There are probably several reasons underlying the differing fortunes of insider and outsider CEOs. Last year, we hypothesized that outsiders have a mandate from the board to oversee a major, needed change, but frequently lack the personal networks, cultural understanding, and deep knowledge of the multiple operating environments — in sum, the “social capital” — to sustain change and high performance at a firm throughout their tenures.
But there’s probably a more subtle reason outsiders fail more frequently than insiders. Outsiders typically are brought in to execute a specific playbook — to solve this problem now in this way. But in our experience, the most successful CEOs are those who can adapt and modify the playbook, their own leadership styles, or both; they create new directions as needed. It’s a rare skill, and it seems to reside primarily, and somewhat ironically, with untested insiders.
Why do boards increasingly hire outsiders despite this spotty track record? Part of the answer may be the incorrect assumption that outsiders are better equipped to drive major change. But we think there’s another, knottier reason: the shortage of attractive internal candidates.
Consistent with our hypothesis that there’s an inadequate pool of attractive CEO candidates, boards are also increasingly turning to executives who have previously been CEO of another publicly traded corporation. In 2003, 11 percent of departing CEOs were completing at least their second turn as a chief executive, more than double the percentage over the previous five years we studied. But, as with outsiders, prior CEO experience does not correlate with superior performance. To the contrary, across the six years studied, CEOs who previously led other companies delivered returns for investors 3.7 percentage points per year lower than those of first-timers globally. (See Exhibit 11.)
It is interesting to note that prior CEOs underperform during the first half of their tenures. Apparently, experience as CEO of a publicly traded company does not contribute to a strong start as much as does time spent working in a company’s various business units — the usual path for those who haven’t previously been a CEO.
Boards of directors play four critical governance roles: removing underperforming CEOs, ensuring effective internal control systems, helping the CEO and management team sustain superior performance, and creating viable successors to the CEO. Too often, discussions of governance reform focus on the first two roles. Although that focus is understandable, given the accounting problems surfacing in both Europe and North America and the notorious (but not numerous) examples of long-tenure, underperforming CEOs, we think the debate should be rebalanced, with far more attention paid to helping the current CEO and ensuring a smooth and effective succession process.
At leading companies, the leader doesn’t make the company — the company makes the leader. Well-managed companies have institutionalized the ability to extend and perpetuate a good management system.
The governance debate presumes that easier removal of underperforming CEOs will enhance returns to investors. In 1995, when only 1.1 percent of CEOs were removed for poor performance, that presumption was probably right. In 2002 and 2003, when three to four times as many CEOs were removed for poor performance, we might have reached the point of diminishing returns.
At some juncture, the prospect of forced dismissal will seem so likely that it will hang like a cloud of misery over a chief executive, undermining his or her ability to perform. Concerned about their mortality, CEOs will try to get even more done quickly, emphasizing quick fixes at the expense of company transformation. Revolving-door CEOs will likely face increasing difficulty in driving change — much like the difficulties elected officials face with public sector bureaucracy.