UP OR OUT? Turnover at top firms can benefit both the employee and the employer. (Getty Images photo)
Elite firms’ notorious ‘revolving door’ culture isn’t arbitrary but a rational way to signal talent and boost profits, a new study finds.
Why do the world’s most prestigious firms—such as McKinsey, Goldman Sachs and other elite consulting giants, investment banks, and law practices—hire the brightest talents, train them intensively, and then, after a few years, send many of them packing? A recent study in the American Economic Review concludes that so-called adverse selection is not a flaw but rather a sign that the system is working precisely 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 person, particularly in fields such as law, consulting, fund asset management, auditing, and architecture. They argue that much of the professional services world operates through “intermediaries”—firms that both hire employees (also referred to as “agents” or “managers”) and market their expertise to clients—because clients can’t themselves easily judge a worker’s ability from the outset.
“Identifying skilled professionals is critical yet presents a major challenge for clients,” the researchers write. “Some of the firm’s employees are high-quality managers,” says coauthor Ron Kaniel, the Jay S. and Jeanne P. Benet Professor of Finance at the University’s Simon Business School, “but the firm is paying them less than their actual quality, because initially the employees don’t have a credible way of convincing the outside world that they are high-quality.”
‘Churning’ to boost reputation
At the start of an employee’s career, the firm has an advantage, Kaniel and his coauthor Dmitry Orlov contend, because the firm (“the mediator”) can assess an employee’s talent more accurately than outside clients can. During what the authors call “quiet periods,” the firm keeps those who perform adequately and pays them standard wages.
Workers accept being underpaid temporarily because remaining at a top firm signals their elite status to the market.
Over time, however, 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 shrinks, the firm needs to pay some employees more because clients are now able to observe an employee’s good performance and hence update their beliefs about the employee’s skills.
“At some point, the informational advantage becomes fairly small,” says Kaniel, “and the firm says, ‘Well, I will basically start to churn. I will let go of some employees, and by doing that, I can actually extract more from the remaining ones.’”
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