June 15, 2005

Inherited control and firm performance

In general, CEOs related to a founder or large shareholder of a corporation underperform their peers, but some heirs make effective leaders. Is nepotism always harmful or can it be strategically advantageous?


Philosophy, punditry and common sense tell us that nepotism might be an inefficient determinant of leadership of a country or a public company. Some argue that family control enhances a firm’s performance with the long-term focus of personal interest. But most argue that family succession hurts performance by limiting the scope of labor market competition. While previous studies have examined the impact of families on business performance, none have dealt specifically with successions.

Professor Francisco Perez-Gonzalez has filled this gap, analyzing data from 335 CEO transitions in publicly traded U.S. companies to determine the impact of family succession on firm performance. In roughly a third of the cases he looked at, the new CEOs were related by blood or marriage to a founder or large shareholder of the corporation.

Firms that promote family executives are not all small shops. Previous studies have found that families control more than 53 percent of publicly traded firms with at least $500 million in market capitalization in 27 countries. In the United States, families have a controlling interest in 35 percent of firms in the Standard & Poor’s 500. The companies Perez-Gonzalez studied are comparable to those that promote outside CEOs in terms of both size (sales and assets) and profitability (return on assets, industry-adjusted return on assets and market-to-book ratios). The study found that, on average, CEOs who inherited their jobs experience disproportionately large declines in returns on assets and market-to-book ratios.

Testing for cause, Perez-Gonzalez found that this average is dragged down by heirs who did not attend a “selective” college. Barron’s classifies 33 undergraduate institutions as “most competitive,” 52 as “highly competitive” and 104 as “very competitive.” Perez-Gonzalez considered colleges in these three categories selective and all other colleges nonselective. He found that the proportion of CEOs who attended selective colleges was much higher among heirs than among non-heirs, but that firms led by heirs who did not attend selective colleges dramatically underperformed the other firms in the sample. Furthermore, market valuations do not anticipate that firms led by family heirs who did not attend a selective college will perform as badly as they do.

Firms controlled by heirs who did not attend a selective college suffered decreases in assets and market-to-book ratios and increases in overhead and production costs relative to presuccession market valuations. These declines were not experienced by firms whose family CEO did attend a selective college or by firms whose unrelated CEO attended a nonselective college. Family heirs who attended selective colleges performed as well as all unrelated successors. Thus, family CEOs who did not attend selective colleges account for the economically and statistically large negative decline in the family heir group’s performance.

Overall, the results of this study demonstrate that the costs of nepotism are large and that they are likely to be borne by minority investors who do not share in the private benefits of control. Although family heirs who attend selective colleges may perform no worse than CEOs unrelated to a founder or large shareholder, Perez-Gonzalez concludes that increasing the scope of labor market competition for CEO positions ultimately enhances firm performance.

The lesson for heirs: Work hard, both at school and in the firm, in order to prove your worth.

 

Francisco Perez-Gonzalez is assistant professor of finance and economics at Columbia Business School.

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