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INTERNAL FIRM MONITORING : IMPLICATIONS FOR MANAGMENT STRUCTURE AND CEO PROMOTIONS 

Internal management promotions and the selection of Chief Executive Officers (CEOs) impact the incentives of senior management and, in turn, firm value (see Raheja (2005), Acharya et al. (2011), Dyck et al. (2010), and Masulis and Mobbs (2011) among others). Raheja (2005) provides a theoretical model of how promotions and incentives of senior management impact their incentive to monitor CEOs and reveal information to boards. The paper shows how competition among senior management and future career concerns create an incentive for them to reveal information and inform boards. Raheja and Mobbs (2012) empirically study firms choices of internal promotion of senior management and the effect of the choice to firm value. I discuss the intuition in these two papers on how career concerns impact managerial incentive.

There are two promotion related factors that create an incentive for senior managers to monitor firms. The 1st factor is the internal quality of the firm’s projects and future options. The second factor is the level of competition for CEO promotion. The complexity of a company's projects, and the quality of the management team affect how much emphasis is placed on each of these factors.

First, all else equal, internal managers aiming at becoming a future CEO prefer a higher expected firm value. This increases their expectation of becoming CEO (boards become more likely to promote from within the firm) and increases their expected pay if they become CEO (CEOs of higher value receive greater average pay). Raheja (2005) motivates this empirical result by assuming that corporate boards select an external CEO if firm performance is poor1. As a result, internal managers prefer to select projects that have a higher firm value, and as a result, are motivated to inform boards when CEOs propose inferior projects. The intuition is as follows: in the event that a CEO proposes an inferior project, senior managers need to make a choice between speaking against the CEO by revealing the poor project to the board (causing them to lose the CEO support) or remaining silent and allowing the company to take on the poor project. The decision to reveal information depends on which option gives the insider an higher probability of becoming CEO. If the insider reveals, then the insider considers the probability that the board will evaluate the project and realize that it is of poor quality, thus implementing a project of higher value and rewarding the insider with the CEO position. If the insider remains silent, the probability depends on the likelihood that the project will succeed despite the poor prospects (the incumbent CEO will support the insider because the insider remained silent and allowed the poor project). The lower the probability that the proposed project will succeed, the greater the incentive for an insider to reveal information to the board.

The 2nd factor that impacts insiders’ incentive to monitor is the competition for the CEO position. Firms can have some choice in this factor because they are able to select the level of internal competition. When insiders face internal competition for CEO succession, it is no longer sufficient that the project succeeds. Even if the project succeeds, the insider needs to be the chosen successor among all the potential successors. The decision of the insider again depends on which option gives the insider higher probability of being chosen CEO. Consider a case when the CEO proposes a poor project (there is no decision to be made if the project is of high quality). First, if the insider remains silent, then the insider will become the CEO if the following happen: no other insider informs the board so the board does not evaluate the project, the project succeeds, and the CEO selects the insider as the next CEO. Second, if the insider informs the board, then the insider will become the CEO if the following happen: the board evaluates the project, and the board selects the insider to become the next CEO. Notice that the issue here is that there are multiple insiders that can be selected. As a result, the insider competes with all the other insiders that are favored by the CEO (in the case of project not monitored by the board) and the insider competes with all the insiders favored by the board in the case of project monitored by the board. The higher internal competition increases the incentive for an insider to reveal the information to the board so that the board favors the insider.

Not all companies require this second level of competition. Some company specific qualities may make it difficult for companies to have multiple insiders competing to become the next CEO. In addition, companies need to have multiple high quality candidates willing to participate in the competition to crease a tournament. Mobbs and Raheja (2012) study internal senior executive promotions and succession planning. They shows how different methods of internal promotion impact managerial incentives and how these methods depend on specific firm requirements. The paper also makes a significant contribution to the existing empirical literature on tournament incentives because it develops a new empirical method that ranks managers based on their likelihood of being the internal candidate to succeed the CEO.

The paper examines the determinants of the promotion method selected by firms. As expected, CEOs with longer tenure are more likely to select a single successor. More importantly, firm-specific characteristics impact internal promotion. First, stable, manufacturing firms are more likely to maintain tournament incentives whereas service oriented firms, where relational firm-specific human capital is important, or volatile firms are more likely to have a single successor. Second, the CEO labor market is important. Tournaments are more likely in more homogenous industries, where less effort is required to evaluate participants and there is a greater availability of outside substitutes (Parrino (1997)) and high quality candidates are more available to create a competition.

Additionally, firms are less likely to hire from the outside once they elevate a single executive, regardless of the organizational structure. Conversely, as long as multiple executives are competing to be the CEO, outside candidates are possible, which essentially increases the number of contenders. Thus, important firm and industry characteristics are associated with a firm’s promotion method.

Finally, Mobbs and Raheja study firm valuation to gauge the importance of a firm’s promotion method. Prior research suggests that firms with a single successor are detrimental to firm value because of a lack of a comparison group, reduced competition among senior managers, and a greater likelihood of entrenchment by the CEO and the top executive (see arguments in Lazear and Rosen (1981), and Kale et al. (2009) among others). Indeed, in crosssectional OLS regressions there is a 2.2% lower valuation in companies implementing a successor-incentive promotion. However, when they account for the endogenous choice by firms to self-select to have a successor-incentive structure, the authors find evidence of a negative selection effect. Once the negative selection effect is accounted for in a two-equation treatment model, there is a positive treatment effect for having a successor. In other words, firms that require a successor-incentive structure are also associated with lower valuations but having an heir is better than maintaining a tournament for these firms. This is consistent with companies selecting a succession method based on their own specific needs.

To summarize, Raheja (2005) and Mobbs and Raheja (2012) add to the understanding of internal corporate governance and management incentives. First, both tournaments and successor-incentive promotions are used to promote internal management. Second, companies select their promotion method based on their own firm and management characteristics.

Although companies with single successors are associated with lower a valuation, the single successor in these firms is associated with a higher valuation than they would otherwise experience. Finally, promotion incentives are an important tool available to companies beyond compensation incentives and more research is needed to understand how to implement them effectively.

 

 Posted October 2nd 2013


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Charu
Raheja 
Triagelogic
Management

Professor Raheja (PhD in Finance, NYU) teaches courses in corporate finance, financial management, and corporate and asset evaluation. She has received multiple teaching awards, including Excellence in Teaching Award from the Wake Forest University professional MBA program. She has published multiple papers in academic finance refereed journals, and she has contributed to articles in non-academic periodicals such as the Harvard Business Review. Professor Raheja founded TriageLogic in 2005 with Dr. Ravi Raheja with the goal of improving access for health care and health care information to individuals and communities. TriageLogic offers reliable, accurate, and cost-effective triage software and services for both hospitals and private practices.

RESEARCH INTERESTS

Corporate Board Structure, Board Monitoring, CEO Succession Planning

INSTITUTIONS

CEO at TriageLogic Management

REFERENCE PAPER

Determinants of Board Size and Composition: A Theory of Corporate Boards, Journal of Financial and Quantitative Analysis, 40 (2), June 2005(Winner of 2005 William F. Sharpe Award for Scholarship in Financial Research, Best Paper in Journal of Financial and Quantitative Analysis). Available here!

WEBSITE

http://www.charuraheja.com/

www.triagelogicnurse.com