The notorious ‘revolving door’ culture of elite companies is not arbitrary, but a rational way to signal talent and increase profits, a new study has revealed.
Why do the world’s most prestigious companies – like McKinsey, Goldman Sachs and other elite consulting giants, investment banks and law practitioners – hire the brightest minds, give them intensive training, and then, after a few years, send many of them packing? A recent study in American Economic Review Concluded that so-called adverse selection is not a defect, but rather a sign that the system is working exactly as intended.
Two financial economists from the University of Rochester and the University of Wisconsin–Madison, respectively, created a model that explains how reputation, information, and retention interact in professions where skill is essential and performance is both visible and attributable to a specific individual, particularly in fields such as law, consulting, fund asset management, auditing, and architecture. He argues that much of the world of professional services operates through “intermediaries” – companies that hire workers (also called “agents” or “managers”) and market their expertise to clients – because clients cannot easily assess a worker’s competence from the outset.
“Identifying skilled professionals is important yet remains a major challenge for clients,” the researchers write. “Some of the employees in the firm are high-quality managers,” say co-authors J. S. and Jeanne P. Bennett Professor of Finance at the university’s Simon Business School, “but the company is paying them less than their actual quality, because the employees initially have no credible way to convince the outside world that they are of high quality.”
‘Manthan’ to increase reputation
Kaniel and his co-author Dmitry Orlov argue that early in an employee’s career, the firm has an advantage, because the firm (“intermediary”) can more accurately assess an employee’s talent than external clients. During what the authors call a “quiet period,” the company retains adequate performers and pays them standard salaries.
Workers accept temporarily lower wages because remaining at a top company signals their elite status in the market.
However, over time, an employee’s public performance—measured by successful cases, profitable investments, or well-executed projects—reduces the firm’s informational advantage. As the informational gap decreases, the firm needs to pay more to some employees because customers are now able to observe an employee’s good performance and therefore update their beliefs about the employee’s skills.
“At some point, the informational advantage becomes small enough,” says Caniel, “and the firm says, ‘Okay, I’ll basically start churning. I’ll let some employees go, and by doing that, I can actually get more out of the people who remain.'”
The irony is that customers find these fired or strategically fired employees just as good as the ones the company kept. Churn does not occur because these employees have failed, but rather because they may be somewhat less skilled than their peers. Subsequently, churn enhances the reputation of both the firm and the remaining employees.
a contradictory balance
Somewhat counterintuitively, researchers show that brainstorming can benefit both parties. Employees who remain at a specific company accept lower pay in the short term in exchange for building a stronger reputation for themselves. When these employees eventually leave specific firms, they can receive higher fees directly from clients.
What looks like a cruel system of constant employee turnover is, in fact, a finely tuned mechanism that helps the market find and reward true talent.
As a result of churn, the informational gap between the firm and the customer narrows as the customer learns what the company knows about its employees and who it values most. Both argue that at first glance, profits should now fall further due to the company’s low informational advantage. But here comes the strategic twist: The company begins to pay less to the better workers who kept their jobs, as if they had to pay to be “selected.” As a result, profits do not decrease and may even increase.
“Firms can now essentially threaten remaining employees: ‘Look, I can let you go, and everyone will think you’re the worst in the pool. If you don’t want me to let you go, you have to accept a below-market salary,'” Kaniel says.
The result is a contradictory but stable balance. Employees temporarily accept lower pay because remaining at a top company serves as a signal to the market about their elite status. This also helps explain why reputable employers can attract ambitious newcomers despite tough hours and relatively modest starting salaries.
Meanwhile, researchers argue that people who are let go are not failures – rather, their exit is part of a system that signals who is really top level. In fact, laid-off employees often find success on their own because potential clients interpret an individual’s prior affiliation with a top firm as evidence of the employee’s strong potential and qualifications.
In short, the “up or out” path of professional life may be not only a cultural phenomenon among top professional services firms, but also an efficient response to how reputations are maintained and information flows. Researchers argue that what looks like a cruel system of constant turnover is actually a streamlined mechanism that helps the market find and reward true talent.