CEO turnover, firm performance, labor market demand, compensation

JEL Classification: G30, G32, G34