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American Accounting Association

Ben Haimowitz (212-233-6170)

Disappointment is the rule rather than the exception when CEOs are hired from high-performing companies, study finds

When Robert Nardelli was unceremoniously dismissed as CEO of Home Depot four and a half years ago, almost forgotten in the public uproar over his extravagant severance package was a question of equal import for students of corporate governance: How could someone who had risen to the top ranks of one of the world's leading corporations have proved such an utter failure at the company that had hired him away?

As it turns out, Mr. Nardelli's ill-fated tenure as CEO was not as surprising as it may appear. According to new research, disappointing performance is the rule rather than exception when CEOs are hired from high-performing companies.

In the words of a study to be presented at the Annual Meeting of the American Accounting Association> (Denver, Aug. 6-10), "CEOs coming from firms with strong prior returns receive an economically significant pay premium from their hiring firm [which] is on average negatively associated with the hiring firm's future operating performance."

In addition, "future firm performance is consistently negatively associated with past returns in CEOs' prior firms," write the study's authors, Richard A. Cazier of Texas Christian University and John M. McInnis of the University of Texas at Austin.

"Prior-firm success," the professors conclude, "is a noisy indicator of managerial skill [which] does not transfer well across organizations...Fixating on executives' prior-firm performance can lead boards to make suboptimal hiring and compensation decisions," and is most likely to happen "with busy or inattentive boards" (although, they add, that may not have been true of the Home Depot case).

The findings emerge from a test of two opposite views about hiring chief executives away from other companies, a practice that rose from about 15% of all CEO appointments in the 1970s to more than 30% in recent years. One view is that candidates from successful firms are the best bets because they can bring the winning strategies of their prior firm to the hiring firm; a contrary view is that there is little evidence managerial success transfers from one firm to another and that fixating on a candidates' prior company distracts from the more important task of assessing whether he or she has the specific skills needed by the hiring firm.

In deciding for the latter view, Profs. Cazier and McInnis analyzed 192 external CEO hirings, a sample that included all such initiatives by public U.S. firms from 1993 through 2005 for which there was requisite data on 1) board composition, 2) recruited chiefs' compensation arrangements, and 3) hiring companies' three-year financial performance post-recruitment. About one third of the hired CEOs were chief executives at their previous firms, and about two thirds held other executive positions there.

The study finds a strong relationship between the financial performance of the new chiefs' prior firms and their first-year compensation at their new companies; for example, CEOs hired from companies in the top quartile in stock returns over the three previous years average $5.2 million more in excess pay (judged by the norm of the hiring company) than CEOs recruited from firms in the lowest quartile. Yet, when the professors tested whether such pay premiums predicted superior financial performance for hiring firms in the three years following recruitment, they found the relationship not to just to be non-existent but to be negative.

In other words, the bigger the premium, the poorer the post-hiring performance.

Such results, they write, "are not consistent with the view that contracting on CEO candidates' prior-firm performance leads to future success for hiring firms. The results are more consistent with the view that boards overweight the performance of CEO candidates' prior firms in making hiring and compensation decisions."

Cazier and McInnis also find that stocks of firms that award the most excessive pay drop by an average of about one percent around earnings-announcement dates in the three years after the hire date. In the authors' words, "Firms paying a higher prior-performance pay premium tend to experience worse future stock price performance, particularly in short windows around future earnings-announcement dates."

What leads boards to assign excessive importance to the performance of a CEO candidate's prior company? Cazier and McInnis find this propensity increases significantly with the number of outside boards that directors sit on and with the number of directors who attend less than three fourths of board meetings. It is inversely related to the number of directors who are above retirement age and thus likely to devote adequate attention to their board duties.

Thus, in the words of the study, "the tendency to hire executives from highly performing predecessor firms is greatest among firms with busy or inattentive boards. This finding suggests that boards facing greater time pressure rely more heavily on easily observed signals such as firm performance to guide their choice of CEO."

The professors also find, though, that this lapse is not forever and that "externally hired CEOs' prior-firm performance is not associated with a pay premium in years subsequent to the CEO hire date."

Finally, if predecessor-firm performance is not a sound basis for hiring a CEO, what is? "We do not infer," the professors write, "that boards should ignore past performance completely or hire candidates from the lowest end of the past-performance distribution. However, our analyses do suggest that boards of directors should cautiously consider both the extent to which an executive's prior-firm performance is a reflection of his managerial ability and the extent to which that managerial ability is likely to transfer to the hiring firm...Fixating on candidates' prior-firm performance can distort the CEO selection process because it causes boards to discount potentially more informative criteria such as firm-specific knowledge or specific managerial skill sets that are more likely to contribute to company success."

The study, entitled "Do Firms Contract Efficiently on Past Performance when Hiring External CEOs?" will be among hundreds of scholarly presentations at the Annual Meeting of the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. More than 3,000 scholars and practitioners are expected to attend the meeting in Denver, Aug. 6th through Aug.10th


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