Consider all options

Thursday, 01 October 2015

Professor Paul Kerin photo
Professor Paul Kerin

    Professor Paul Kerin considers the pros and cons of external and internal candidates when appointing a chief executive officer.

    With the benefit of hindsight, many chief executive officer (CEO) appointments do not work out. Up to 40 per cent of CEO exits are forced by the board, so how can boards best ensure their CEO choices prove successful in practice?

     Consider the choice between insider and outsider appointees and how boards can best support them pre- and post-appointment. Statistically, on average, insiders and outsiders perform equally well as CEOs on measures such as shareholder returns and return on assets. However, outsiders perform better in some circumstances and insiders perform better in others.

     Empirical studies show that outsiders perform better if appointed when a firm is performing poorly or when industry growth is high. This is not unexpected, as these circumstances call for major change to lift performance or capture growth opportunities. Outsiders’ new perspectives and lack of internal baggage enable them to  lead such change more successfully. However, the evidence shows that insiders perform better in other circumstances, largely because firm-specific human capital is very valuable. It is particularly valuable in more complex firms. Consequently, larger and more diversified firms are more likely to appoint insiders.

    There is another important reason why firms favour insiders: it motivates internal executives to work very hard. The higher the perceived probability of internal succession, the stronger the motivation is; empirical evidence demonstrates that this significantly improves firm value. Therefore, most CEOs are appointed from within. About 60 per cent of appointees are long-term insiders, 20 per cent have joined from the outside within the previous two years and 20 per cent are complete outsiders. 

    How can boards best ensure that internal candidates are ready to be CEO? Researchers have studied two main strategies. Most boards adopt the “relay” strategy. An heir apparent is designated well before the current CEO’s expected exit time and given extra responsibilities to groom (and test) him or her before the baton is passed. About 40 per cent of large companies have a designated heir apparent four years beforehand and 60 per cent have one immediately before the CEO exits. The heir apparent’s succession is not guaranteed; studies show that it depends heavily on share price performance in the year prior to the current CEO’s exit.

    Other boards adopt the “horse race” strategy, in which multiple insiders compete to be the next CEO. The choice between these strategies involves trade-offs. A horse race motivates multiple insiders to work very hard. By designating an heir apparent, a relay strategy can lessen other insiders’ motivations; however, it enables greater focus on grooming the heir apparent to succeed. A horse race may work better in firms with competitive cultures and multiple business units that have few synergies between them.

    However, when synergies and cross-company co-ordination really matter, this favours a relay strategy. Of course, these strategies are not mutually exclusive. Often, a horse race is run before an heir apparent is designated. A pure relay strategy – putting all your eggs in the heir apparent’s basket – is risky. Boards need to maintain flexibility. The next CEO should represent the best fit with the firm’s expected future challenges and opportunities. 

    A common blended strategy is to identify and recruit an outstanding outsider a couple of years before a new CEO is needed. That way, the board can test the outsider’s fit in practice and the outsider can build firm-specific human capital and become the complete package, ready for a flying start as CEO. Outsiders recruited directly into the CEO role need an understanding board early in their tenures. 

    For example, evidence shows that outsiders are more successful if they replace some members of the management team quickly; this helps boost their support and reduces remaining management team members’ resistance to change. Boards can help by not questioning such changes. Evidence also shows that outsiders perform better when they take time to understand the firm’s business and culture, and build relationships before making major strategic changes. However, boards often appoint outsiders to engineer major changes quickly; new CEOs can easily succumb to perceived pressure and act too quickly. Board patience pays on the strategy front.

    Skills education – a major prerequisite for a productive and competitive economy – is still run separately by each state. Workplace relations and work health and safety remain with a semi-complete national regulatory structure. These are areas in which the division of Commonwealth and state responsibilities must be resolved.

    The only notable success of the last 10 years, although still a work in progress, is the National Disability Insurance Scheme.

    Finally, Australia’s governments need to commit  to an agenda of practical federalism in microeconomic reform and the elimination of the remaining areas of duplication. When was the last time you heard a Prime Minister or Premier talk about microeconomic reform? While there are some signs of hope, not since Bob Hawke and Nick Greiner’s “New Federalism” agenda in the early 1990s have we heard a shared vision for reform. These debates require reasoned argument and the willingness for us all to win and lose for the nation’s betterment.

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