Inside the Family Firm

Bennedsen, Morten; Nielsen, Kasper; Pérez-González, Francisco; Wolfenzon, Daniel Working Paper Inside the Family Firm Working paper, No. 21-2005 Provided in Cooperation with: Department of Economics, Copenhagen Business School (CBS) Suggested Citation: Bennedsen, Morten; Nielsen, Kasper; Pérez-González, Francisco; Wolfenzon, Daniel (2005) : Inside the Family Firm, Working paper, No. 21-2005, Copenhagen Business School (CBS), Department of Economics, Frederiksberg, https://hdl.handle.net/10398/7594 This Version is available at: https://hdl.handle.net/10419/208514 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ Comments welcome Inside the Family Firm: The Role of Families in Succession Decisions and Performance * Morten Bennedsen Copenhagen Business School and CEBR Kasper Nielsen University of Copenhagen and CEBR Francisco Pérez-González Columbia University Daniel Wolfenzon New York University and NBER First draft: June 2005 This draft: September 2005 This paper uses a unique dataset from Denmark to investigate (1) the role of family characteristics in corporate decision making, and (2) the consequences of these decisions on firm performance. We focus on the decision to appoint either a family or an external chief executive officer (CEO). We show that a departing CEO’s family characteristics have a strong predictive power in explaining CEO succession decisions: family CEOs are more frequently selected the larger the size of the family, the higher the ratio of male children and when the departing CEOs had only had one spouse. We then analyze the impact of family successions on performance. We overcome endogeneity and omitted variables problems of previous papers in the literature by using the gender of a departing CEO’s first-born child as an instrumental variable (IV) for family successions. This is a plausible IV as male first-child family firms are more likely to pass on control to a family CEO than female first-child firms, but the gender of the first child is unlikely to affect firms’ performance. We find that family successions have a dramatic negative causal impact on firm performance: profitability on assets falls by at least 6 percentage points around CEO transitions. These estimates are significantly larger than those obtained using ordinary least squares. Finally, our findings demonstrate that professional nonfamily CEOs provide extremely valuable services to the organizations they work for. JEL classification: G32, G34, M13 Keywords: family firms, successions, CEO turnover, governance * Morten Bennedsen ([email protected]), Kasper Nielsen ([email protected]), Francisco Pérez-González ([email protected]), Daniel Wolfenzon ([email protected]yu.edu). We thank Marianne Bertrand, Mariassunta Giannetti, Maria Guadalupe, Jonah Rockoff, David Yermack and seminar participants at the CEPR annual meeting in Gerzensee and at the Corporate Governance of Closely Held Firms Conference in Copenhagen for comments. We are grateful to CEBR and the Danish Social Science Research Foundation for financial support under the research project GOCOW. All errors are our own. Family firms have gained increasing attention in the finance and economics literatures as recent work has documented that founders and their families are often the dominant owners in publicly traded corporations. Given the prevalence of family firms, it is not surprising that a growing body of work has explored their impact on firm performance, often with mixed results.1 Yet to this date, we know little about the specific mechanisms through which family firms affect performance or about the precise roles played by the families behind these firms.2 As a result, it is hard to identify the distinctive features of family firms that differentiate them from other corporations with concentrated ownership.3 The objective of this paper is to shed light on two questions. First, do family characteristics affect firm decisions? Family heterogeneity might be fundamental to understand the role of families in these decisions. Second, if family characteristics indeed affect firms’ decision-making, what are the consequences of these decisions on firm performance? We evaluate these two questions in the context of firms’ top management succession decisions. At succession, family firms face the often tough decision of hiring a family or an unrelated chief executive officer (CEO). We analyze CEO transitions because succession decisions are likely to play a key role in determining the survival of firms and because this decision is likely to be influenced by the preferences of the controlling family, as arguably family firms tend to prefer family CEOs. 1 On the prevalence of family firms, see La Porta et al. 1999; Morck, et al., 2000; Claessens et al. 2002; Faccio and Lang, 2002; Anderson and Reeb, 2003; Pérez-González, 2003; Villalonga and Amit, 2004. On the performance of family firms, see Morck et al. 1988a and 1988b; Yermack, 1996; McConaughy et al. 1998; Morck et al. 2000; Anderson and Reeb, 2003; Pérez-González, 2003; Villalonga and Amit 2004; Sraer and Thesmar (2004); Ehrhardt et al (2005). 2 Some exceptions include Pérez-González (2003) who provides evidence on nepotism in CEO appointments in U.S. family firms and Bertrand et al. (2005) who explore the consequences of sibling rivalry in family firms in Thailand. 3 For the impact of large shareholders in general see Shleifer and Vishny (1986 and 1997). 1 Using a unique dataset from Denmark that contains information on all limited liability firms in the country, we show that family characteristics have a strong predictive power in explaining both, the decision to hire a family or an unrelated CEO, as well as the choice of the family member who receives the top post.4 We find that family CEOs are more frequently selected the larger the size of a departing CEO’s family, the higher the fraction of sons in the departing CEO’s children and when the departing CEO had only had one spouse. The magnitudes of the changes in the probability of observing a family succession attributable to these variables are very large. For example, firms where the departing CEO had three children were 7.4 percentage points —25 percent— more likely to undergo a family succession than firms where the departing CEO had only one child. More surprisingly, family successions declined from 33.7 percent for cases where the departing CEO had only one spouse to 24.6 percent in firms where the departing CEO had a history of multiple spouses, a decline of 27 percent. Family structure also affects who gets the top post among members of the family behind the family firm. In particular, there is a strong preference for children relative to spouses, parents or siblings in family successions. Comparing firms where the departing CEO had no children to those where she or he had only one child, we find that the fraction of firms that pass on control to children increases by 9.4 percentage points while the fraction of other relatives who get the top post declines by 5.1 percentage points. Having established that family characteristics affect firms’ succession decisions, we then explore the consequences of these family successions on firm performance. Given that family as well as firm characteristics are likely to be endogenous, we examine this question using instrumental variables (IV). 4 Herein we refer to family characteristics as the family characteristics of the departing CEO and we define an incoming CEO as family when the departing and incoming managers are related by blood or marriage and as unrelated, if not. 2 We instrument for family successions using the gender of the first-born child of a departing CEO. The gender of the first child is a plausible instrument for family successions because it affects the probability of observing a family CEO and because it is unlikely to be correlated with firm performance. Our evidence indicates that the gender of the first-born child of a departing CEO is strongly correlated with the decision to appoint a family CEO: the frequency of family transitions is 28.6 percent when the first-born child is female and it increases more than 7 percentage points to 35.7 percent (a 24.8 percent increase) when he is male. This difference is statistically significant at the one-percent level. We also document that prior to succession decisions, firms’ profitability, age, and size do not differ statistically as a function of the gender of the first child. These results indicate that it is unlikely that the gender of the first child affects firm performance beyond their impact on who is promoted to the CEO position. Our main finding is that family successions are significantly negatively correlated with changes in firm performance around CEO successions. The relationship between family successions and firm performance is extremely strong: family CEOs cause an average decline in firm profitability on assets of at least 6 percentage points. We then compare our results to those obtained using a difference-in-differences (DD) approach. We show that DD estimates provide robust empirical support for the notion that family successions hurt performance, yet the estimated coefficient on the negative effect of family CEOs is significantly lower than the one found using IVs. We posit that our results point to an important bias in OLS estimates, as family CEOs are more likely to be promoted to the helm of corporations when firms’ prospects are positive. We also test for differences in pre or post-CEO transition changes in performance and we fail to find significant differences across groups in periods where CEO transitions do not occur, bolstering the case for the causal interpretation of our findings. 3 We examine whether industry characteristics that might be associated to differential costs of employing a “professional” rather than a family CEO affect our findings. Presumably, managerial skills are more valuable in rapidly changing or innovative economic environments. We find that family CEOs tend to be costlier in fast growing industries, in sectors with significant firm entry, as well as in environments with relatively higher levels of research and development. An alternative way to interpret our analysis is that it provides a clean test of the direct effect of professional CEOs on firm performance. An ideal laboratory to test professional CEOs’ worth would be to randomly assign individuals from the general population and professional managers to the CEO position, and then compare their outcomes. This is close to what the instrumental variables estimator does: it compares the performance of firms with an unrelated CEO to the performance of firms that promote a family member only because the departing CEO’s first-born child was male. If unrelated CEOs were valuable, then the performance of the former firms should exceed the latter, which is indeed what we find. Professional CEOs seem to provide extremely valuable services to the organizations they work for. An additional advantage of our empirical approach is that we do not need to take a stand on which firms are family firms and which others are not, a common source of debate in the literature. We allow the data to identify the firms where family characteristics, such as, the gender of a first child, have a bearing on succession decisions. Our focus on the interaction between family characteristics and economic decisions relates to the seminal work of Becker (1991), and to the large body of work in economics that links the gender of offspring to various economic decisions (see for example, Angrist and Evans, 1998; Angrist and Krueger, 1999; Dahl and Moretti, 2004, Bertrand et al 2005, among others). Our evidence that family succession decisions favor first-born males is consistent with fathers’ preference for boys in other settings (Dahl and Moretti, 2004). Yet parental preference over male children would presumably predict higher family involvement and superior performance when first-male children are in control, which is not supported empirically. 4 Overall, our results cast doubt on the benefits of promoting a CEO from within the ranks of the controlling family of a corporation. These findings are important for the governance of both public and private firms around the world. Controlling families that enjoy the private benefits of control might select a family CEO even when performance is negatively affected as a result. Other stakeholders, from minority shareholders to creditors or workers, might not share in these benefits and would therefore be negatively affected by family successions. The rest of the paper is as follows. The next section summarizes prior work on the role of founders and their families. Section II describes the data and presents summary statistics. Section III outlines our empirical strategy. Section IV presents the results and Section V concludes. I. Existing Literature Family and Family-Heir Firms: Prevalence and Performance Demsetz and Lehn (1985) and Shleifer and Vishny (1986) have previously shown that the Berle and Means (1932) corporation with separated ownership and control is, in practice, not widespread. Even in the United States, families own and control a significant number of publicly held firms. Family ownership (founders and descendants) is present in 35 (37) percent of firms in the Standard and Poor’s (Fortune) 500, where families hold an average of 18 (16) percent of shares (Anderson and Reeb, 2003; Villalonga and Amit, 2004). Outside the United States, evidence of ownership concentration by La Porta et al. (1999) indicates that families control over 53 percent of publicly traded firms with at least $500 million in market capitalization in 27 countries. Additional evidence of the prominent role of families in public firms is provided by Morck et al. (2000) for Canada, Claessens et al. (2002) for East Asian countries, and Faccio and Lang (2002) for Western Europe. The role of families in privately held firms is, presumably, even larger. 5 From a theoretical perspective it is unclear whether family CEOs should have a positive impact on firm performance (Donnelley, 1964). For example, family members could perform better than other CEOs because they face steeper incentive schemes: In addition to monetary rewards, they derive significant personal satisfaction from the success of the organization (Davis, et al. 1997; Palia and Ravid, 2002) and face higher levels of shame or guilt in case of failure (Kandel and Lazear, 1992). Also, the trust and loyalty established with key stakeholders might be more easily transferred to family executives (Donnelley, 1964). An additional benefit of family members is that, by virtue of having grown up close to the day-to-day business of the organization, they might be more knowledgeable than outsiders about the firm (Donnelley, 1964). However, there are also strong reasons to believe that family CEOs might deliver worse performance than professional managers (Christiansen, 1953; Kepner, 1983). First, outsiders are a self selected group of individuals with significant managerial expertise and presumably, with an established record on their competence (Pérez-Gonzalez, 2003). Second, family CEOs, even if competent, might be affected by the potential conflicts between family and business norms with regard to the allocation of management positions, executive pay or other resources (Levinson, 1971; Barnes and Hershon, 1976; Lansberg, 1983). To date, several studies have empirically examined the impact of founders and their families on performance. Regarding the role of founders, Johnson, et al. (1985) find that sudden deaths of founder-CEOs are associated with large stock price increases, which suggests that founder CEOs hindered performance. Yet, Slovin and Sushka (1993), in analyzing deaths of large shareholders, find that founder status does not have a significant effect in explaining abnormal returns. They do, however, find that the death of CEOs with concentrated ownership is associated with positive abnormal returns and with substantial subsequent control activity, which is consistent with entrenchment. 6 It is important to highlight that, although Panel A shows a strong pattern between the number of children and the probability of family successions, it is difficult to interpret these correlations as causal since larger families and family successions might be determined by omitted variables. For example, a preference for a close family could explain the correlation of family size and family CEOs. Table II also shows that the structure of the family could also affect the choice of CEO inside the family. In particular, family firms seem to have a preference for children relative to spouses, parents or siblings at the time of succession. In Table II Panel A, we observe that family transitions account for 24.8 and 29.1 percent of all successions when the departing CEO has no children or one child, respectively. Yet, the number of children promoted to the top executive position increases from 0 (by construction) to 9.4 percent of all observations. In other words, the frequency with which other family members are promoted to the CEO position decreases from 24.8 percent of all cases when the CEO had no children to 19.7 percent when he or she had one child. That is, children crowd out other members of the family. In Panel B we document that the marital history of CEOs can potentially affect both the choice of family or unrelated CEOs and whether children arrive to the CEO position. We show that family successions seem to be less common in firms in which the outgoing CEO had no spouse than in firms in which they had exactly one spouse. This could simply reflect the fact that the pool of potential family candidates is larger when the outgoing CEO has a spouse. More interestingly, the frequency of family transitions decreases for CEOs that, at the time of succession, had been associated with more than one spouse. For this group, it is 9.1 percentage points or 27 percent lower than for firms where the departing CEO has had only one spouse, a difference that is significant at the one-percent level. Column VII shows that more than 75 percent of this difference (7.1 out of 9.1) is attributable to fewer children arriving to the CEO position. These correlations suggest that exploring the impact of family conflicts on firm performance might be an interesting topic in its own right. 13 In Table II Panel C, we explore the correlation between the ratio of male to total number of children and successions decisions. We report that firms in which more than 50 percent of the outgoing CEO’s children are male are 8.7 percentage points more likely to have a family successor than firms in which less than 50 percent of the outgoing CEOs children are male. This difference is significant at the one-percent level. A drawback of this ratio is that it is partly endogenous as individuals can affect its variance through their choice of family size (it converges to 50 percent as the number of children increases). In contrast, the exogenous component of this ratio is the gender of the first child, which is determined by nature. The Gender of the First-Born Child To explore whether family characteristics might have a causal impact on the probability of observing a family succession we report in Table II Panel D, the correlation between a family trait that is likely to be random and the decision to promote a family CEO. We argue that the gender of the first-born child of a departing CEO is likely to be randomly assigned. This is likely to be the case for departing CEOs in the sample, as over 80 percent of them had their first child prior to 1980, before current techniques to identify the gender of children were widespread. Table II, Panel D shows that outgoing executives whose first-born child is male are 7.1 percentage points more likely to leave the firm to a family member than their counterparts whose first-born child is female. The difference between these two groups is significant at the onepercent level. Moreover, Column VII shows that the difference in the frequency with which the outgoing CEO’s children get the top position increases by 8.7 percentage points, also significant at the one-percent level. Once more, these numbers indicate that children crowd out other relatives: the frequency of non-children family CEOs declines from 18.2 percent when the outgoing CEO’s first-born child is female to 16.7 percent when he is male. 14 These correlations confirm anecdotal evidence that male children are preferred to females at the time of succession or that primogeniture inheritance rules are still followed even in a developed country like Denmark. The magnitude of the difference (24.8 percent) might appear large given that Denmark is a country with a high overall level of gender equality (it ranks fourth among 58 countries according to data from the World Economic Forum) and one of the highest female labor force participation rates in the world.8 Nevertheless, these numbers are consistent with the low levels of female participation among top management positions in Denmark. In 2004, the fraction of women among top managers was only 25 percent compared with 61 percent in intermediate level positions.9 Having established that firm characteristics affect both (1) the decision to name a family CEO, and (2) who within a family gets the CEO position, we turn to describing our empirical strategy to investigate the consequences of family successions on firm performance. III. Empirical strategy III.A. Difference in differences A simple way to evaluate the impact of family CEOs on performance is to estimate the change (difference) in firm profitability around CEO successions, and assess the way in which firms’ outcomes have changed as a result. This statistic is attractive because it provides an estimate of the impact of CEOs on performance that is not affected by firms’ time-invariant characteristics. However, a drawback of this approach is that it can potentially fail to control for aggregate changes in performance that are due to, for example, macroeconomic trends, or succession-specific patterns in performance. Two common fixes to this problem are (a) adjusting the measures of profitability using industry benchmarks, and (b) using a difference-in-differences 8 See http://www.weforum.org/pdf/Global_Competitiveness_Reports/Reports/gender_gap.pdf for statistics on gender inequality and 2001 Statistical Yearbook published by Danish Statistics for cross country comparison on women’s labor force participation. 9 See http://www.dst.dk/HomeUK/Statistics/ofs/Publications/Yearbook (Table 136). 15 analysis by comparing the changes in performance of firms that name a family member to the CEO position to those of other firms that experience a succession by unrelated CEOs. We start by performing a difference-in-differences (DD) analysis on the relative performance of family and unrelated CEOs as described below: iiii famCEOcbXay 111 ' 1 ε +++= , (1) where the subscript 1 denotes the equation number. is the difference in performance estimated using the three-year average before and after CEO transitions. is an indicator variable equal to one if the incoming CEO is family and zero if unrelated. Under the null that all CEOs are equally talented would not be different from zero. i y i famCEO 1 c III.B. Instrumental Variables A shortcoming of implementing a DD analysis is that it requires that the program to be evaluated not be implemented based on differences in outcomes (Bertrand et al. 2004). In our setting, this requirement implies that the decision of naming a family or an unrelated CEO be uncorrelated to firms’ determinants of performance. This assumption appears to be a strong one. To overcome this problem we use instrumental variables (IVs). An example To illustrate the potential drawbacks of a DD approach and the advantages of using IVs in this setting, we use the following example: Suppose that post succession performance is given by Q + I, where Q is the quality of the firm’s new projects, and I is related to the identity of the successor. CEO successions can be of two types: family or unrelated. Let I=f when the incoming CEO is related to the outgoing CEO and I=u when the incoming CEO is unrelated. We are, therefore, interested in estimating f-u. 16 Suppose further that there is heterogeneity in the quality of firms’ new projects around succession decisions that the econometrician cannot observe or perfectly control for. Specifically, the quality of a firm’s new projects can be high (qH), medium (qM), or low (qL) each with probability one third. The DD estimator would yield f-u directly if family and unrelated CEOs were randomly assigned to firms. To make the example interesting, however, and in the spirit of Hermalin and Weisbach (1998), suppose that the better the quality of the firm’s investment opportunities, the more likely the departing CEO is to choose a family successor. Also, suppose that, as suggested by Table II, the likelihood of a family succession is higher when the CEO’s first-born child is male. The following table illustrates an example of a decision rule that satisfies these conditions: Opportunities Male Female High Family CEO Family CEO ( q H +f )( q H +f ) Medium Family CEO Unrelated CEO ( q M +f )( q M +u ) Low Unrelated CEO Unrelated CEO ( q L +u )( q L +u ) Investment Gender of First Child Under such decision rule, family (unrelated) successions would never occur under low (high) quality of new projects and thus the DD estimate would reflect not only the true effect of family CEOs but also a selection bias, which would then be incorrectly attributed to CEO talent. In consequence, the DD estimate in this example would have an upward bias.10 Graphically, the DD estimator compares the changes in performance of family successions, which would tend to occur in the upper part of the table above, to unrelated successions, which would tend to happen in the lower part of that table. 10 It is easy to see that a selection bias in the DD estimator would exist as long as the decision to appoint a family CEO is not orthogonal to other determinants of firm performance. Using the example above, the sign of the bias would change depending on the correlation of family CEOs and investment prospects. 17 The IV approach, in contrast, starts by using information on all CEO successions conditional on the gender of the first-born child and then compares the outcome of CEO successions as a function of the instrument. Intuitively, this is equivalent to comparing the outcomes of all CEO transitions in the table above and calculating the difference in performance across columns. In the previous example, if (a) the quality of new projects is high, all firms promote a family CEO regardless on the gender of the first child, (b) if the quality of new projects is low, all firms promote an unrelated CEO, regardless of the gender of the first child, and (c) if the quality of new projects is medium, those firms with a male first child would promote a family CEO while those with a female first child would promote an unrelated CEO. (a) and (b) imply that, if the quality of the firm’s new projects is either high or low, both the male and female groupings are identical and therefore these observations cancel each other out when the difference between groupings is performed. As a result, in this example, the IV estimator uses only the information of the group with medium investment prospects. This is a general result: estimates from instrumental variables use only the information of the group of firms that respond to them (Imbens and Angrist, 1994). We can also see in the table that the IV estimator is not contaminated by differences in investment opportunities, which are constant for all firms in the moderate category. The example above highlights the advantages of using instrumental variables, namely, that this method is explicit about the source of variation used to estimate the relative impact of family and unrelated CEOs, and that this variation is arguably orthogonal to firms’ prospects. Yet, it also points to a potential concern in interpreting the estimated results: they are only based on a sub-sample of firms which are affected by the instrument. Specifically, they are based on the firms that get a family (unrelated) CEO only because the first-born child was male (female). 18 Instrumental Variables Estimation Framework We use the gender of the first-born child of a departing CEO of a corporation to instrument for whether a firm will be managed in the next succession by a family CEO. iiii tgenderfirscbXafamCEO 222 ' 2 ε +++= (2) As before, is an indicator variable equal to one if the incoming CEO is related by blood or marriage to the departing CEO and zero otherwise. Here genderfirst is an indicator variable that is equal to one if the first child is male and 0 if female. Note that even though is a dichotomous variable, we estimate (2) using ordinary least squares (OLS) since a probit or a logit first stage can harm the consistency of the estimates (Angrist and Krueger, 2001). The second stage equation estimates the impact of family successions on changes in firm performance: i famCEO i famCEO iii EOCfamcbXay 333 ' 33 ˆ ε +++= (3) We estimate (3) using two-stage least squares (TSLS). We are interested in c3, which captures the direct effect of a family succession on changes in performance. Sorting by the Gender of the First-Born Child: Firm and Family Characteristics As we previously argued, we think that the gender of the first child born to the departing CEO of a corporation is likely to be a valid instrument for family transitions as, historically, a first-born male is more likely to receive inheritances (primogeniture rule), one of which might be the helm of the family firm. Panel D in Table II shows that this historical pattern holds true for the case of Denmark. We also posit that it is hard to make the case that firms’ prospects are directly related to the gender of the first child of the CEO. 19 In Table III we present firm and family characteristics by the gender of the first-born child of a departing CEO as an initial test for whether this variable is directly correlated with firm or family characteristics beyond its effect on succession decisions. At the time of transition, we find no difference in terms of firm size, operating profitability and net income between those firms whose departing CEO had a male first child and those whose first child was female. Table III stands in stark contrast to Table I in which we found significant differences in firm characteristics for family and unrelated transitions. One concern of the above-described instrumental variable is that families with a strong preference for male children and whose first-born child is female would tend to be larger in size than their male first-child counterparts. As a result, the gender of a first child would be correlated with family size, which in turn might affect firm performance. To assess the relevance of this potential channel, Table III presents the average number of children born to departing CEOs. It shows that, conditional on having at least one child, the average number of children is 2.2 irrespective of the gender of the first child. In short, we find no evidence that the gender of the first child affects family size. Alternatively, and given the evidence from Dahl and Moretti (2004) who document differential marriage rate as a function of the gender of children (larger for males), male firstchildren might affect the departing CEOs’ marriage decisions and potentially firms’ prospects. If this effect were present in this sample, the IV strategy would be incorrectly attributing this effect to CEO talent. However, the last line of Table III shows that the number of spouses is not statistically different for departing CEOs with female or male first children. In sum, based on Table III we find no evidence that firm characteristics or family size differ as a function of our instrument. This “no difference” table bolsters our confidence that the gender of the first child of a departing CEO is likely to be uncorrelated to firms’ prospects. 20 IV. Results IV.A. Difference-in-Differences To analyze the relative performance of family CEOs, we first examine changes in firm performance of both family and unrelated CEO around CEO transitions using a difference-in- differences approach. Following the CEO turnover literature (Denis and Denis, 1995; Huson et al. 2004) and prior work on family CEO transitions (Pérez-González, 2003), Table IV, Panel A presents measures of operating profitability relative to assets. To control for common industry time-trends the measures are adjusted using the average of the relevant four-digit NACE industry. The measures are three-year average profitability for all firms before and after CEO transitions. Column I in Table IV indicates that firms that experience CEO transitions, on average, exhibit lower profitability relative to their industry peers before succession. This average is significant at the one-percent level. After transitions, the firms in the sample do not significantly improve their performance. When we compare the profitability levels prior to the transitions for family and unrelated successions (Columns II and III, respectively), we find that family successions tend to occur in firms with above-average profitability while unrelated successions tend to happen in firms with below average performance. Prior to CEO transitions, the difference in profitability between these groupings is economically and statistically significant at conventional levels and it is equivalent to 1.4 percentage points relative to assets, as shown in Column IV Given that, as suggested by Table I, firms that promote family CEOs are likely to differ relative to those that select unrelated CEOs, we proceed to compare the within group change in performance around transitions. Within firm variation allows us to control for both observable and unobservable time-invariant characteristics that might affect firms’ profitability. 21 We find that firms that promote family CEOs experience a decline in profitability of 1.1 percentage points. This difference is statistically significant at the one-percent level. In contrast, firms that promote external CEOs undergo improvements in profitability of 0.2 percentage points, an increase that is not statistically different from zero at conventional levels (t-statistic of 1.4). As a result, the average difference-in-differences (DD) suggests that family successions are associated with 1.35 percentage points lower performance relative to unrelated successions. This decline is equivalent to 25 percent of the average unadjusted operating income to assets. The estimated gap in profitability is similar in magnitude to the one found by Pérez-González (2003) in publicly traded firms that promote family over unrelated CEOs in the United States. In Table IV, panel B, we further investigate the gap in performance associated to family CEOs using alternative measures of profitability. In each row we present the difference in average profitability for family and unrelated transitions, respectively, as well as the mean difference-in-differences estimator. In addition we report the median difference-in-difference. We show changes in three measures of performance: (1) operating income to assets, (2) industry-adjusted operating income to assets (used in Panel A) and (3) industry-adjusted net income over assets. The results confirm the patterns presented in Panel A. Namely, firms that promote family CEOs undergo significant declines in profitability while the profitability of firms that promote unrelated CEOs is marginally higher or unchanged, but not statistically different from zero at conventional levels. In every case, however, the mean difference-in-differences estimator is negative and statistically different from zero. The results obtained using median regressions yield similar findings and indicate that these differences in performance are not driven by outliers. To further investigate the improvements in profitability associated with unrelated CEOs we also present a difference-in-differences estimator on the natural logarithm of total assets. The results indicate that unrelated successors increase the asset base by more than family successors. Together with the results on profitability, these patterns indicate that unrelated CEOs increase 22 We hypothesize that managerial skills are potentially more valuable in certain economic environments, such as innovative industries and less important is mature business where managers might be relatively less important than, for example, firms’ established production processes or organizational cultures. As before, we first create an industry wide measure of alternatively, (1) industry maturity, (2) firm entry, (3) research and development (R&D) activity and (4) industry concentration, and then we interact these measures with our instrumental variable We classify an industry as “mature” if the growth rate in the value of production between 1990 and 2002 was lower than the median growth rate of all industries in Denmark. Similarly, industries are classified as “dynamic entry”, “R&D intensive” or “concentrated” if its average firm age, R&D spending between 1990 and 2002, or Herfindahl-Hirschman Index in 1992, respectively, were above the median of the universe of firms in Denmark, and zero otherwise.12 Table IX, Columns III to IV presents the results. In each column we present IV-TSLS results for family CEO and the interaction between family CEO and the above described industry characteristics. We find that family CEOs tend to be costlier in fast growing industries, in sectors with significant firm entry and in environments with substantial innovation as captured by our measure of R&D intensity. These patterns suggest that family CEOs are particularly damaging to firm performance in situations that are complex to manage. Finally, Column VI in Table IX shows the differential effect of family successions as a function of industry concentration. The result shows higher gaps in performance in relatively concentrated industries, where perhaps the scope for poor performance is higher as survival is potentially guaranteed by the lack of competition. 12 Industry level data on the value of production and spending in R&D by industry is from the OECD, where available. Industry concentration numbers are calculated using the shares in the book value of assets in an industry. Assets values and firm age are obtained from the main primary source as the key variables of interest. 29 Interpretation In this paper we are explicit about the source of variation we use to examine the impact of family successions on firm performance. Given that the variation in the gender of the departing CEO’s first-born is likely to be uncorrelated to firms’ investment opportunities, the results demonstrate that family successions cause significant declines in firm performance. The findings show that qualified CEOs provide extremely valuable services to the organizations they work for. They also demonstrate that primogeniture rules that dictate who gains access to the helm of a firm based on birth order or gender, but not competence, can have disastrous consequences for firm performance. The negative effect of family CEOs on performance suggests that minority shareholders at family-controlled firms are likely to suffer the most under family CEOs as non-controlling investors do not participate in the private benefits of control. It also indicates that other stakeholders interacting with family firms should pay close attention to succession decisions as the competence gap between family and unrelated CEOs might be substantial. A common caveat in interpreting the estimated results using instrumental variables is that not every firm in the sample is affected by the IV, and as such, the results of this paper are only representative for those firms whose succession decisions are affected by it. In particular, one might posit that the sub-sample of family CEOs that are promoted due to the instrument are of a lower average quality relative to the pool of family CEOs that get control irrespective of it. If that were the case, the average causal effect of family CEOs on performance might not be as disastrous as the results from our instrument indicate. 30 V. Conclusions In this paper we used a unique dataset from Denmark to investigate the inside workings of family firms. Our objective was to shed light on two questions: first, do family characteristics affect firm decisions? And second, what are the consequences of these decisions on firm performance? These questions were examined in the context of CEO succession decisions. We showed that family characteristics such as family size, the gender composition of children or the marital history of a family head can affect both the decision to appoint a family or an unrelated CEO and the identity of a family successor. We then used the fact that the gender of the first child born to a departing CEO is exogenous as an instrument for testing the impact of family successions on performance. We found that family CEOs had a dramatic causal impact on firm profitability: family CEOs reduced firm profitability on assets by at least 6 percentage points, which is significantly larger than prior estimates in the literature. Our findings show that addressing endogeneity concerns related to firms’ decisions are extremely important for understanding the role of family firms. The result that family CEOs hurt firm performance might suggest that countries where the control and management of assets is commonly transferred among kin, can potentially underperform other economies where assets and management are competitively matched. The implications of our findings are potentially important for other settings in which families play an active role in firm decision-making. La Porta et al. (1999) have documented that families are the most common large shareholder of publicly traded corporations; and private firms are commonly associated to one family. 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FIRM CHARACTERISTICS BY TYPE OF CEO SUCCESSION Chief executive officer (CEO) successions are classified into two groups: family, when the entering CEO is related by blood or marriage to the departing CEO, unrelated, otherwise. Ln assets is the natural logarithm of the total book value of assets in Danish Krone. EBIT / Assets is the ratio of operating (ordinary) income to total assets. Net income / Assets is the ratio of net income (final result) to total assets. Industry adjusted EBIT / Assets is the difference between EBIT / Assets and the average of its four-digit NACE (European industry classification system) benchmark. Firm age is the difference between the year of CEO transition and the oldest of: the year of establishment, the year of registration or the year of firms’ by-laws. Number of children of departing CEO is the number of children registered in the Danish Civil Registration System (CPR). Firm information is from the Købmandsstandens Oplysningsbureau's (KOB) dataset, which is based on firms’ annual reports to the Danish Ministry of Economics and Business Affairs. Standard errors are in parentheses and the number of observations in square brackets. V ariable All (IV) Ln assets 8.421 8.096 8.569 -0.473 *** (0.020) (0.0276) (0.026) (0.0379) [9,511] [2,980] [6,531] EBIT / Assets 0.045 0.055 0.041 0.014 *** (0.0015) (0.0026) (0.0019) (0.0032) [9,511] [2,980] [6,531] Net income / Assets 0.031 0.037 0.028 0.010 *** (0.0013) (0.0022) (0.0016) (0.0028) [9,511] [2,980] [6,531] Industry adjusted -0.007 0.002 -0.011 0.013 *** EBIT / Assets (0.0015) (0.0026) (0.0019) (0.003) [9,511] [2,980] [6,531] Firm Age 18.091 18.569 17.873 0.696 (0.2106) (0.3357) (0.2657) (0.4281) [9,511] [2,980] [6,531] Type of Succession (III)(II) Family Unrelated Difference (I) ***, ** and * denote significance at the 1, 5 and 10 percent level, respectively. 36 TABLE II. FIRM SUCCESSIONS AND FAMILY CHARACTERISTICS OF DEPARTING CEOS Chief executive officer (CEO) successions are classified into two groups: family, when the entering CEO is related by blood or marriage to the departing CEO, unrelated, otherwise. Family successions are further classified as family-children successions, when the entering CEO is the child of the departing executive. In Panels (A) to (D) the frequency of family and unrelated successions are presented by alternative family characteristics of the departing CEOs: (A) the number of children, (B) the number of spouses, (C) by the gender of the first-born child, and (D) the ratio of males to the total number of children. CEO successions data are from Købmandsstandens Oplysningsbureau's (KOB) dataset, which is based on firms’ annual reports to the Danish Ministry of Economics and Business Affairs. Family characteristics data are from the Danish Civil Registration System (CPR). Standard errors are presented in parentheses. Number Percent Number Percent Number Percent (I) (II) (III) (IV) (V) (VI) (VII) 9,511 2,980 0.313 6,531 0.687 1,229 0.129 A. Number of children: 0 1,253 311 0.248 942 0.752 - 0.000 1 1,419 413 0.291 1,006 0.709 133 0.094 2 4,265 1,307 0.306 2,958 0.694 578 0.136 3 1,994 727 0.365 1,267 0.635 400 0.201 4 or more 580 222 0.383 358 0.617 118 0.203 Difference (1) minus (0) 0.043 ** 0.094 *** (0.017) (0.008) Difference (3) minus (1) 0.074 *** 0.107 *** (0.016) (0.013) B. Number of spouses: 0 820 160 0.195 660 0.805 8 0.010 1 7,534 2,536 0.337 4,998 0.663 1,130 0.150 2 or more 1,157 284 0.246 873 0.755 91 0.079 Difference (2 or more) minus (1) -0.091 *** -0.071 *** (0.015) (0.011) C. By gender ratio (male/children): < 50 percent 2,743 747 0.272 1,996 0.728 248 0.090 = 50 percent 2,363 791 0.335 1,572 0.665 359 0.152 > 50 percent 3,152 1,131 0.359 2,021 0.641 622 0.197 Difference (>50%) minus (< 50%) 0.087 *** 0.107 *** (0.012) (0.009) D. By gender of first born child: Female 3,947 1,129 0.286 2,818 0.714 409 0.104 Male 4,311 1,540 0.357 2,771 0.643 820 0.190 Difference male minus female 0.071 *** 0.087 *** (0.010) (0.008) Type of Succession Description Family: ChildrenFamily UnrelatedNumber of Successions All ***, ** and * denote significance at the 1, 5 and 10 percent level, respectively. 37 TABLE III. FIRM AND FAMILY CHARACTERISTICS BY THE GENDER OF THE FIRST CHILD OF DEPARTING CEOS Chief executive officer (CEO) successions are classified by the gender of the first child born to the departing CEO: male, when the first-born child was a male and female, if the first-born child was female. Firms where the departing CEO had no children are omitted. Ln assets is the natural logarithm of the total book value of assets in Danish Krone. EBIT / Assets is the ratio of operating (ordinary) income to total assets. Net income / Assets is the ratio of net income (final result) to total assets. Industry adjusted EBIT / Assets is the difference between EBIT / Assets and the average of its four-digit NACE (European industry classification system) benchmark. Firm age is the difference between the year of CEO transition and the oldest of: the year of establishment, the year of registration or the year of firms’ by-laws. Number of children of departing CEO is the number of children registered in the Danish Civil Registration System (CPR) and the number of spouses is calculated using the number of historical marriages registered at the CPR. Firm information is from the Købmandsstandens Oplysningsbureau's (KOB) dataset, which is based on firms’ annual reports to the Danish Ministry of Economics and Business Affairs. Standard errors are in parentheses and the number of observations in square brackets. V ariable All (IV) Ln assets 8.456 8.451 8.461 -0.011 (0.0215) (0.0295) (0.0314) (0.0431) [8,258] [4,311] [3,947] EBIT / Assets 0.046 0.045 0.048 -0.003 (0.0016) (0.0023) (0.0024) (0.0033) [8,258] [4,311] [3,947] Net income / Assets 0.032 0.030 0.033 -0.003 (0.0014) (0.0019) (0.0020) (0.0028) [8,258] [4,311] [3,947] Industry adjusted -0.006 -0.008 -0.005 -0.003 EBIT / Assets [0.0016) [0.0022) [0.0023) [0.0032) [8,258] [4,311] [3,947] Firm Age 18.151 18.108 18.198 -0.090 (0.2285) (0.3064) (0.3414) (0.4587) [8,258] [4,311] [3,947] Number of children of 2.230 2.240 2.219 0.021 departing CEO (0.0095) (0.0131) (0.0139) (0.0191) [8,258] [4,311] [3,947] Number of spouses 1.108 1.102 1.114 -0.012 (0.0049) (0.0066) (0.0073) (0.0098) [8,258] [4,311] [3,947] Male Female Difference (I) (II) (III) Gender of First Child ***, ** and * denote significance at the 1, 5 and 10 percent level, respectively. 38