If the labour market was efficient, CEO pay would be reasonable. That is, CEO demand, supply and pay would settle at a level whereby pay would be sufficient to ensure supply meets demand. Pay would be rational, and hence reasonable.

Several influential studies argue that the market for CEOs is well described by models with perfect competition and no frictions (for example, see HERE and HERE).

A recent paper has suggested that the market is not at all efficient, and as a consequence, CEO pay cannot be a result of an efficient market. It described CEO hiring practices and compared them to the predictions of these efficient market theories.

CEO hires are mainly insiders

The paper investigates the appointment of new CEOs in the S&P 500 from 1993 to 2012, examining CEOs’ prior connections to the hiring company, whether new CEOs were poached from other companies, and how hiring choices vary across companies.

The researchers chose the S&P 500 since

1. its constituent companies were considered to face the fewest frictions in the managerial labour market; and,

2. because of the range of their activities undertaken by the companies, they are likely to require CEOs with general skills.

The result? S&P 500 companies do not cast a wide net when hiring CEOs, but rather dip into a very small pool of talent: the vast majority of new CEOs have close prior links to the hiring company.

Seventy-two percent of new CEOs are promoted internally. Eight percent are former executives or current or former board members. In total, 80% of CEO hires are insiders. Only 20% are newcomers. What’s more, the number of outsiders decreased in the later years of the study, reversing what the researchers noted was an earlier trend of increased hiring of outsiders.

Majority of outsiders are networked to insiders

Of the 20% “outsiders”, 54% have worked with at least one of the hiring company’s directors. Therefore, more than 90% of new CEOs are either insiders or co-workers of its directors.

The researchers found this fact difficult to reconcile with the view that CEOs are chosen for their general managerial skills and move freely across companies.

Most CEO hires were not previously CEOs

Only 3% of new CEOs previously held a CEO position at another company. When companies do poach CEOs, it is generally from companies that are three to four times smaller. This suggests barriers to the reallocation of CEO talent across companies. Rather than targeting CEOs, most of the 20% outsider hires are below-CEO executives at other (typically much larger) companies (55%) or individuals not currently in an executive position (31%).

Companies vary in how heavily they preference insiders

Larger companies are more likely to promote internally than smaller ones. Companies with low stock returns and low sales growth are more likely to hire outsiders, but still generally choose insiders. Many badly performing companies turn to former employees and directors rather than to outsiders for help.

Is the insider preference because outsiders cost too much?

Outsiders are more expensive than internal promotions. However, the differences are small compared to the scale of S&P 500 companies. In the first full year of employment, outsider hires receive on average $1.5 million more than executives promoted internally to the position. For other non-CEO hires found externally, the difference is even lower,

Since prior research has shown CEOs have large effects on company value, these pay differences should not explain the dominance of internal promotions over external hires.

So what?

CEO hiring appears to be determined by company-specific human capital and personal connections rather than an efficient market where CEOs move freely between positions.

This impacts our understanding of CEO remuneration. The outside options of both companies and CEOs appear severely limited, as companies’ effective candidate pool is small and incumbent CEOs rarely move to other companies. This suggests that from an attraction and retention point of view, boards could push back more on executive pay.

It also suggests an imperfectly competitive market in which pay is determined, at least in part, by CEOs and shareholders bargaining over the surplus created by each CEO-company match. It is, then, the value of this surplus in remuneration terms that is defined by benchmarking similar companies of a similar size.

One aspect the study did not take into account is risk – it is riskier to hire an unknown outside CEO, and yet it is more expensive. From a risk and return perspective it is, therefore, more rational to hire internally. The risk of losing a CEO to another company is also not nil, being 3% according to this study. If boards believed the loss of the CEO could be highly detrimental, boards may decide that paying a market median or better rate may be a necessary cost to reduce this risk.

Nevertheless, it is useful to have some statistics.

See research HERE.

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