The Consequence of Family Succession on Firm Performance
When heirs take the helm of the family business, it’s bad news for key employees striving for promotion. But is it also bad news for the firm?
Anecdotal evidence seems to suggest that family succession is costly for the firm itself. To begin with, the odds appear to be stacked against the next generation. Most firms do not survive beyond ten years, indicating that we only observe successions in firms with talented founders. This observation raises an intriguing question: Can firms flourish if they let an “average” offspring succeed a “talented” entrepreneur? The potential problem of selecting the new CEO among the founder’s offspring is elegantly summarized by Warren Buffet, who once compared family succession to “choosing the 2020 Olympic team by picking the eldest son of the gold-medal winners of the 2000 Olympics”. This skeptical view is succinctly echoed in the proverb “from shirtsleeves to shirtsleeves in three generations”, which exists, interestingly, in many languages: Chinese: “富不過三代” (Wealth does not pass three generations), Italian: “Dalle stalle alle stelle alle stalle” (From stable to stars to stables), Japanese: “三代目が会社を滅ぼす”(The third generation will destroy the company), and Spanish: “Quien no lo tiene, lo hace; y quien lo tiene, lo deshace” (He who doesn’t have it, makes it; and he who has it, wastes it). Although proverbs, in many cases, distill wisdom passed down from generation to generation, it’s hard to rely on them as conclusive evidence of how family succession bears on firm performance.
In fact, economic intuition suggests two plausible and opposing effects of family succession on firm performance. On the one hand, family CEOs have large economic incentives to run the company well, given their large ownership of shares. They also know a lot about the firm and have earned the trust of key stakeholders. On the other hand, family CEOs are selected from a small pool of managerial talent. The best candidate among the founder's relatives may not be as good as the best available manager in the executive labor market. Thus, it remains an open empirical question how family succession affects firm performance.
A simple way to address the question is to compare changes in firm performance around CEO successions and assess the way in which firm outcomes change as a result of whether the firm appoints a family or unrelated CEO. Economists refer to this approach as a difference-in-differences estimate of the consequence of family succession. Using this method, academic studies find negative consequences of family succession on firm performance measured by either stock prices or profits.
On its face, the difference-in-differences estimate looks like a straightforward way to evaluate the consequence of choosing family vs. unrelated CEOs. If CEO appointments were the result of a controlled experiment, in which we could randomly select some firms to pass the torch to the founder's relative and others to an unrelated candidate, then we would conclude that choosing an offspring reduces firm performance. But the decision to hand over the reins within the family is hardly random. The main concern with the difference-in-differences method is that firms that opt for family succession might be systematically different from firms hiring unrelated CEOs. For instance, it is natural to expect founders to be more willing to pass on the torch to a relative when the company’s future looks bright, and appoint unrelated CEOs whenever the prospects look bleak. If so, the difference-in-differences method will estimate the effect of family succession on firm performance plus the difference in the future performance.
As with so many empirical questions about business, we are at a loss in uncovering causes as opposed to associations. Or rather, we were at loss until we came up with a way to measure the effects of family succession that solves the identification problem. The solution is to exploit the preference for male first-borns observed in many cultures around the world, combined with the fact that gender is randomly assigned by nature. To test this thesis, we took advantage of Denmark’s relaxed attitude toward disclosure of personal data from administrative registers. Italy is relaxed about work; Hong Kong is relaxed about taxation; and Denmark is relaxed about giving researchers access to detailed personal data of exceptional quality, which allowed us to examine the consequence of family successions on performance based on 5,000 Danish CEO succession decisions.
It turns out that the random event – a first-born boy – raises the probability of family succession by 10 percentage points (from 30 per cent to 40 per cent), a factor that by itself should have no effect on the firm's subsequent operating performance.
By exploiting the random variation in family succession generated by the gender of the first-born child we uncover large economic consequences of family successions. Intuitively, this means that if the choice between a family or unrelated CEO were made by the flip of a coin, the choice of a family CEO would wipe out all of the firm’s profit. An alternative way to interpret the analysis is that it provides a clean test of the direct effect of “professional” CEOs on firm performance. An ideal way to test how much extra value a “professional” CEO might contribute to firm performance would be to randomly assign individuals from the general population and professional managers as CEOs and then compare firm performance. This is close to what the above method does: it compares the performance of firms with an unrelated CEO (i.e. a “professional” CEO) to the performance of firms that promote a relative simply because the departing CEO’s first-born child was male. If unrelated CEOs were better, then manager-led firms would systematically out-perform successor-led, which is indeed what we find. Thus, professional CEOs seem to provide extremely valuable services to the organizations they head.
We also examine whether industry characteristics that might be associated with differential costs of employing unrelated CEOs, rather than family CEOs, affect our findings. We find that family CEOs tend to underperform in fast-growing industries and in industries with relatively highly-skilled labor forces, environments where managerial skills are presumably more valuable. Conversely, we find no gap in performance between family and unrelated CEOs when they possess similar professional qualifications. This result highlights that the cost of family succession can largely be mitigated if succession is planned and the family CEOs possess adequate professional qualifications.
Our findings also suggest that primogeniture rules (or nepotism), which dictate who takes the helm of a firm based on birth order or gender, but not competence, can have negative consequences on firm performance. The drag on firm performance can be thought of as a way to quantify the nonpecuniary benefit the departing CEO might derive from naming an underqualified family CEO as successor. Unfortunately, the cost of such unfavorable successions in family-controlled firms is mainly borne by
minority shareholders, who are unlikely to enjoy the private benefits of naming a family CEO, but suffer from the resulting underperformance. Our results also suggest that family firm stakeholders should pay close attention to succession decisions, as any significant competence gap between family and unrelated CEOs can substantially harm firm performance.
Understanding the consequence of family succession on firm performance also has implications beyond the firm. Nowhere are these challenges more acute than in Asia, where family businesses represent more than half of large corporations and account for a significant percentage of employment and growth. Many of these organizations are still run by their founders. As this extraordinary generation of Asian family business owners is ageing, many Asian economies are facing the uncomfortable question of whether the upcoming family successions will impact economic growth. In Hong Kong, for instance, the family heads of the 50 largest businesses are on average 70 years, and 10 out of 50 are above 80 years. These entrepreneurs have overcome many formidable challenges in building some of the most successful businesses in the world. Passing on the business to the next generation is their final challenge, one that without sufficient planning can threaten their legacy and potentially undermine the economy.
On the positive side, Asian family businesses seem better at providing future generations with education and relevant business experience, suggesting that the cost of family succession might be mitigated. On the negative side, however, Asian family businesses often mismanage succession planning – either by failing to plan, or by automatically appointing children, nieces, or nephews to the helm of firm. While the consequences are yet to be felt, one thing is certain: No other corporate event is as important as family succession to firm performance, and research demonstrates that decisions to appoint family CEOs based on primogeniture rules alone have adverse consequences for firm performance. These adverse consequences can however be mitigated by engaging in long-term planning and equipping the next generation with relevant professional knowledge and experience to lead the family business.
By Professor Kasper Meisner Nielsen, Department of Finance, HKUST Business School
M. Bennedsen, F. Pérez-González, K.M. Nielsen and D. Wolfenzon, “Inside the family firm: the role of families in succession decisions and performance”, The Quarterly Journal of Economics 122 (2), 647-691. May 2007.