Research Perspectives on the New CEO
Academic studies of the recruitment of chief executives suggest that those from outside the industry do relatively well, companies pay more for generalists than for specialists, and “shadow emperors” hamper performance.(originally published by Booz & Company)
Management researchers are taking note lately of factors affecting recruitment, selection, and performance of new CEOs. Since mid-2012, a number of academic papers have explored the impact and performance of different types of incoming chief executives. Three particularly intriguing reports shed light on some broad and significant questions:
- When recruited from outside companies as new CEOs, are industry specialists or broad-based generalists more likely to be successful?
- Which new CEOs—specialists or generalists—tend to command higher salaries?
- What role, if any, should the old CEO play when a new CEO takes over?
Of course, there are no universal answers to any of these questions. Each successful company has its own unique circumstances. But the findings in these studies might prove particularly useful to those who make decisions about chief executives or have a stake in the outcome, such as boards, shareholders, sitting CEOs, and executives with aspirations for the top office.
A Premium for Cross-Industry Experience
Most firms consider outside candidates for CEO even if there are strong internal contenders. But how far outside? Should someone be brought in from another industry? A new CEO with industry-specific knowledge would presumably have better-informed judgment, but someone from another sector could offer fresh ideas.
“Outsider CEO Succession and Firm Performance,” by Abu M. Jalal and Alexandros P. Prezas of Suffolk University in Boston, examines the impact of appointing external candidates on a firm’s operating model and stock performance, and also on CEO compensation. The results suggest that many companies that look outside would do better in the long term by hiring someone from far outside—from another industry.
This finding, to be sure, applies to only about one-third of the large companies seeking CEOs. That is the percentage that, for planned transitions in 2012 at the 2,500 largest public companies in the world, chose an outsider as a new chief executive (see “Portrait of the Incoming Class,” by Ken Favaro, Per-Ola Karlsson, and Gary L. Neilson, s+b, Summer 2013). Even so, the number of CEO vacancies filled by outsiders, including those from other industries, has been increasing in recent decades.
No previous research had reached a conclusion about whether general managerial skills or specialized industry expertise has more value when leading a major company, especially when coming in from the outside. Jalal and Prezas aimed to fill the gap by examining the stock market’s reaction to the arrival of the two types of outsiders. They also looked at other results: the company’s stock performance, short-term profitability, and long-term growth potential during the five years that followed each new CEO’s arrival. Combining data from Compustat and the Center for Research in Security Prices, the authors analyzed outside CEO successions at 528 companies from 1993 through 2009; of these turnovers, 216 hires came from the company’s industry and 312 were from other sectors. (The study did not include CEOs hired from inside the same company.)
On average, firms bringing in someone from within the same industry had higher overall returns than those with non-industry outsiders, at least during the first few months. But the picture soon began to change. By the third or fourth year following succession, firms that had reached beyond their own industry to appoint a CEO posted better stock returns, on average, than those hiring closer to home.
“It appears as if initially the market is not as favorable about the prospects of firms hiring CEO successors from another industry, but once these firms introduce policy changes and demonstrate better performance under their new CEOs, the market turns and remains in their favor,” the authors write.
The companies that hired CEOs from a different industry also enjoyed other performance gains. On average, they paid more dividends to shareholders, engaged in higher capital spending, and demonstrated better operating performance, as measured through profitability and Tobin’s Q (the ratio of a company’s market value to the total value of its assets).
The authors also looked for correlations to explain why companies made the hiring choices they did. The greater the number of similar firms there were in the hiring company’s industry, the more likely it was that the new CEO would be hired from that sector. By contrast, firms that had smaller boards, more independent directors, or more members who were also sitting on other major company boards were more likely to appoint a CEO from another industry.
Paying More for Generalists
The Suffolk University study also found that CEOs brought in from another sector received more compensation than newcomers from the same sector. That finding jibes with another recent paper, “Generalists versus Specialists: Lifetime Work Experience and CEO Pay,” by Cláudia Custódio of Arizona State University, Miguel A. Ferreira of the Nova School of Business and Economics, and Pedro Matos of the University of Virginia. This study finds that CEOs who have accumulated more general managerial skills during their career have been increasingly better paid during the past two decades than their counterparts who specialized in one industry or company.
The authors assembled a database of almost 4,500 resumes from CEOs at firms in the Standard & Poor’s 1500 list from 1993 through 2007. This collection of resumes listed some 32,500 previous jobs. After indexing these documents, the researchers created a list of general skills that could be accumulated and transferred across companies and industries.
After controlling for many characteristics of firms and executives—including CEO age, tenure, and educational background—the authors found that generalists earned a significant pay premium compared with specialists. CEOs with more general abilities than the sample’s median received a premium of 19 percent in annual pay, on average, or almost US$1 million in extra compensation. Pay increased the most when the generalist CEO was also an industry outsider replacing an industry insider.
Pay was also higher than the median for generalist CEOs who were hired to oversee complicated projects such as restructuring or acquisitions. This implies that the labor market rewards CEOs who can guide their firm through a challenging business landscape. Indeed, the premium for generalists was higher at firms that were distressed, undergoing intense M&A activity, or operating in turbulent industries.
Although the premium for generalists was prevalent across sectors, it was higher in segments that had gone through regulatory and technological shocks in the past two decades, the authors also found. As an example, they cited the telecom industry, which has experienced disruptive leaps in innovation, shifting consumer trends, and legislation that has reshaped business models.
The researchers point to the late Michael H. Jordan as a model of the versatility and increasing value of high-powered generalists. Jordan was the CEO of PepsiCo from 1986 to 1990; of Westinghouse Electric from 1993 to 1998, overseeing the acquisition of the CBS television and radio network; and of Electronic Data Systems (EDS) from 2003 to 2007. His chief executive experience thus encompassed consumer nondurables, electronics and industrial supplies, broadcasting, and business services. While he headed EDS, Jordan was paid $10 million more a year than the average single-industry CEO was.
The Shadow Emperor Effect
Another recent paper offers worrisome findings for any new chief executive whose predecessor is looking over his or her shoulder. The paper, “When the Former CEO Stays on as Board Chair: Effects on Successor Discretion, Strategic Change, and Performance,” by Timothy J. Quigley of Lehigh University and Donald C. Hambrick of Pennsylvania State University, finds evidence that an ex-CEO who stays on as chairman can cramp his or her successor’s style and strategic initiatives—to the firm’s detriment.
The authors of this paper cite Booz & Company’s 2009 study of chief executive trends, “CEO Succession 2000–2009: A Decade of Convergence and Compression” (by Ken Favaro, Per-Ola Karlsson, and Gary L. Neilson, s+b, Summer 2010), which indicated that more than half of incoming chief executives were assuming office as their predecessor stepped up to the role of chairman. The percentage of companies with this dynamic was increasing worldwide, and it was particularly evident in North America.
Because lingering ex-CEOs can reasonably be expected to support policies they enacted themselves and have power over their replacements, previous researchers have referred to them as “shadow emperors.” It has been argued that they can blunt many of the desired effects of succession, such as breaking through inertia or increasing efficiency. But until now there has been a lack of quantitative evidence to show that these negative effects are actually occurring.
Quigley and Hambrick drew on the ExecuComp database to identify all 181 CEO successions between 1994 and 2006 in three industries: computer hardware, computer software, and electronics. These sectors were chosen because they are fast-moving industries with plenty of turnover at the top and a variety of leadership structures. Only companies that had been public for at least three years and that had annual revenues of more than $100 million at the time of succession were considered, in an attempt to eliminate the influence of younger companies that might face distinctive challenges. Interim and short-term CEO appointments were also excluded from this study.
The researchers measured firms’ post-succession performance for up to five years or until the new CEO departed, comparing return on assets (ROA), shareholder dividends, and stock returns. Extensive controls were employed, including company size and resources, pre-succession performance, and typical indicators of a board’s desire for change (such as hiring an outsider, forcing a turnover, or promoting an heir apparent).
The analysis showed that shadow emperors do indeed constrain their successors. The presence of a predecessor CEO significantly suppressed several types of strategic initiative: namely, resource reallocation, divestures, and the replacement of executives. Even more striking, as long as the predecessor stayed on as chairman, company performance tended to be about the same as before succession.
“In allowing predecessors to stay on as chairs—perhaps as an honorific courtesy or because of institutionalized custom—boards need to be vigilant of the possibility that their new CEOs may be explicitly or implicitly thwarted in their attempts to update their firms’ profiles,” the authors write. In a supplementary analysis, they discovered an abrupt increase in resource reallocation, divestitures, and executive replacement once the predecessor relinquished the chairman’s position. Performance, as measured by ROA, also then tended to diverge significantly from pre-succession levels, suggesting a predecessor’s influence does not linger long after he or she actually departs. In this way, a predecessor’s retention as chairman can be termed a “quasi-succession,” say the authors, delaying many of the typical after-effects of CEO turnover.
When a board is relatively confident in an incoming CEO’s ability to exert influence, it should probably part ways with the predecessor completely, the researchers conclude. But a departing CEO with valuable wisdom and experience should perhaps be retained in a consulting role for six months or so, enough time for the successor to settle in and feel comfortable charting a new strategic direction.
Can we draw conclusions from these three papers, and from others like them, about the best CEO candidates for a successful company? The value of generalist skills, as described in the first two papers, seems clear. But perhaps the critical factor is not what it might appear to be. Rather than breadth of experience, boards and recruiters should look for a proven track record of challenging conventional wisdom and experimenting with unconventional ideas—especially those that pay off.
The final paper is a warning to boards and recruiters not to hedge bets. If you hire a CEO to shift your company’s direction, don’t undermine that choice by keeping the old CEO around, at least not for more than a few months. Let him or her depart, ideally in friendship, but also in totality.
Reprint No. 00185
- Matt Palmquist is a freelance business journalist based in Oakland, Calif., and the author of s+b’s Recent Research column.