Do Insiders Hire CEOs with High Managerial Talent?
Jason D Kotter, Yelena Larkin
Review of Finance, Volume 28, Issue 1, January 2024, Pages 271–310, https://doi.org/10.1093/rof/rfad016
Hiring a new CEO is an important and difficult task. The board of directors must evaluate candidates, considering both their skills and experience, in order to select the best person for the job. Yet, CEO candidates are “difficult to vet and costly if you make a mistake. Moreover, the risk of selecting the ‘wrong’ candidate is greater than any time in the past” (Fortune 250 survey).
In “Do Insiders Hire CEOs with High Managerial Talent?” Jason Kotter and Yelena Larkin examine the effect of the composition of the board of directors, and inside directors in particular, on the firm’s CEO hiring decision.
They first create a new measure of managerial talent using résumé data from a large sample of U.S. executives, board members, and officers. This measure reflects the rate at which individuals ascend the corporate hierarchy via managerial ranks. Using this measure, Kotter and Larkin find that the presence of an inside director leads to hiring a CEO with a stronger record of prior managerial success—the new hire is around 60% more talented than the average CEO hire. These results hold for both inside and outside hires and are robust to various measures of inside director influence.
One concern with these results is that well-performing firms might simultaneously attract CEO candidates with high managerial talent and retain inside directors. To address this issue, Kotter and Larkin use an experiment based on the passage of the Sarbanes-Oxley (SOX) Act of 2002. SOX forced some firms to add independent directors to the board, reducing the influence of inside directors on board decisions. Using this exogenous change in composition of the board, Kotter and Larkin confirm that a reduction in the influence of inside directors leads firms to hire CEOs with lower levels of managerial talent.
Why does having an inside director on the board lead to hiring CEOs with more managerial talent? The data suggests that there are two primary channels. First, inside directors have stronger incentives to screen for managerial ability. Second, their information set differs from that of outside directors. This additional information is particularly important when hiring a CEO that has prior connections to outside board members, suggesting that insiders play an important role screening board-nominated candidates.
Combined, Kotter and Larkin’s results indicate that inside directors can benefit the firm by increasing the probability of hiring talented managers. However, inside directors also impose agency costs on firms’ shareholders, which suggests that the optimal board composition is neither fully independent nor fully insider. While this paper does not determine the optimal board structure, the results hint at the likelihood that a single inside director provides most of the benefit in terms of improved CEO hiring decisions.