Why do firms usually make, not buy, their chief executive officers (CEOs)? Public corporations hire their CEOs from within the firm 78% of the time. They do so although earlier studies have found no clear evidence that internal hires perform better than external ones. So why do firms prefer them? Few scholars have focused on this simple question.
The reason why firms favor internal candidates matters not only in its own right, but also for an overlooked reason: it informs the controversial question of executive compensation. Currently board-compensation committees look to peer benchmarks to set executive pay. But, taking cues from comparable companies presumes a robust managerial market, one where firms must pay their CEOs "market price" or risk poaching. If firms predominantly hire from within, it is far from clear why benchmarking, with its concomitant upward pressure on executive pay across the board, is appropriate.
Why firms hire internal candidates thus provides a theoretical basis for determining appropriate pay. For example, if candidates' superior knowledge of the institution (firms specific capital) drives the internal preference, then firms can pay less than a "market" rate because no true market for managers exists: a CEO's value is tied up with a particular firm, and he cannot credibly threaten to leave. Similarly, if firms promote from within to inspire competition in lower ranks (tournament theory), then compensation should reflect the price needed to incentivize lower ranks to compete to become CEO. In contrast, if the board's better information on internal candidates (informational asymmetry) explains the preference, then a true market may exist for externals able to demonstrate their superiority. Which of these theories is motivating boards to favor internal candidates?
To answer this question, this Article considers leadership in an area where the firm specific capital and information asymmetry explanations apply, but a tournament is absent: academia. Analysis of a sample of top university presidents reveals a bias in favor of external, rather than internal, candidates. This finding suggests that the tournament theory motivates public firms and has important implications for executive compensation policy.
Tournament of Managers: Lessons from the Academic Leadership Market
, 43 J. Corp. L. 537
Available at: https://digitalcommons.law.uga.edu/fac_artchop/1312