Good governance includes succession planning
The tenure of CEOs at listed companies is getting shorter and shorter. Yet, boards are often unprepared when it comes to finding a new CEO. For all company directors and equity investors here is a brief guide on what to do and not to do when it comes to replacing a CEO or a CFO.
Claudio Fernandez-Arao from Harvard Business School and his collaborators have done a great job summarizing the impact CEO hires have not just on the company that hires the CEO, but on the portfolio of equity investors and the corporate ecosystem as a whole.
Basically, they realised that when a company hires a new CEO, it has to make a choice between promoting internally or hiring someone externally. From a company’s perspective, it makes sense to hire an external candidate if they believe that the knowledge and experience this candidate has can make the company more profitable in the future. However, if they hire an external candidate that has detrimental effects on other companies. First, the new hire leaves behind a knowledge gap in her previous company which is a cost to that company. Second, by hiring externally, CEOs everywhere gain market power because every new hire is benchmarked against typical CEO salaries and the new CEO will likely get more money for joining the new company. Thus, with every external hire, CEO salaries rise and costs for companies everywhere increase.
Equity market investors typically hold not just the stock in the company that hires a new CEO but in many other stocks, most likely also in the company that loses a key person. So for equity investors, the question is what is the net impact of these three factors (loss of knowledge from a departing executive, gain in profitability from that executive joining another company as CEO, overall increase in executive compensation) on their portfolio? For boards, on the other hand, the question is simply, is it better to bring someone external in as new CEO or should we hire internally?
Let me answer the board’s question first. The literature is near unanimous in its verdict. Externally hired CEOs or CFOs on average do not add value to a company in the form of higher profitability. In fact, many external hires engage in restructuring exercises which create additional costs and typically reduce productivity in the short term due to employees fearing about their jobs or jumping ship. This result is replicated in the study quoted above. Even more so, they look at the performance of hiring high profile, highly credentialed external candidates as CEOs and find no discernible increase in corporate profitability from these high-profile hires. Yes, the share price usually jumps after a new externally hired CEO is announced, but that jump only reflects the hope that the new person will be able to turn the company around – a hope that will soon be squashed.
So, here is top tip number one: If you are a director and have to replace the CEO or the CFO, try finding someone internally. The chances of finding a new executive who will be able to make a material difference are slim at best, no matter what the headhunting firms tell you. Also, if you are an investor and you hold shares in a company that just announced a new external hire for CEO, use the share price jump to take profits and invest your money elsewhere. If against the odds, the new CEO does make a difference, you can always come back once the evidence is materialising.
But while externally hired executives don’t make a material difference to the company they join, their departure hurts the company they leave. The loss of institutional knowledge in their previous company is difficult to compensate for and leads to a measurable and significant decline in profitability and share price of their previous company. Compare this to an internal hire. If the internal hire has been trained as a potential successor to the CEO of a company (for example by being a member of the board of directors and by taking on different roles within the company) the costs of the internal hire are minimal. They are clearly bigger if the internal hire has no prior experience as a senior executive and wasn’t groomed to be a successor. But these costs are much, much smaller than the costs of hiring an external CEO. The study above suggests that the costs of hiring an external CEO to the S&P 1500 stock index are some 1% of market value per year compared to a situation where all S&P 1500 companies would hire their CEOs internally from well-prepared candidates. If all S&P 1500 companies would hire internally and all candidates were unprepared, the costs would amount to a mere 0.3% per year.
So, here is the top tip on how to hire a CEO from best option to worst option (and this ranking applies to both directors trying to find an executive and shareholders trying to identify the most profitable companies):
Best option: Groom successors for your CEO and CFO internally and spend a lot of time on preparing them as best you can for their future roles, for example by making them executive board members.
2nd best option: Hire an internal successor to your CEO even if he or she hasn’t got enough senior management experience.
If you must: Hire an external candidate as CEO or CFO but don’t expect any miracles.
Worst option: Hire an external candidate as CEO or CFO and then let that person restructure the company. That is highly likely to destroy value for your company and your shareholders.