In addition, outsiders are more likely to inherit companies performing poorly — 5.3 percentage points worse for investors over the two years prior to selection of the new CEO than is the case for companies where insiders are appointed. Much of the difference is social. Insiders are known; they are products of the company and its culture, and they unquestionably understand what’s distinctive and valuable about the company. Outsiders are, well, outsiders. Employees and channel partners are suspicious that the outsider will just cut costs to boost margins in the short term (and, perhaps, to prepare the company for a sale). No wonder outsiders excel at big structural changes, like cost reduction and asset sales, that deliver value to investors in the first three or four years but don’t require the kind of organizational and cultural transformation that may deliver increased value over the long run.
One implication of the pattern of insider/outsider performance for boards of directors is the “five-year rule”: Boards that hire a CEO from the outside should plan for the chief’s tenure to last about a half decade. A series of outsiders, each hired to lead a specific transformation and each remaining in office for four to five years, could prove even more effective than long-term insiders. Companies like Yahoo, where Terry Semel followed Tim Koogle, and Qwest, where Richard Notebaert replaced Joseph Nacchio, are testing the viability of a series of outsider-driven transformations. To be sure, this kind of strategy requires a different kind of planning. Boards could focus on recruiting only the skills needed by a CEO in the next five years, but then would have to begin recruiting or grooming a successor almost as soon as the new CEO is hired.
Governance’s Next Wave
Governance reforms to date have addressed the “agency problem,” the innate conflict between the interests of owners (investors) and those of managers, even though managers are ostensibly acting in the shareholders’ interests. As early as the 1980s, leveraged buyouts targeted companies ripe for restructuring, singling out in particular those chief executives who had stockpiled cash to insulate their companies from the discipline of the stock and bond markets. More recently, the wave of governance reform described above has pushed boards to move more quickly to remove underperforming CEOs.
Because these reforms have been successful and boards of directors have stepped up to advocate on behalf of shareholder interests, we feel that the most deleterious aspects of the agency problem have been addressed. Some governance activists will lobby for additional expansions of shareholders’ authority, for example, declaring that resolutions that receive majority support will be binding upon boards, or requiring shareholder votes on merger offers. However, the proposals we’ve seen for expanded governance reform do not seem to be clearly in the interest of shareholders, much less other stakeholders, and skillful boards will learn to circumvent the rules.
In any case, corporate governance issues are increasingly shifting away from agency-related issues and toward strategic issues. Boards will become more deeply involved in creating value by helping management better identify threats and opportunities, by supporting management’s efforts to effect major change, and by enhancing the quality of the management team. Although self-confident CEOs invite their boards to perform these tasks today, management typically leads in formulating strategies and plans, and the board reacts. That won’t last: In today’s demanding, rapidly changing world, a reactive role for the board isn’t enough. An effective board is better equipped than are institutional investors, hedge fund operators, or private-equity firms to ask probing questions and suggest value-creating changes in strategy or organization.
During the past decade, successful companies have learned to mobilize the best thinking of employees at all levels. The next governance wave will enlist the full insights and experience of the board of directors as well, fundamentally changing the governance relationship between management and the board, and requiring much greater involvement by directors. The companies that thrive in this environment will be those in which the CEO and the board maintain a healthy level of tension, while keeping their eye on the long-term growth of the enterprise. Without returning to the “imperial CEO” of the past, such companies will also avoid the costs and turbulence of a high CEO turnover rate.