Hiring Executives with Customer Experience: A Double-Edged Sword?

Transcription

1 Hiring Executives with Customer Experience: A Double-Edged Sword? Yiwei Fang Stuart School of Business Illinois Institute of Technology 10 West 35th Street, 18th floor Chicago, IL 60616, USA Telephone: yfang15@stuart.iit.edu Iftekhar Hasan Gabelli School of Business, Fordham University 45 Columbus Avenue, 5th Floor New York, NY Telephone: ihasan@fordham.edu and Bank of Finland, Helsinki, Finland Jiong Sun Stuart School of Business Illinois Institute of Technology 10 West 35th Street, 18th floor Chicago, IL 60616, USA Telephone: jsun@stuart.iit.edu 1

2 Abstract: We investigate the impact of hiring of executives with customer experience (ECEs) on supplier firm value. When suppliers make relationship-specific investment (RSI), we find that the impact is positive; otherwise, it is negative. We also find that the positive (negative) effect is more pronounced when the customer has higher (lower) reliance on the supplier. To explain the underlying mechanism, we argue that the knowledge gained from ECEs can reduce hold-up costs incurred by RSI through diversification. On one hand, we find that ECE hiring by suppliers with RSI is positively associated with the latter s sales growth, both to the former employer of the hired executive and to the broader market (sales diversification). In addition, hiring ECEs reduces the likelihood of relationship termination for suppliers with RSI around downstream sales and innovation shocks (time diversification). On the other hand, hiring ECEs does not increase sales or reduce the likelihood of relationship termination for supplier firms without RSI. Keywords: Executives with customer experience, supply chain, firm value JEL codes: G30, G34 2

3 1. Introduction The supplier-customer relationship has been a topic of considerable interest in the recent finance literature. Research suggests that this relationship can be a significant source of risk. For instance, suppliers experience negative abnormal stock returns when customers declare bankruptcy (Hertzel 2008; Kolay, Lemmon, and Tashjian 2013), engage in horizontal mergers (Fee and Thomas 2004; Shahrur 2005), or replace their CEO (Intintoli, Serfling and Shaikh 2014). Banerjee, Dasgupta, and Kim (2008) show that dependent suppliers tend to maintain lower debt ratios to protect themselves from such risks in the relationship. Suppliers may suffer significant losses from risks that are transmitted from their customers. Because many rely on a few major customers for a large portion of their sales, and they invest substantially in relationship-specific assets (such as R&D), suppliers are often strongly dependent on the relationship. Relationship-specific investment (RSI) is often tailored to the specific needs of customers and offers little value outside of the relationship (Raman and Shahrur 2008; Crawford 1990; Titman and Wessels 1988). This strong dependence makes it costly for these suppliers to switch to new customers and, hence, makes them vulnerable to risk or disruption in the downstream supply chain. In this sense, firms with higher RSI are less diversified and face higher hold-up costs. In spite of evidence that suppliers suffer significant losses due to risk from the downstream supply chain, we know little about how they proactively seek to protect themselves from such risks. Our paper investigates the phenomenon that a large number of suppliers hire senior executives (e.g., CEO, CFO, COO, president, executive vice-president) who have previously worked for their major customers. As indicated in Table 1, 10 percent of 3

4 supply chain dyads in our sample have hired at least one such senior executive. This type of hiring reached its peak (16 and 18 percent, respectively) in 2001 and This paper argues that executives with customer experience (ECEs hereafter) help suppliers gain insider knowledge of customers and their industries. ECEs knowledge offers a channel for reducing hold-up costs incurred by RSI. Similar to existing studies that focus on the value of related-industry experience of board members (Dass et al., 2014), we argue that a senior executive with work experience at a major customer firm can help the supplier obtain firm-specific knowledge about the customer s way of doing business, as well as knowledge of the downstream industry. This knowledge can, in turn, help the firm better manage its relationship with the customer by increasing sales and maintaining stability, as well as increase sales to other customers. From this perspective, we hypothesize that ECE hiring offers a channel for reducing hold-up costs due to RSI through diversification and, as such, adds value to the firm. On the other hand, customers may view ECE hiring by the supplier as opportunistic behavior and realize that their bargaining position could be weakened as a result of leakage of private information. An executive previously employed by a customer has the potential to reveal proprietary information (such as trade secrets, bargaining strategies, financial data, contract details with competing suppliers, and cost structure). Customers may also react opportunistically. Such opportunistic behavior, in turn, would encourage detrimental short-term behaviors such as early termination of relationships and increased risk transmitted from downstream industries when the customer maximizes individual transaction rather than long-term profits (Raman and Shahrur 2008). Such behavior would ultimately negatively influence supplier 4

5 shareholders wealth. 1 Thus, whether or not hiring an ECE is a double-edged sword that would enhance or hurt firm value is an empirical question that is important to answer. We contribute to the literature by investigating the following questions: (1) Does ECE hiring increase or reduce firm value from the perspective of a supplier firm s shareholders? And (2) If such a double-edged-sword effect exists, what is its underlying mechanism? Using a two-stage least-square instrumental variable approach to control for endogeneity in hiring ECEs, we find a positive effect on suppliers firm value when suppliers make RSI, proxied by suppliers R&D intensity. When suppliers have no RSI, however, the impact of hiring ECEs is negative. Namely, our results suggest that whether the positive or the negative effect dominates is governed by the presence or lack of RSI in the supply chain. To explain our findings, we argue that the higher the RSI, the higher the value of knowledge the executives bring in and the greater the reduction of hold-up costs stemming from RSI. Therefore, the presence of RSI enhances the positive effects of hiring ECEs. Existing studies also argue that the higher the RSI, the greater the dependence of the relationship (e.g., Intintoli, Serfling and Shaikh 2014; Kale and Shahrur 2007). When suppliers make RSI, customers have a strong incentive to maintain a long-term relationship because it is costly for them to change to alternative suppliers who can serve their specific needs. In other words, it is less likely that customers will 1 The implicit contract theory (Cornell and Shapiro 1987) suggests that opportunistic behavior among stakeholders would lead to an unhealthy relationship. Empirical evidence shows that trust is a key determinant of continuity in conventional channel relationships (Anderson and Weitz 1989), anticipated future interactions with a supplier (Doney and Cannon 1997), and development of a long-term orientation (Ganesan 1994). 5

6 change their long-term orientation in the relationship in response to suppliers hiring of ECEs. Hence, in this case, the positive impact of hiring ECEs would outweigh any negative effects. On the other hand, when suppliers make no RSI, executives knowledge can be less valuable in decreasing hold-up costs and customers face lower switching costs in changing to alternative suppliers. Thus, negative effects such as damaging the longterm health of the relationship can dominate and suppliers are likely to experience worse performance subsequent to their ECE hiring. We explore the circumstances under which hiring ECEs is more beneficial (harmful) to suppliers. We find that suppliers benefit more from hiring ECEs when customers have a higher reliance on the relationship due to their high cost of switching to alternative suppliers. We proxy customers reliance on the relationship by using (1) customers sales dependence, calculated as the percentage of sales between the supplier and the customer, to the customers cost of goods sold (COGS); (2) the intensity of competition in the supplier industry; and (3) whether or not customers operate in the service or durable goods sectors. When a customer relies on a supplier for a large number of its input factors, the former s ability to switch from the latter to another supplier is weak. Similarly, when the supplier s industry is less competitive, the likelihood of the customer switching to a different supplier is reduced. Finally, when firms operate in the service or durable goods industries, they probably have an ongoing relationship with their trade partners and are also likely to create relationship-specific assets (Johnson, Kang and Yi 2010; Titman and Wessels 1988). Our findings suggest that a benefit from such hiring accrues to suppliers who make RSI and whose customers are highly dependent on them. 6

7 On the other hand, when suppliers do not make RSI and customers are not strongly dependent on them, the negative effect of hiring becomes more pronounced. To elucidate the mechanism through which hiring ECEs enhances (or reduces) firm value, we explore two channels, sales growth and the likelihood of relationship termination. First, we find that hiring ECEs leads to sales growth for suppliers who make RSI. Sales growth accrues not only to the former employer of the ECE but also to the broader market. ECE hiring does not, however, lead to sales growth for suppliers without RSI. This result suggests that, by hiring ECEs, the firm benefits from reduced hold-up costs through sales diversification. We also examine how such hiring impacts the likelihood of relationship termination and how it affects a supplier s exposure to downstream risk during two types of downstream industry shocks: negative sales shocks and positive innovation shocks. Both industry shocks put the existing customer-supplier relationship at risk of early termination, either because the supplier might face a sudden drop in demand from the customer or the supplier s technology cannot meet the customer s new technological requirement. Hence, when such shocks occur, the supply-chain relationship is likely to experience disruptions, which can hurt suppliers with high RSI. If information acquisition were underlying mechanisms for the positive effects on suppliers who make RSI, hiring ECEs would help suppliers to proactively react to such shocks and maintain long-term relationships with their major customers. The negative effects for suppliers without RSI might be explained by a change in customers long-term orientation in the focal relationship in response to the supplier s ECE hiring. If such were the mechanism, suppliers who hire ECEs would face higher risk under downstream negative sales shocks. 7

8 Short-term-oriented customers who maximize their individual transaction (rather than long-term) profits are more likely to pass high market volatility on to their upstream suppliers (compared with smoothed-out volatility when maximizing long-term profits). 2 Supporting our proposed mechanisms, under conditions of negative sales shocks, we find that suppliers who make RSI experience a lower likelihood of termination of the supplychain relationship when such ECE hiring takes place than when there is no such hiring. For suppliers without RSI, however, ECE hiring does not reduce the likelihood of such termination. Under innovation shocks, hiring ECEs significantly reduces the odds of relationship termination for suppliers with RSI; it does not, however, help reduce the termination risk for suppliers without RSI. This result suggests that a firm that hires ECEs benefits from reduced hold-up costs through time diversification. Our results are robust under different model specifications. In our baseline regressions, ECE hiring is instrumented using county-level median household income to mitigate any endogeneity concern. In robustness tests, we consider the potential contaminating effect of board directors experience. In particular, we control for the number of directors with related-industry experience, which is documented in Dass et al. (2014), as a way to bridge the information gap between suppliers and customers and enhance supplier firm value. Our results remain robust after teasing out the impact of directors experience. Furthermore, using a subsample of firms that have hired new senior executives, we test how hiring ECEs affects firm value compared with hiring non-eces. This framework allows us to capture the change of firm value subsequent to the hiring events. Using the change of Tobin s Q after hiring as the dependent variable, we show 2 Relationships based on a long-term orientation allow firms to sacrifice short-term gains in favor of benefits accruing to both parties over the long run (Ganesan 1993; Narayanan and Raman 2004). 8

9 that our results confirm the double-edged-sword effect. Finally, using the same framework of new hires, we address the concern that it may be industry knowledge in general, and not the customer-specific knowledge possessed by the ECEs, that drives our results. By focusing on the subsample where all newly hired executives possess such related-industry experience, we confirm that hiring ECEs does bring a significant incremental value to suppliers. Our paper contributes to several streams of literature. First, it adds to the literature that examines the impact of customer events on an upstream supplier firm s performance (Hertzel et al. 2008; Kolay, Lemmon, and Tashjian 2013; Fee and Thomas 2004; Shahrur 2005; Intintoli, Serfling and Shaikh 2014). These studies offer an important economic underpinning regarding the role of the supplier-customer relationship in affecting firm value. Building on this literature, we document the popular practice among suppliers of hiring ECEs. To the best of our knowledge, our study is the first to document this phenomenon and to investigate its value implications for suppliers. Our findings are interesting in the sense that we identify a double-edged-sword effect depending on the level of suppliers RSI. Our main results suggest that ECEs provide a great deal of insider knowledge to the supplier and decrease the hold-up costs due to RSI. Raman and Shahrur (2008) provide evidence on the assessed risk due to RSI. However, the long-term health of the relationship may be hurt due to a potential change in the customer s orientation in response to the supplier s opportunistic behavior of hiring ECEs and the customer s potentially weakened bargaining power. Raman and Shahrur (2008) also show that supply-chain partners may use earnings management to influence other parties RSI. 9

10 Such opportunistic behavior would, in turn, lead to early termination of the relationship. Our findings indicate that the net impact hinges on suppliers commitment to RSI, and the degree of the impact varies with the level of customers reliance on their suppliers. Finally, the mechanisms through which ECE hiring affects supplier firm value are tested through sales growth and downstream industry shocks. Our findings indicate that ECE hiring increases sales and reduces the likelihood of relationship termination for suppliers making RSI; however, ECE hiring does not increase sales for those firms without RSI. Second, our study relates to a major stream of studies on management turnover. It has been well documented that senior management turnover is associated with operational and strategic changes (e.g., Denis, Denis, and Sarin 1997; Weisbach 1995; Johnson et al. 1985; Bertrand and Schoar 2003; Xuan 2009). Intintoli, Serfling and Shaikh (2014) is one of the few studies that have examined management turnover in the context of supply chains. They investigate the replacement of a customer s CEO and report a negative effect on its suppliers financial performance. Different from Intintoli, Serfling and Shaikh, we examine the impact on suppliers of hiring a senior executive who has prior work experience at a major customer. Another related work by Dass et al. (2014) finds that members of boards of directors from related industries can help bridge the information gap and increase firm value. To address a concern that the positive effect on firm value can be attributed to the presence of board directors who have relatedindustry experience, we perform several robustness tests by controlling for both executives and board directors experience in related industries. Our results remain robust. Our findings show that although related-industry experience is important, customer-specific knowledge is also crucial. We contribute to this stream of literature by 10

11 increasing our understanding of the effects of management turnover along the supply chain. More importantly, our study brings attention to the potential dark side of hiring executives with customer-specific knowledge. 2. Theory and Development of Hypotheses 2.1 The Double-Edged-Sword Effect Information asymmetry is a common source of friction between/among partners in the supply chain. Customers have no incentive to fully or truthfully share their private or market information with upstream firms because of concerns about losing bargaining power (Lee and Whang 1999). In the presence of such information asymmetry, firms cannot correctly react proactively to downstream disruptions such as customer firms financial distresses or product market risk by, for example, switching to new customers. Previous studies have argued that such friction can be eased by strategic alliances between supply-chain partners, because they facilitate information flow (Fee, Hadlock, and Thomas 2006). In a similar manner, we conjecture that ECEs can serve as conduits of information and help the supplier gain knowledge about the customer, the customer s industry, and competing suppliers. Such knowledge can benefit a supplier in two ways. First, knowing the customer s industry (market trends, competition, demographics, consumer behavior, and regulations) can help the supplier serve its major customers in a more responsive and appropriate manner because it can help the former make more informed decisions. When anticipating new industry trends, it can also help the supplier capture business opportunities and acquire new customers. Knowledge of the customer s industry can also help protect against demand shocks by overcoming any information 11

12 time-lag (Johnson, Sohi and Grewal 2004) and by anticipating potential risks that can arise from the customer s industry, such as competition, industry shocks, and market structural changes, and reacting accordingly. Second, ECEs may have insider knowledge of customers private information, including business prospects, operations, and resources as well as its objectives, such as capital constraint, cost structure, and negotiation and pricing strategies. Such knowledge can help the supplier serve the customer in a better way and react to any risk that may arise at the customer s end, such as potential financial distress or changes in market focus. Anticipating such risk, the supplier can be proactive in seeking alternative solutions. Knowledge of customers private information can also significantly enhance suppliers bargaining power in the relationship (Gal-Or 1991). In addition to the collaborative nature of the partnership in serving the downstream market and enlarging the total profit of the entire supply chain, suppliers and customers compete simultaneously to divide the profit. ECEs may have considerable knowledge of customers bargaining strategies and contract details with other suppliers, as well as the latter s private information. Hence, by taking advantage of such insider knowledge, a supplier that hires an ECE is able to strategically design its actions in negotiating/contracting with the customer and greatly enhance its position in the relationship. We conjecture therefore that suppliers benefit from hiring ECEs because such hiring reduces hold-up costs incurred by RSI due to reduced information asymmetry. It is worth noting that a recent paper by Dass et al. (2014) finds that members of boards of directors from downstream industries can help bridge the information gap and thereby 12

13 add value to a company. An argument similar to this can be extended to the context of our research. Customers may well react unfavorably to ECE hiring, however, because they may view such ECE hiring by a supplier as opportunistic behavior to obtain customers private information. Supply-chain partnerships are competitive (in terms of dividing the pie) as well as collaborative (in terms of maximizing the pie) in nature. As mentioned above, knowledge of customers proprietary information can significantly enhance suppliers bargaining power and help them negotiate favorable contract terms. The corresponding change in customers bargaining power can, in turn, encourage them to change from a long-term to a short-term profit-maximizing orientation. Raman and Shahrur (2008) also show that supply-chain partners will react negatively to other parties opportunistic behavior by using earnings management to influence their R&D investment, which, in turn, could lead to early termination of relationships. The extant literature on supplier-customer partnerships suggests that partners long-term orientation determines the healthiness of the relationship (Cannon and Homburg 2001; Cousins et al. 2006; Kalwani and Narayandas 1995; Krause 1999; Narayandas and Rangan 2004). Customers who maximize their short-term profits can more easily transmit downstream risk to upstream suppliers. The supply-chain management literature has shown evidence that market volatility is passed upstream and is amplified when longterm coordination between supply-chain partners is lacking. This phenomenon is termed the bullwhip effect (Lee, Padmanabhan and Whang 1997). Customers who maximize their long-term profits can smooth out their own market-transient fluctuations when placing orders to suppliers, which can decrease the latter s demand volatility and lead to a 13

14 more stable relationship. Conversely, customers who maximize their short-term profits will pass their own market volatility on to suppliers through individual transactions. For example, when facing market uncertainty and competition, customers often inflate their order size to upstream suppliers in the absence of a long-term commitment (Kaihla 2002). Prior studies have shown that a long-term orientation allows partners to sacrifice shortterm gains in favor of benefits accruing to both parties over the long run (Ganesan 1993; Narayanan and Raman 2004), enables supply-chain partners adjust to their mutual needs (Lusch and Brown 1996), and leads to greater longevity of the partnership (Anderson and Weitz 1992), while a short-term orientation hurts channel communication effectiveness and sales performance (Jap and Anderson 2007, Palmatier et al. 2006). We therefore conjecture that the supplier can be harmed by hiring ECEs and this harm can result in increased risk faced by suppliers and a higher likelihood of relationship termination in the presence of downstream market shocks. Hence, the stock market may anticipate the risk inherent in ECE hiring, which then reduces the supplier firm s value. The two above-described effects compete with each other with regard to the impact of ECE hiring on supplier firm value. 2.2 The Role of Relationship Dependence and Customers Reliance RSI and Relationship Dependence The economics literature suggests that types of trading relationship range from market to relational exchanges (Williamson 1979). Market exchanges are mainly for standardized products and are more dynamic, based on prices. Hence, firms that rely on arm-length market exchanges are more short-term-oriented and maximize their profits in a 14

15 transaction. For specialized products, partnerships are based more on continuous improvement of products/services and can span multiple years. Such firms are likely to be long-term-oriented and their ongoing relationships incentivize firms to maximize their profits over a series of transactions because they are dependent upon each other and switching partners is costly. Consequently, we expect that the dominating effect of ECE hiring on suppliers depends on their level of RSI, proxied by R&D, as a measurement of relationship dependence. We conjecture that the positive effect of ECE hiring dominates when the supply chain makes RSI. First, the higher the RSI, the greater is the level of dependence in the relationship (e.g., Intintoli, Serfling, and Shaikh 2014; Raman and Shahrur 2008; Kale and Shahrur 2007). It is natural to argue that firms invest more in R&D in trading relationships for specialized products, compared with market exchanges for standardized products. Greater dependence implies a longer-lasting relationship and, hence, a higher value of executives knowledge to the supplier. Suppliers normally must design their manufacturing equipment and business processes for specific buyers in order to respond rapidly to their demands; however, they rarely receive formal protection for their unilateral RSI (Kang, Mahoney and Tan 2009). Thus, the higher the supplier s RSI in the relationship, the higher the hold-up costs and the greater the risk the supplier faces. The supplier will be more vulnerable to shocks to the downstream customer or industry. Hence, the value to the supplier of knowledge of its customers and customers industries will be greater when RSI is higher. Second, supply chains with RSI emphasize long-term partnerships, because suppliers invest in RSI in order to secure a long-term relationship with major customers. 15

16 Such investments also increase the dependence of the customer on the supplier because customers suffer from abrupt interruption in their businesses if such relationships break up, and they must expend significant efforts and resources to secure alternative partners. Such efforts increase by supplier firms asset specificity (Joskow 1988; Klein 1988; Tiróle 1988). Hence, a customer in a relationship with high RSI has a stronger incentive to maintain a long-term relationship instead of reacting opportunistically to ECE hiring by the supplier. In this case, the positive effect of valuable information dominates the negative (indirect) effect of a potentially impaired long-term relationship and, hence, hiring enhances supplier firm value. On the contrary, in industries that produce standardized or homogeneous goods, firms compete mainly on prices and may not have a strong incentive to maintain a long-term relationship. In such cases, the value of executives insider knowledge of customers can be limited. Customers will likely react opportunistically to ECE hiring by a supplier because their costs of switching to alternative suppliers are low. Hence, in such cases, the negative (indirect) effect may dominate. We follow the literature (Intintoli, Serfling, and Shaikh 2014; Raman and Shahrur 2008; Kale and Shahrur 2007; Allen and Phillips 2000; Acs and Isberg 1991) by using suppliers R&D expenditure to measure RSI. When a firm has no R&D investment, the tangible RSI may not be significant. On the other hand, if a firm has considerable R&D investment, and/or produces differentiated products, RSI is necessary to add value to products/services, or is of particular importance in differentiating the firm from other suppliers. 16

17 2.2.2 Customers Reliance on Suppliers To understand the circumstances under which a supplier benefits more from hiring ECEs, we hypothesize that the customer s reliance on the relationship plays an important role. The stronger such reliance, the stronger is the value-enhancing role of ECE hiring on the supplier s financial performance because, when a customer relies more heavily on a specific supplier, the cost of switching to a different supplier is higher. The literature on supplier-customer relationships also suggests that the customer s dependence on the supplier has a consistently strong effect on the customer s long-term orientation (Cannon and Homburg 2001; Cousins et al. 2006; Kalwani and Narayandas 1995; Krause 1999; Narayandas and Rangan 2004) and, hence, its reaction to the supplier s ECE hiring. We proxy customers reliance using their sales dependence (the percentage of sales to the customer s cost of goods sold (COGS)), the competition intensity of the suppliers industry, and whether or not the customer operates in a relationship-based industry (i.e., service and durable goods industries). A direct measure of the customer s reliance on the supplier is its level of sales dependence. Intuitively, the higher this percentage is, the greater the effort and resources the customer must bring to bear to search for alternative suppliers. In addition, stronger reliance of the customer on the supplier also indicates a higher level of importance of the former to the latter. We hypothesize that the positive effect of hiring is more pronounced when sales dependence is higher, in the presence of RSI. On the other hand, when sales only account for a small portion of the customer s COGS and the supplier is without RSI, the negative impact of ECE hiring on the supplier is stronger. 17

18 Second, we use the supplier s industry competition intensity as another proxy for the customer s level of dependence. In a highly competitive supplier industry, there are many similar firms and the customer can easily find a qualified substitute once an existing relationship ends. When the supplier s industry is less competitive, however, the likelihood of switching to a different supplier is lower, which prevents opportunistic behavior on the part of the customer in response to the supplier s hiring and potential leakage of proprietary information. Hence, we predict that the benefit of hiring is stronger for suppliers who operate in a less competitive industry because the customer faces higher switching costs, and it is less likely for the customer to behave opportunistically. When a supplier operates in a highly competitive industry, however, the customer can easily replace an existing supplier or diversify its supplier base, which enhances the negative aspect of ECE hiring. Lastly, the nature of customers industries also reflects the strength of their reliance on their suppliers. The literature (e.g., Johnson, Sohi, and Grewal 2010; Titman and Wessels 1988) argues that trading partners in the service or durable goods sector likely maintain ongoing relationships. Service industries such as IBM and Microsoft normally provide longer-term services. Industries that sell durable goods such as automobiles and heavy equipment are also likely maintain longer-term relationships with their trading partners, for maintenance or servicing reasons. Once long-term relationships are established in such relationship-based industries, customers are locked in because of high switching costs. These industries are also those most likely to create relationshipspecific assets or to be subject to information asymmetries. Hence, we expect that ECE 18

19 hiring benefits suppliers to a greater degree when the customer is in a relationship-based industry. Formally, we state our principal hypotheses as follows: H1: ECE hiring has a positive impact on the financial performance of a supplier with RSI. H2: ECE hiring has a negative impact on the financial performance of the supplier without RSI. H3: The positive effect on firm performance of ECE hiring is more pronounced when customers reliance on suppliers is stronger. H4: The negative effect on firm performance of ECE hiring is more pronounced when customers reliance on suppliers is weaker. 3. Data and Sample 3.1 Supplier-Customer Data Following other financial/economic studies of the supply chain (e.g., Fee and Thomas 2004; Fee, Hadlock, and Thomas 2006; Hertzel et al. 2008), we gather firm-customer relationship data from Compustat. The sample period is from 2000 to Pursuant to Financial Accounting Standard No. 14, firms are required to report names of customers whose share is greater than ten percent of the firm s total revenue. Compustat segment files contain such disclosure information. However, the file format does not allow the direct use of such information, because customer names are often abbreviated, and several different names refer to the same firm. Furthermore, many major customers are subsidiaries of a large conglomerate. Augmented by an automated 19

20 text-matching algorithm, we visually inspect each firm s major customer information file one by one, and carefully match a reported customer name to a GVKEY in Compustat. This process may involve some discretion when matching abbreviated names to GVKEYs. To avoid measurement errors, we exclude a pair when it is not possible to confirm that the firm is a match by comparing the abbreviation with previous years customer descriptions. In other words, we follow the literature (Fee and Thomas 2004; Fee, Hadlock, and Thomas 2006; Hertzel et al. 2008) by using this conservative approach because, as argued in the literature, the potential costs of misidentifying noncustomer firms as customers are greater than the potential costs of failing to identifying a limited number of actual customers. Because the periodicity of disclosure is annual, we form supply firm/major customer dyads for each calendar year. We choose 2000 as the starting year of our main sample because the information for ECE hiring provided by BoardEx is available from 2000 onward. In addition, following other papers that study financial performance (e.g., Deng, Kang, and Low 2013), we exclude regulated utilities and financial firms (SIC and SIC ) from our sample. 3.2 Identifying Hiring ECEs We rely on the BoardEx database provided by Management Diagnostics Limited to identify ECEs. This dataset contains employment history and biographical information for senior executives of U.S. companies. The detailed procedures to create measures of hiring away are as follows: (1) We obtain names of senior executives of suppliers and customers for each pair of supplier/customer dyads in a given year. (2) To investigate 20

21 whether or not the supplier hires at least one ECE, we check each individual s employment history and mark it if this individual has worked for the customer company in the past. (3) Our primary measure, ECE hiring, is labeled as ECE hiring dummy, which is equal to 1 if the supplier has hired at least one ECE, and 0 otherwise. We create this measure for the supplier-customer dyad level. <Insert Table 1 about here> Panel A of Table 1 reports the percentage of suppliers that hired at least one ECE from 2000 to In 2000 about 12 percent of suppliers experienced at least one such hiring. The number rises to a peak in 2001 and 2002, when almost 20 percent of suppliers experienced at least one such hiring. After 2002, the percentage lowered and became stable at around 10 percent over the next seven years. Toward the end of our sample, because of incomplete coverage of executive information in 2010, the percentage of hiring dropped, down to 2.6 percent. This is a missing-data issue, but does not reflect the downward trend of such hiring. Overall, the average percentage of the whole sample period is 9.8 percent. Panel B reports the percentage of hiring by industries. We find that such ECE hiring is highly concentrated in industries with a 1-digit SIC code of 2, 3, 7, and 9. These are the industries where supply chains are widely present. Regulated industries (SIC1=4 and 6) are excluded. 3.3 Supplier and Customer Characteristics We match suppliers and customers financial data using Compustat annual files. After matching the financial data, we yield a final sample with 3867 supplier/customer/year observations, which includes 1022 suppliers and 413 major customers. Table 2 reports 21

22 the summary statistics of key variables for the main test. Detailed variable definitions are described in Appendix A. <Insert Table 2 about here> The summary statistics of ECEs are provided in Table 2. In total, there are 245 unique individuals with customer experience, which constitute about 10 percent of our overall sample. Among these ECEs, 13.5 percent serve as CEO/Chairman/President of supplier firms, and 86.5 percent are hired as non-ceo, senior executives (e.g., C-suite and executive VP, senior VP, corporate VP, and functional/regional senior executives). The average (median) tenure in a customer firm, defined by the number of years working in the customer firm, is about seven years (four years). The average age of these individuals is Lastly, 42.7 percent of them had a senior management title when they worked in a customer firm. Table 3 reports the univariate comparison of firm characteristics between the samples of suppliers with and without ECE hiring. The hiring sample includes supplier/customer dyads in which a supplier hires at least one ECE. The no-hiring subsample includes all other observations. We find significant differences in means between the two samples in terms of firm-, industry-, and supply-chain relationship characteristics. For example, suppliers that hire ECEs tend to be larger in assets, higher in R&D intensity, and lower in profitability compared with suppliers that do not. Moreover, suppliers with hiring events also operate in more competitive industries, as indicated by the Herfindahl index. Concerning customers characteristics, customers in the hiring group tend to be smaller in size, higher in R&D intensity, and lower in capital investment 22

23 intensity compared with customers in the no-hiring group. Lastly, we examine whether or not supply-chain characteristics are significantly different between the two groups. The results show that the percentage of sales between the supplier and the customer to the customer s COGS is significantly larger for the hiring group. In addition, supply chain relationship duration tends to be shorter for the hiring group. <Insert Table 3 about here> 4. Results 4.1 Why do Suppliers Hire ECEs? This relatively new phenomenon of executive hiring along the supply chain is interesting in its own right. In this section, we investigate the determinants of hiring ECEs by looking at a set of firm characteristics, market environments, and relationship-specific characteristics. Specifically, we apply probit regressions to identify factors that influence the likelihood of a supplier s decision to hire an ECE. <Insert Table 4 about here> Table 4 reports the results of the probit regression models. The dependent variable is ECE hiring dummy, which equals 1 if the supplier has hired at least one ECE in that year. The control variables include previously stated firm and industry characteristics of both suppliers and customers. Note that all these variables are taken using lagged information of one year prior to the testing year. Moreover, if in our sample one supplier has multiple customers in a given year, we treat each of them as distinct dyads. To address repeated observations for the same supplier in the same year, all the standard errors are corrected for heteroskedasticity and clustered at the supplier level. We also 23

24 include year dummies to control for per-year fixed effects. Industry dummies (2-digit SIC) of both suppliers and customers industries are included to control for industry fixed effects. Column (1) includes firm and industry characteristics. It shows that larger-sized suppliers tend to hire ECEs. The coefficient of f_logassets is statistically significant at the one-percent level. Interpreting the margin effect, one percentage increase in supplier assets is associated with a percent increase in the probability that the supplier will hire ECEs. The second significant factor is suppliers profitability (f_roa). The coefficient of f_roa is negative and significant at 10 percent, which means that suppliers with poorer performance tend to hire ECEs as a means to improve their performance or to avoid being replaced by the customer. The marginal effect is percent, meaning that one percentage decrease in f_roa increases the likelihood of hiring by percent. We also find that customers profitability (c_roa) is positively associated with the likelihood of hiring. This result implies that successful ECE hiring by suppliers is more likely to happen with profitable customers. Lastly, we find that suppliers tend to hire ECEs with greater R&D intensity (c_rdtosales), suggesting that information acquisition is an important motivation. Column (2) adds the supply chain relationship characteristics into the regression model. One measure of relationship characteristics, pct_sales, is the percentage of sales between the partners to the total sales of the supplier. Another measure, pct_salestocogs, is the percentage of sales to customers COGS. A higher sales percentage indicates a stronger reliance on the trading partner. We expect that the higher the sales percentage, the stronger will be the incentive to hire executives with experience of that customer. However, we do not find that sales have a significant effect on hiring 24

25 probability. The factors that are found to be significant in Column (1) continue to have significant effects on the likelihood of hiring in Column (2). 4.2 Endogeneity Concerns and Identification Strategy As illustrated earlier, a supplier s decision to hire an ECE is not random, but is determined by certain firm characteristics. Because of the possible selection effect, there could be some omitted/unobserved firm characteristics in the error term that correlate with both hiring decision and firm value. The endogeneity problem, if not corrected, could cause bias in our results. Also, it is difficult to draw conclusions regarding the causal relationship between hiring and firm value. Our main identification strategy is to use the county-level median household income as an instrumental variable to isolate a subset of changes in the likelihood of hiring. The clear economic rationale for using this measure as an instrumental variable is that a higher-income region is more attractive for people to live and work in, and it should, therefore, be positively associated with successful ECE hiring. At the same time, it is unlikely that the local median income level affects firm characteristics and performance, since, if this were the case, all firms would relocate to higher-income regions. To show the statistical validity of the instrumental variable, we report the firststage regression results in Column (1) of Tables 5 and 6. We are particularly interested in the following statistics to ensure that the instrumental variable approach is valid. First, the coefficient of the instrument, county household income, is significant and positive in the first stage (at a one-percent significance level). As shown in Tables 5 and 6, the 25

26 coefficients are both positive and significant at one percentage level (p<1%), which confirms that the instrument we chose satisfies the first criterion. Second, the endogeneity test rejects the null hypothesis that ECE hiring dummy is exogenous (p<1%). It suggests that the regressor, ECE hiring dummy, cannot be treated as exogenous and the endogeneity issue does exist. Third, the LM statistic is 8.97 with a p-value of , which rejects the null hypothesis that the equation is under-identified. Overall, thus, the tests show that the instrumental variable is valid. 4.3 Value Effect on Suppliers with Positive R&D Investment In this section, we analyze the value effect of ECE hiring on suppliers with R&D investment. Table 5, Columns (1) and (2) report the 2SLS IV results for all suppliers with R&D. Column (1) presents the results of the 1 st -stage regression, which shows that the instrumental variable is valid. In Column (2), predicted ECE hiring dummy is the predicted value from the 1 st stage and is used as an exogenous measure for ECE hiring. We find that the coefficient of predicted ECE hiring dummy is 6.055, which is statistically significant at the five-percent level. Hence, it supports our hypothesis (H1) that hiring ECEs significantly improves supplier firm value when the supplier has positive R&D investment. The control variables generally have the anticipated effects on the firm value: higher leverage and larger firm size are associated with lower firm value. Higher R&D intensity is associated with greater firm value. We use a partial option for our year dummies and industry dummies to avoid singleton dummies problems. 3 Thus, the constant is automatically partialled out as well. 3 According to Frisch-Waugh-Lovell theorem, when the regressors include a variable that is a singleton dummy, i.e., a variable with one 1 and N-1 zeros or vice versa, it will cause the robust 26

27 <Insert Table 5 about here> In the remaining columns of Table 5, we divide the positive R&D sample into subgroups based on three factors: 1) competition intensity of the supplier industry; 2) percentage of sales to the customer s COGS; and 3) whether or not the customer operates in a relationship-based industry. These three factors are used as proxy for the reliance of customers on suppliers, but from different perspectives. A higher level of reliance indicates a smaller likelihood of dropping the current supplier and switching to a new one. If a customer has many alternative suppliers, or is not heavily reliant on a supplier for input factors, or the customer industry is not relationship-based, then our expectation is that it is easier for this customer to terminate its relationship with a supplier that hires ECEs. Under this situation, the negative effect of ECE hiring (impairing the long-term health of the relationship) could be stronger, so that the value-enhancing role of hiring is less significant. Column (3) reports the 2SLS IV regression results for the subsample: suppliers with R&D but operating in a low-competition industry. Column (4) reports the 2SLS IV regression results for the subsample: suppliers with R&D but operating in a highcompetition industry. We focus on suppliers competition because a high level of competition in the supplier s industry indicates a higher likelihood for the customer to switch to another qualified supplier. In contrast, if the supplier faces less competition, it is less likely that the customer will switch. The results indicate that suppliers in lesscompetitive industries benefit from hiring at a marginal level (p-value is close to 10 percent), while suppliers in more competitive industries do not benefit from such hiring. covariance matrix estimator to be less than full rank. In this case, partialling out the variable with a singleton dummy solves the problem. 27

28 In Columns (5) and (6), we examine the two subgroups: suppliers with below-median percentage sales (to total customer COGS) versus suppliers with above-median percentage sales. A higher sales percentage suggests a customer s greater reliance on its supplier. The stronger the reliance of a customer on a supplier, the harder it will be for the customer to end the relationship. In this case, the negative effect of hiring can be weak and the benefit of hiring is likely to dominate the outcome. The results in Columns (5) and (6) show that suppliers benefit more significantly from ECE hiring when the sales percentage is high. Lastly, Columns (7) and (8) examine the two subgroups: customers not in relationship-based industries versus customers in such industries. Broadly, relationship-based industries most often operate in the service or durable goods sector. In these industries, firms are likely to have repeat business with a trade partner, for either maintenance or servicing reasons. As findings show, when the customer is in a relationship-based industry, hiring executives with experience of this customer is more advantageous to the supplier. Overall, the results in Columns (3) (8) support our hypothesis that the positive effect on firm performance of ECE hiring is more pronounced when customers reliance on suppliers is stronger (H3). 4.4 Value Effect on Suppliers with no R&D Investment We apply the same methodology to analyze the effect of hiring on suppliers firm value when suppliers have zero R&D investment. We also examine the contingency effect of suppliers industry competition intensity, sales between partners, and whether or not customers are in a relationship-based industry. Table 6 reports the regression results. Columns (1) and (2) are the 2SLS IV regressions for all suppliers with zero R&D 28

29 investment. Interestingly, the coefficient of predicted hiring on supplier is -1.82, which is statistically significant at a five-percent level. This result supports our hypothesis that the information acquisition benefit of hiring is very limited when a supplier does not have R&D investment. The negative effect of an impaired long-term relationship will be more pronounced because it is easier for the customer to switch when the supplier has invested little in R&D. Thus, supporting H2, the net effect of ECE hiring is negative for suppliers without RSI. From the long-term perspective, as captured by Tobin s Q, firm value is damaged rather than improved. Examining the contingency effects, we expect that such a negative impact on the supplier would be more pronounced when the supplier faces severe competition in its industry, when sales to the customer are relatively low, and when the customer is not in a relationship-based industry. Table 6 Columns (3)-(8) report the testing results relating to the above-stated hypotheses. The coefficients of ECE hiring on supplier firm value are negative and significant when suppliers face high competition, when sales are low relative to customers COGS, and when customers are in non-relationship-based industries. Our results all consistently indicate that suppliers will be hurt by hiring when they do not invest significantly in R&D. Furthermore, the negative impact is more pronounced when customers are less dependent on suppliers (H4). <Insert Table 6 about here> 4.5 Effects on Sales Growth In this section, we investigate whether the supplier wins more sales as a benefit of ECE hiring. An improved sales performance can be considered as a channel through which 29