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Hiring an Outsider CEO: Change is Not Always Good
Do firms really benefit when they hire an outsider as the CEO? Professor Nandini Rajagopalan writes from her research.
More than one-third of Fortune 1000 companies are run by CEOs recruited from outside the firm. Outsider CEOs are often hired based on reasons such as “the firm needs a fresh start” or that the firm needs someone to “shake things up.” Firms favour outside CEO candidates because “outside succession” is equated to “organisational change,” which is further equated to ‘‘better performance.” Generally speaking, CEOs recruited from outside the firm are more likely to make bolder changes than CEOs promoted from within the firm because outside CEOs bring new perspectives and experiences, and they are not constrained by prior commitments, formal or informal, with the firm’s internal stakeholders (especially, its employees). As a result, they are less likely to hesitate to make changes, especially painful changes such as cost-cutting, retrenchment and downsizing.
However, the dramatic, bold strategic changes initiated by outsider CEOs are not always beneficial from the viewpoint of firm performance. Too often, bolder changes are applauded because they are equated with adaptability and flexibility. Instead, empirical research shows that bolder changes can be detrimental to the firm’s performance because they may deviate from the firm’s core competences. The disruptive effect of bolder strategic changes can be further amplified if the firm’s leadership lacks a good understanding of the firm’s strengths and weaknesses, which may lead them to initiate large-scale but inappropriate strategic changes. Relative to CEOs promoted from within the firm, those recruited from outside the firm typically lack a good understanding of the firm’s core competences as well as its resource constraints and vulnerabilities. While outside CEOs may indeed initiate bolder changes than inside CEOs, the relative performance consequence of strategic changes under their leadership are often unfavourable.
Recent, large-sample empirical studies have found that outside CEO successions often lead to inferior post-succession firm performance as compared with inside successions. For example, outside CEO successions are associated with lower post-succession financial performance than inside CEO successions. To make matters worse, because an outside CEO succession is a disruption to the firm, it is usually followed by turnover of other top management team members. The departure of experienced top management team members can deprive the outside CEO ––—and the firm – of crucial managerial talent, especially during the critical transition period when the new CEO is developing familiarity with the firm’s resources and constraints, and this can further amplify the negative effect of outside CEO succession on firm performance.
The CEO Relay Race
One of my earlier empirical examinations of the effects of new CEO origin compared the performance consequences of relay CEO succession– in which a newly-appointed CEO has been in the Chief Operating Officer and/or President position and worked with the predecessor CEO in advance of the actual succession event–with the performance effects of non-relay inside successions (“horse race”) and outside successions. We found that relay CEO successions, on average, outperformed non-relay inside CEO succession and outside successions. This effect was particularly stronger when the firm had experienced poor performance in the time prior to succession. The beneficial effects of relay CEO successions may reflect the fact that a relay CEO succession process offers valuable learning benefits to both the firm and to the new CEO. On the one hand, the new CEO has the opportunity (prior to actually assuming the CEO position) to carry out some of the tasks of the CEO position, thereby acquiring and enhancing position-specific knowledge and developing broader leadership skills consistent with the position. On the other hand, the firm can conduct a focused and thorough assessment of the candidate’s cognitive and interpersonal capabilities, and continuously update its evaluation of whether the candidate’s capabilities match the needs of the firm. The firm can then use this evaluation to subsequently decide whether or not to promote the candidate. Thus, a relay CEO succession process can reduce the performance risks after succession, both for the candidate as well as the firm.
One could argue perhaps that the relative disadvantage of outside CEOs is temporary and may very well disappear over time. It may also be argued that outside CEOs’ advantage lies in their ability to break from the firm’s past strategies and thus make the firm more adaptive. So, what does our research into the long-term consequences of choosing insiders versus outsiders for the CEO position tell us? In more recent work we examined the entire tenure histories of nearly two hundred US manufacturing industry CEOs who left their positions (voluntarily or involuntarily) over a six-year time period. We found that in the first three years of tenure, strategic changes under the leadership of an inside CEO and strategic changes under the leadership of an outside CEO yielded essentially the same level of performance in terms of return on assets (ROA). However, after three years, bolder strategic changes initiated by outside CEOs were more disruptive and detrimental to firm performance than similar changes implemented under the leadership of an inside CEO.
When it comes to strategic change, outsiders typically are good at rapid cost-cutting and divestment. Also, because an outside CEO is typically brought in when a firm is not performing well, he or she tends to have a walk-in mandate for change. As tenure increases, obvious opportunities for cost-cutting and divestment dry up. Inside CEOs, presumably due to their deeper knowledge and understanding of the firm’s strengths and weaknesses, are more likely than outside CEOs to initiate and implement strategic changes that are consistent with the firm’s resources and capabilities and are more likely to enhance the firm’s long-term competitive advantage and growth. A troubling conclusion from our research is that the disadvantage of outside CEOs relative to inside CEOs is not temporary, and tends to persist, and even worsen, over time.
When it comes to strategic change, outsiders typically are good at rapid cost-cutting and divestment. Also, because an outside CEO is typically brought in when a firm is not performing well, he or she tends to have a walk-in mandate for change. As tenure increases, obvious opportunities for cost-cutting and divestment dry up. Inside CEOs, presumably due to their deeper knowledge and understanding of the firm’s strengths and weaknesses, are more likely than outside CEOs to initiate and implement strategic changes that are consistent with the firm’s resources and capabilities and are more likely to enhance the firm’s long-term competitive advantage and growth. A troubling conclusion from our research is that the disadvantage of outside CEOs relative to inside CEOs is not temporary, and tends to persist, and even worsen, over time.
More Risk, Fewer Returns
Outside succession also poses greater career risk for the CEO than inside succession. In another large-sample, empirical study, my research collaborator examined why some newly-appointed CEOs are fired after a short tenure (i.e., less than three years) and found that under the same performance conditions, outside CEOs on average are nearly seven times more likely to be dismissed with a short tenure than inside CEOs. An important reason, she argued, is that outside CEO successions are associated with a greater level of information asymmetry between the board of directors of the hiring firm and the CEO candidate. In other words, the CEO candidate knows more about his or her true competency than the board of directors. As a result, in an outside succession, the board of directors is more likely to hire the wrong person, and attempts to rectify the situation by firing the CEO within a short time period following the succession.
The greater career risk of outside CEOs has two other related outcomes, with further adverse impact on the firm. First, the hiring firm is generally forced to pay greater compensation and severance packages to outside CEOs in order to compensate them for their greater career risk. Among large US companies, outside CEOs on average earn 30-40% more non-contingent compensation (i.e., salary plus bonus) than inside CEOs. The compensation premium is even greater for outside CEOs without industry experience than outside CEOs with industry experience, because outside CEOs without industry experience face even greater career risk than those with industry experience. To further reduce their career risk, hiring firms need to pay outside CEOs expensive severance packages in case they are dismissed. Indeed, the terms of these severance packages are typically negotiated at the time the CEO is hired! This phenomenon was particularly evident in the well-publicised exit of Carly Fiorina, the former CEO of Hewlett Packard, who walked away with a severance package worth $42 million when she was ousted in 2005.
Second, outside CEOs are more likely to be dismissed, especially if they succeed a predecessor who was also dismissed. This may lead to a vicious cycle in the firm’s CEO succession process. Research shows that if a predecessor CEO was dismissed, the successor CEO was two times more likely to be dismissed, as compared with a CEO whose predecessor voluntarily left the CEO position. This is because the dismissal of the predecessor CEO often leads to the bypassing of a normal succession process and forces the board to select another new CEO in an unplanned manner. In addition, dismissing a predecessor CEO usually occurs under pressure from shareholders. As a result, the subsequent succession process is driven by the desire to quickly restore investor confidence rather than by a careful consideration of the CEO competencies the firm really needs.
In conclusion, outside CEO successions, high CEO turnover rate, and short average CEO tenure appear to go hand-in-hand. The bias in favour of outside CEO successions may have directly contributed to the continuing instability in the corporate suite and detrimental effects on firm performance.
Nandini Rajagopalan is Captain Henry Simonsen Chair in Strategic Entrepreneurship and Professor of Management and Organisation, Marshall School of Business, University of Southern California, and visiting scholar at the ISB.
This article originally appeared in ISBInsight Volume 9, Issue 2.