A Wharton School professor has analyzed the performance, and pay levels, of external hires vs. internal staff promotions. He used personnel data from a division of a major US investment bank for 2003—2009, and the characteristics of that talent market are remarkably similar to our own:
Investment banking, [Professor Matthew] Bidwell writes, represents “an interesting context in which to study the effects of internal versus external mobility [because] organizational performance often depends on the skills of the workforce, [thereby] increasing the importance of personnel decisions.” In addition, workers in banking are “notoriously mobile, making this a context in which organizations regularly engage in external hiring at all levels.”
The genesis of his study was seeking an answer to the question, what has the increased mobility of workers over the past 30 or so years meant, as firms turn away from offering lifetime employment in favor of relying on the external labor market to find experienced workers at all levels of the organization? Here’s the bottom line:
“External hires” get significantly lower performance evaluations for their first two years on the job than do internal workers who are promoted into similar jobs. They also have higher exit rates, and they are paid “substantially more.” About 18% to 20% more. On the plus side for these external hires, if they stay beyond two years, they get promoted faster than do those who are promoted internally.
“Most jobs are entered into through a variety of different routes, sometimes by being hired from the outside and sometimes by moving up from inside the firm,” says Bidwell. “I was curious as to what the effect of these different routes would be” on an individual’s job performance.[…]
The issue has significance for organizations, Bidwell says, as they think about where they source their employees, especially higher-level ones. Do they “grow their own” or do they go out into the job market and hire outsiders? “My research documents some quite substantial costs to external hires and some substantial benefits to internal mobility,” he notes.
The “two year learning curve” which represents the primary risk for external hires is the length of time it takes them to learn how to be effective in the new organization, and specifically to build relationships, learn who to trust and whose judgment is questionable, and so forth. Internally promoted people already know this landscape instinctively.
The converse is true as well, is it not? That is, firms know more about potentially promotable internal candidates than they do about external hires. To counterbalance that (consciously or unconsciously), firms require greater education and experience from external hires than internal candidates:
“When you know less about the person you are hiring, you tend to be more rigorous about the things you can see” — such as education and experience levels listed on a person’s CV, or what Bidwell calls “externally observable attributes.” And yet “education and experience are reasonably weak signals of how good somebody will be on the job,” he notes.
He’s not done. While external hiring has a poorer track record, and is more costly to the firm, than internal promotions, it’s also becoming more prevalent—partly because it’s exciting (as are dating and new romances):
External hiring has grown much more frequent since the early 1980s, especially for experienced high level positions and especially in larger organizations. “It used to be that smaller organizations always did a lot of outside hiring while big ones focused more on internal mobility. But now the pendulum has shifted toward external hiring and away from internal mobility for large organizations as well.
“Companies should understand that it can often be harder than it seems to bring in people who look good on paper,” says Bidwell. “In addition, there is a suspicion that ‘the grass is always greener’ attitude plays a role in some companies’ desire to hire from the outside. Managers see a great CV and get excited about playing ‘Let’s Make a Deal,’ even when it’s hard to know what weaknesses the external hires bring with them.”
On the other hand, “to promote more people internally also means that companies need to have a long-term perspective [emphasis mine] and know how big a pipeline of people will be needed in the future,” notes Bidwell. … “Finally, there are clearly some costs to internal mobility — for example, the cost of training people in-house versus piggybacking on someone else’s training.”
There you have it.
I’m not sure this piece requires additional extensive exegesis, but let’s summarize the findings:
- External hiring has increased substantially vis-a-vis internal promotions over the past 3 decades.
- Despite the fact that (because?) we know less about them than we do about potential internal candidates, it’s an exciting hunt.
- External hires fail at greater rates than internally promoted candidates.
- They come with a 15—20% premium in compensation.
- This is particularly true in jobs that “require high levels of general skills [citing securities research, surgery, and scientific research, because] while such work depends on individual workers’ skills and knowledge, it also requires intense coordination with others in the organization.”
Now let’s change the subject, while not really changing the subject.
We now know that Dewey issued guarantees to many laterals—not at all unusual—and to many incumbent partners—extremely unusual. Based on public reports, many of these guarantees had the following characteristics:
- They ran for more than one year; and
- They were not tied to the firm’s performance, nor so far as Dewey has disclosed, to the individuals’ performance.
Now it’s worth stepping back for a minute to ask whether this sort of compensation arrangement has any analogues in the financial world.
I’d like to suggest that what the Dewey partners-with-guarantees had negotiated with the firm was essentially a contract that not only fixed their compensation at a very generous level, but simultaneously permitted them to opt out of their financial involvement with the firm’s performance (and possibly their own). If this were the financial markets, what these partners have functionally done is buy a “put” option on Dewey itself. (Yes, yes, I know the analogy isn’t exact; that’s why it’s an analogy. But stick with me here.)
A put option gives the owner the right, but not the obligation, to sell an underlying asset at a pre-specified price on or before a date certain. Importantly, should the buyer of the put option choose to exercise it, the seller of the put option is obligated to purchase the underlying asset at the specified price regardless of its actual price in the market on the exercise date.
In a nutshell, the buyer of the put is purchasing insurance against the value of the asset declining while the seller is wagering the asset will maintain or increase its value. Thus:
- Dewey partners-with-guarantees have the right
- To collect their specified compensation
- On a date certain
- Regardless of the financial performance of the firm (or the partner personally).
Courtesy of Wikipedia, here are the generic strategies of buyer and seller of puts in a nutshell:
The put buyer either believes that the underlying asset’s price will fall by the exercise date or hopes to protect a long position in it. […]
The put writer believes that the underlying security’s price will rise, not fall. The writer sells the put to collect the premium.
So: Dewey partners-with-guarantees (put buyers) wanted to protect their position even if Dewey itself suffered reverses or underperformed. Dewey itself (the put writer, as it were) was willing to assume the risk that the firm would underperform in order to gain the marquee names of partners-with-guarantees or else to protect its investment in existing partners (which was rational from the firm’s perspective since it didn’t believe material underperformance was a realistic possibility).
Now let’s see how asymmetric the payoff calculations are for these two positions.
The following two charts are apropos puts on equities, but extrapolate in your imagination. Consider the horizontal access not “share price at maturity” but “fair market value of partner’s services when the guarantee is due;” that’s fairly straightforward. Figuring out what the “premium” represents in Law Land is a bit more problematic, but if you care to make the heroic assumption that all involved are behaving rationally, it is a stand-in for the amount of compensation sacrificed by the partner receiving the guarantee in order to negotiate the guarantee.
This makes sense: I should be willing to sacrifice some portion of my probable but otherwise uncertain compensation simply in order to lock in for certain what I’m going to get. From the firm’s side it makes equal sense: It’s hard to justify guaranteeing a partner the highest compensation he/she could earn if everything goes perfectly. The firm can and should rationally expect to get “a break” from that best-of-all-possible worlds compensation level in exchange for issuing the guarantee.
Of course, it’s at least equally likely that firms and partners don’t negotiate this way with each other at all, and if you prefer to believe that, then the “premium” is arguably much closer to zero than the graphs indicate. This does not vitiate the analysis in the slightest.
Here’s the schematic payoff for the put buyer (the partner-with-guarantee):
And the payoff for the put writer (the firm):
To call the payoff matrices asymmetric is to belabor the obvious.
Why, you may be asking yourself by now, would the two parties enter into such an arrangement? Frankly, their intent is irrelevant to the analysis: This is simply meant to portray and help explicate the nature and potential consequences of the bargain.
But if you care to speculate, the most logical explanation is probably that no firm (certainly senior management of no firm) expects the firm’s fortunes to decline; the risk of being “short” the put is presumed to be imaginary. The partners’ motivation is presumably more straightforward, acquiring an insurance policy against disappointment.
What matters is that this whole exercise of deconstructing the consequences of puts on equities in the financial markets is an analogy and only that. Shareholders are presumed (certainly under the efficient markets hypothesis) to have no ability whatsoever to influence share price, so it’s the unseeing and unfeeling operation of the market that determines who’s pleased and who’s sorry that they entered into one side or the other of the put transaction.
This is quite the opposite of partners, particularly significant rainmaking partners, in a law firm; decoupling their financial fortunes from the firm’s performance would seem to violate the very spirit of what partnership should mean. Many observers argue the original sin of investment banks was going public, eviscerating the notion of partnership and substituting the infamously named “OPM” in its place: Other People’s Money. We could do worse than to take a lesson from that sorry, expensive, and checkered history.
When a firm brings in lateral partners of the kind that get guarantees, they aren’t hiring talent. They are buying clients and market share, same as a company in a mature industry does when it acquires a competitor. The math can only make sense – and I’m not saying that it usually does – when you look at it in that light.
Bruce, I think this analysis will survive the test of time. I agree with Ray Campbell that firms are functionally buying market share. The guarantees are part of the price … and that price is arguably too high. Providing guarantees, however, to incumbent partners is moral hazard incarnate. No other way to say it. bh.
The analysis presumes that the hired talent is a robot, or a human who ceases making independent game decisions. Of the scenarios ignored include a new hire/guarantee holder who perceives a “vacation” of sorts. Oft neglected personal interests along the lines of health, relationship, or personal/professional development can be moved to a front burner. While incentive is eliminated for the new hire to maximize profits of the firm in the short term, the new hire is free to extend his horizon to maximize personal utility. Simplified, his horizon to evaluate decision choices is shifted until after the guarantees expire. Bill Henderson is spot on, though an extreme short term predicament at Dewey LeBoeuf might arguably justify such seemingly foolish guarantees to existing members. Remember the king who rationally contemplated the trade of his entire kingdom for “a horse”. So before we issue a final judgment on the management decisions at Dewey, are we absolutely sure that we have all of the information? Something rotting in the state of Denmark beyond revenues?
I think the risk that the partners might view the guarantee period as a semi-sabbatical where they can indulge their passion for breeding orchids, or whatever, is exactly the moral hazard Bill Henderson had in mind.
The guarantees are not a crazy thing to demand if you are successful where you are. You leave behind your mentors and your political allies, you face unknown conflicts and challenges when moving work over, and just as management doesn’t know you all that well you don’t know them. If the firm brings in a major client that creates conflicts with your major clients, you are screwed if you don’t have a cash guarantee. If the firm decides to do a merger that makes you superfluous, or worse, a source of conficts, you are screwed if you don’t have a cash guarantee. The guarantee shifts that risk to the entity buying market share, which presumably can better afford and amortize a mistake.
While the risk of moral hazard is there, I would expect that relatively few of the lateral acquisitions fail because they go on semi-vacation. A guarantee might run for two or three years, but after that big career problems loom if anticipated numbers aren’t being hit. The kind of people who get these offers in banks and law firms aren’t exactly live for the moment types, or they wouldn’t be where they are. They deferred gratification in college, in law school, in early career phases, and it would be out of character to go all live-in-the-moment just because they have a short term guarantee. While the rate of failure is higher with laterals, I think there are a lot of factors at play – adverse selection (why did their former firm not bid up to keep them?), loss of essential support networks, conflicts, failure to grasp a new firm culture, etc..
All that said, and even shifting the analysis from the partner’s time to the overall book of business brought over, including the upside volatility implied by the prospect of cross selling to all those new clients, I’m willing to believe that firms often pay too much for laterals. The core problem is not just that they don’t understand options, but that they face a need to grow but don’t know other ways to bring in new clients so reliably or so quickly.
I agree with your analysis, up to the point where you suggest that conflict of interest rules would impede this type of firm’s pursuit of revenue. The State of Missouri’s insurance dept had their $3 Billion (treble) complaint against Dewey LeBoeuf predicated on sworn allegations that the firm hid their overwhelming conflicts – resulting in harm to General American Mutual. Sworn above signatures of two of the state’s most prominent law firms. They are not talking about failing to adequately disclose the pro and con of simultaneous representation in required written waivers, they swore that the conflicts had been hidden.
My simple mind infers that conflict waivers were not obtained. Kind of difficult to get that wrong, if the most basic pre-complaint fact checking (by THE party holding privilege) did not result in the mandatory written documents surfacing. Given the well settled duties of law firms to construct and maintain systems and controls adequate to the conflict avoidance duties, it seems implausible that these conflict failure actions involving billion dollar clients would not ensnare senior management of the firm as well. To be fair, many of the largest law firms have been skirting the law and ethics rules on conflicts. But this blatant disregard for conflict of interest rules seems an institutional norm when during this litigation threat to their existence, Dewey LeBoeuf willfully accepts for membership lawyers with a known history of conflict issue problems.
Your focus on “sabbatical” behavior as a personal “game choice” by a guarantee holder shows my attempt at subtle illustration failed. My intent was to suggested one easily grasped scenario demonstrating divergence between an individual’s and institution’s best interests. Though your “breeding orchids” example suggests the humor was not completely lost. I’d like to address the false dilemma implied by choices of “live in the moment” and “deferred gratification” as fully describing the player game space. There are more than a few possible darker motivations behind the game decisions of management and laterals. When the barbarians are approaching, burning down the farm sometimes works to save one’s skin. Sucks if you own stock in the farm, but burning the farm can be a rational decision if you’re the farmer and you’re personal ham hock is in danger of getting roasted. Let’s say you’re management and you know the farm will be raided. Why not get other sharecroppers to fill the grain silos?
The problems at Dewey may be deeper than admitted. What explains the $155 million accounting “something” described by Mr. Shutran? Did Dewey pull a “Streisand” by seeking to hide the truth via a court order? The kind of truth which lenders, insurance carriers, and clients all have a right to know…