External CEOs cost more, deliver less

2011

Companies that embark on expensive and lengthy searches for a new CEO could well be wasting both their time and money. Because according to a 20-year study of American S&P 500 non-financial companies, companies that only appoint internal candidates as CEO significantly outperform those that appoint outsiders to the top job.

The study, by The Kelley School of Business at Indiana University and management consultants A.T. Kearney, identified 36 companies that exclusively promoted CEOs from within their own ranks between 1988 and 2007. These include Abbott Laboratories, Best Buy, Caterpillar, Colgate-Palmolive, DuPont, Exxon, FedEx, Honda, Johnson Controls, McDonald's, Microsoft, Nike and United Technologies, among others.

It found that these companies outperformed other companies across seven measurable metrics - return on assets, equity and investment, revenue and earnings growth, earnings per share (EPS) growth and stock-price appreciation.

The analysis also found that no non-financial S&P 500 company with an externally recruited CEOs generated 20-year performance numbers that surpassed or even equalled those of the top 36 in the above metrics

And it isn't just poor performance that characterises external CEOs. The cost to attract them in the first place is significantly higher than that of internal candidates. The average total compensation - salary, bonus, and equity incentives - for external CEOs is 65 per cent higher than for those promoted from within.

Yet despite this, four out of 10 of CEOs recruited from outside stay in the jobs for two years or less and almost two-thirds are gone before their fourth anniversary – many taking with them hefty "golden goodbye" payments .

Paul A. Laudicina, chairman of A.T. Kearney, said that recruiting externally is often far more risky, costly and disruptive than seeding succession from within, underlining just how important it is that boards proactively manage their leadership pipelines.

"Boards of directors often fail when it comes to CEO succession planning," he said. "Rather than focus on leadership development and creating a qualified stable of internal CEO candidates, boards too often end up going outside the organization to fill the top spot. Unfortunately, their stakeholders more often than not pay a big price for their star search."

The study concludes that an effective process of succession planning and fully-engaged boards of directors is critical to selecting the right leader. The process must be comprehensive and institutionalized in the company, and it must include a long-term understanding of candidates' records, references, leadership style and values under various conditions and in different roles.

And as Phil Morgan, partner at A.T. Kearney London, pointed out, these are responsibilities that cannot be left to the CEO, the Chief Human Resources Officer, or just to chance.

"Boards need to develop relationships with CEOs that enable them to monitor, advise and, when necessary, adjust the process to ensure that a talented executive is ready to step in, whether in an emergency or over a three- to five-year transition."

Older Comments

This piece contains many valid points about the importance of CEO succession planning. Unfortunately, it also paints a simplistic and misdirected picture of the relative merits of internal and external CEO candidates that doesn’t accurately reflect the real-world considerations many companies face.

The article states that “Companies that embark on expensive and lengthy searches for a new CEO could well be wasting both their time and money. Because according to a 20-year study of American S&P non-financial companies, companies that only appoint internal candidates as CEO significantly outperform those that appoint outsiders to the top job.”

No one would dispute that any company exhibiting the talent-development and succession-planning acumen needed to consistently produce suitable internal CEO candidates over a 20-year period is likely to be high-performing. As a leader in both CEO executive search and board advisory services, we at Spencer Stuart also wholeheartedly agree that succession planning is perhaps the most critical responsibility of the board.

But many companies lack the scale and track record of talent development that the stable, mostly blue-chip companies highlighted in the A.T. Kearney/Kelley study demonstrate. For most companies faced with an immediate or approaching CEO succession event, considering the relative merits of internal and external candidates is no waste. In fact, it is an obligation for boards that wish to do their due diligence in making an informed CEO selection decision.

We recently completed a major study of CEO transitions that was published in the November 2010 Harvard Business Review. We analyzed each of the 300 CEO transitions that occurred at S&P 500 companies between 2004 and 2008.

Our analysis found that there was no overall difference in the performance of CEOs promoted from the inside versus appointed from the outside. Instead, we found that the main factor influencing the relative performance of the insider and outsider groups was the health and competitive position of the company at the time of succession.

Of the 300 transitions we studied, 218 involved companies that were healthy (i.e., stable or growing). In those companies, insider appointments were three times more likely to achieve outstanding performance than outsiders. In the 82 companies we studied that were in a challenged condition or crisis, however, the opposite was true. In these troubled companies, outsiders achieved outstanding performance at three times the rate of insiders.

For some companies, an insider is the best answer; for others, an outsider may be the best ' and is sometimes the only ' choice.

Prudent succession planning involves a commitment to both internal talent development and to gaining an understanding of the overall talent market. Our experience indicates that the wisest decisions are typically made not by relying on platitudes about internal versus external candidates, but by considering all appropriate options and then selecting the right individual for the company’s current situation and future needs.

In the end, such a conscientious approach to succession planning will always yield the best results, even though CEO selection remains ' and will always be ' part art, and part science.

James M. Citrin, Co-leader, North American Board & CEO Practice, Spencer Stuart