The High Cost of Poor Succession Planning
The following contribution corresponds to the Harvard Business Review portal and the authors are Gregory Nagel and Carrie Green
A Better Way to Find Your Next CEO
Many large companies don’t pay enough attention to their leadership pipelines and succession practices. That leads to excessive turnover at the top and destroys a significant amount of value—about $1 trillion a year among the S&P 1500 alone, the authors say…more
In August 2013, Steve Ballmer abruptly announced that he would step down as Microsoft’s chief executive as soon as his replacement could be found. Thus began one of the most consequential CEO searches of the past decade—and a case study in the dos and don’ts of top management succession.
At the time, Microsoft was the third-most profitable company in the United States and the fourth most valuable.
Yet this respected global tech giant did not seem to have a plan to replace Ballmer, even though, according to most informed observers, it had been underperforming for years (critics cite its slow transition into mobile, social media, and video, along with ill-fated acquisitions and product reboots).
While some high-profile executives, such as Windows chief Steven Sinofsky and Xbox chief Don Mattrick, had jumped ship during his tenure (another sign of trouble), with a workforce of 100,000, Microsoft could surely have identified other promising candidates in senior management positions, not to mention outsiders, who would be willing to take Ballmer’s place.
Instead, Microsoft appeared to start from scratch, focusing largely on outside candidates.
According to the director who chaired the search committee, the board cast a wide net across a range of industries and skill sets, identifying more than 100 candidates, speaking to several dozen, and then focusing intently on about 20.
Among them was Steve Mollenkopf, Qualcomm’s chief operating officer, who fell out of contention when he was promoted to that company’s top job.
Alan Mulally, fresh from a turnaround at Ford and the front-runner, took his name off the list in January, at which point the press described Microsoft’s board as turning to Plan B.
Finally, in February, six months after Ballmer declared himself a lame duck, Microsoft announced that a member of his team, Satya Nadella, would become the third CEO in its history.
We now know that despite that clumsy succession process, Nadella was an excellent choice
He moved Microsoft away from fiefdoms and a “know-it-all” culture and toward a more open and collaborative “learn-it-all” culture; he built the cloud computing business; he made Office available on every smartphone; and he executed dozens of profitable acquisitions, including the purchase of LinkedIn.
In his first nine months as CEO, Microsoft’s stock rose 30%, increasing its market value by $90 billion. As we write this, seven years into his tenure, it is the second most valuable company in the world.
But what if Microsoft had not promoted Nadella? What if its rushed, extremely broad, externally focused search had resulted in the hiring of an outsider? What if Mulally, who had no experience in the technology sector, had been appointed?
Why hadn’t the board already been grooming Nadella?
Why hadn’t the board already been grooming Nadella (a 21-year veteran of the company with clear leadership competency, cultural fit, and experience in emerging areas of technology) or any of his similarly qualified peers?
While Microsoft made the right decision in the end, its lack of planning could have led to a costly disaster.
Like Microsoft, many large companies fail to pay adequate attention to their leadership pipelines and succession processes. And most of them aren’t as lucky as Microsoft.
In our nine decades of combined experience in executive search and talent development (Claudio), professional investing (Carrie), and financial and management research (Gregory), we’ve seen flawed succession practices lead to excessive turnover of senior executives and, in the end, significant value destruction for companies and investment portfolios.
In our recent research we have attempted to quantify those costs
According to our analysis, the amount of market value lost due to poorly managed CEO and senior executive transitions in the S&P 1500 is close to $1 trillion a year.
We estimate that better succession planning could help the US large-cap stock market add a full point to the 4% to 5% annual gains that Wall Street projects for it.
In other words, company valuations and returns to investors would be 20% to 25% higher.
In this article, we will examine those findings and then make recommendations on how to significantly improve corporate performance and returns to investors through better practices for preparing and selecting CEOs. Of course, these lessons can also be applied to succession planning for other key senior management roles.
Quantifying the Problem
In our view, large companies’ excessive tendency to hire outside leaders is one of the biggest problems with succession practices.
This propensity generates three main types of costs: poor performance in companies that hire unfit outside CEOs, loss of intellectual capital in the top positions of the organizations that executives leave behind, and, for companies that promote insiders, lower performance from poorly prepared successors.
A landmark study that Rakesh Khurana and Nitin Nohria of Harvard Business School
conducted years ago sheds light on the first type of cost. Khurana and Nohria examined the impact that different types of CEO succession had on the operating returns of 200 organizations over a 15-year period.
They compared four scenarios:
(1) a promoted insider at a reasonably well-performing company; (2) an internal employee promoted at a poorly performing company
(3) an external employee hired at a reasonably well performing company
(4) an external employee hired at a poorly performing company.
They found that, on average, internal employees did not significantly change their company’s performance.
That makes sense: similar people working in similar ways at the same company will produce similar results.
In the case of external candidates, the change was much more radical. In the rare cases where a company was not doing very well, the externals added a lot of value, on average.
But in companies that were doing reasonably well, the externals destroyed enormous value.
This suggested that companies looking for a new CEO should hire external candidates only in rare cases, when a cultural shift or radical change is needed. Balint Alovits
Other research has confirmed that external hiring often fails to deliver on its promises
For example, Matthew Bidwell of the Wharton School of Business found that while external hires tend to have better experience and training than internal hires, they are paid more, perform worse, and have higher exit rates
Other studies back this up: one by Cláudia Custódio, Miguel Ferreira, and Pedro Matos showed that externally hired CEOs were paid 15% more than internally hired ones, on average
Another study by Sam Allgood and Kathleen Farrell
found that CEOs who come from outside are 84% more likely to be replaced than those who come from within within the first three years, usually for poor performance.
Another recent study found that companies often choose outsiders because they have already been CEOs at other companies, indicating that companies value prior experience in the position over the potential of insiders to excel.
But that experience rarely guarantees success: When researchers looked at S&P 500 CEOs who had run more than one company, they found that 70% had delivered better performance the first time around.
Despite those drawbacks, S&P 1500 companies hired their CEOs from outside 26% of the time between 2014 and 2018, according to ExecuComp data — perhaps because, as Wharton’s Peter Cappelli has found, companies have an irrational bias toward interesting, flawless outside hires about which they know less.
We wanted to investigate how outside CEOs performed relative to what insiders in the same positions might have done.
Without the ability to go back in time and run through different scenarios, it would seem impossible to do so. But we believe that with statistics we can predict what would have happened with different CEO hires.
We used a technique known as structural self-selection modeling (SSSM), derived directly from the research of Nobel Prize winner James Heckman.
It’s similar to the multiple regression model that companies frequently employ in forecasting and scenario planning exercises.
We first identified 80 independent variables, including firm characteristics (such as size and capital expenditures), industry, risk, board structure, and short- and long-term performance before and after a CEO change.
The performance metric we used was cash flow return on assets, which unlike operating return on assets takes into account the reorganization and restructuring costs that are common after an outside CEO comes in.
We then looked at each case in which an outside CEO was hired to run a U.S. public company over a 17-year period
and calculated the change in cash flow return on assets over his or her tenure. We plugged the 80 independent variables for each of those companies into the SSSM to create a “counterfactual”: what would have been the expected change in cash flow return on assets if the company had promoted an insider.
We found that only 39% of external hires would have performed better than a theoretical internal hire.
Large companies’ excessive tendency to hire outside leaders is one of the biggest problems with succession practices
Of course, no one knows in advance how any appointed executive will perform, but boards must base momentous and risky hiring decisions on their best estimate of future results.
Our analysis shows that in only 7.2% of cases will an externally hired CEO have a 60% chance of outperforming an insider, and in just 2.8% of cases will he or she have a 90% chance of outperforming an insider.
As dramatic as these numbers are, they only tell part of the story. A key effect of outside choices for CEOs and other senior positions is the loss of intellectual capital in the top executives of the companies from which those executives were hired.
And because, on average, executives perform worse at the company they join, the negative impact on the entire market is even greater.
We can calculate the effect that the loss of intellectual capital has on market valuations by analyzing the impact of sudden CEO departures and using the economic model provided by Hanno Lustig, Chad Syverson, and Stijn Van Nieuwerburgh to track how much intellectual capital a departing manager can transfer to his or her next employer.
Reduced intellectual capital and falling profitability
Our analysis shows that the decline in intellectual capital at companies where new executives previously worked leads to a 0.7 percentage point reduction in total shareholder returns for the S&P 1500, or $255 billion, each year.
If we add in the poor performance of companies that hire outside CEOs, total shareholder returns fall by about another half percentage point, costing investors an additional $182 billion.
The final impact, when companies do promote internal CEOs but fail to adequately prepare them to take over, costs an additional 0.3 percentage points, bringing the total loss across the S&P 1500 portfolio to $546 billion.
To calculate the third cost, we draw on a study of 2,900 companies by Northeastern University’s Olubunmi Faleye, which found that the return on assets of companies with poorly prepared internal CEO successors is significantly lower than that of companies that adequately prepared them.
A simple extrapolation of these findings to global stock markets, which together are worth about $58 trillion at the time of this writing, implies that total annual costs to global shareholders would amount to $870 billion.
This global estimate is likely conservative, given that governance, succession, and talent practices are typically significantly better in the United States than in most other countries.
We are currently expanding our analysis to other major stock markets to try to confirm this.
Another negative consequence of poor succession planning and excessive outsourcing is rising CEO pay as companies compete for the same top executives.
Financier Worldwide reported that across the top 350 US companies, the average CEO pay had risen to $17 million in 2018, or about 278 times the pay of a typical employee.
From 1978 to 2018, CEO pay had risen by more than 1,000%, while average worker pay had risen by only 12%.
While these numbers are alarming, our analysis shows that skyrocketing CEO pay actually plays only a small role in value destruction.
The main costs of poorly thought-out successions remain poor performance by outside CEOs, the loss of intellectual capital by senior executives in companies that CEOs and other senior executives leave behind, and internally promoted executives who are not well prepared.
A final note: We intentionally focused this analysis on large companies because we believe that is where the problem of poor succession at the top is most acute.
Small companies often lack a deep talent pool, so they can best benefit from hiring outside CEOs.
Implementing Solutions
Why are some of the world’s largest and most powerful organizations making such misguided CEO appointments?
For five main reasons:
lack of attention to succession, poor leadership development, poor board composition, lazy hiring practices, and conflicted search firms.
Here are some recommendations for fixing those problems.
Plan for succession long before you think you need to do so. According to PwC’s latest Strategy& CEO Success study, CEO turnover at the world’s largest 2,500 companies reached nearly 18% in 2018, the highest rate ever recorded by PwC. A disturbing 20% of those CEOs who left were forced out, and for the first time in the study’s history, more CEOs were fired for ethical misdeeds than for financial performance or conflicts with their boards.
Looking ahead, we suspect that unplanned CEO turnover will continue to rise due to increased attention to moral issues (such as sexual harassment) and industry and market volatility.
Despite this trend, boards continue to be caught off guard because they have not spent enough time developing talent and mapping out potential succession lines.
Some believe that it is enough to have an informal “if tomorrow the CEO gets hit by a bus” plan, which selects a replacement but does not groom or vet that person or weigh alternatives. Not so.
Others delegate succession planning to the CEO, which is an equally unacceptable abnegation of duty.
For example, we know of a major company, valued at hundreds of billions of dollars, with a CEO in his late sixties who has been unwilling to adequately develop any potential replacements.
Unfortunately, because the company’s recent results and stock market performance have been good, board members are afraid to confront him.
Balint Alovits’ Time Machine project explores the Bauhaus and art deco spiral staircases of Budapest, using perspective and repetition of shapes to evoke a sense of infinity. Balint Alovits
Succession planning should begin the moment a new CEO is appointed
Take Ajay Banga, former CEO and current chairman of Mastercard, for example: He began discussing when he might hand over the CEO role to a successor even while he himself was in the process of interviewing for the position.
The process should remain robust, with directors constantly monitoring and, if necessary, adjusting the process. If there is not yet a potential successor among the CEO’s direct reports, the board should look to the next level and consider promotion and development opportunities that will help executives there progress.
If that level is empty, directors can promote or hire high-potential individuals to join it or senior manageme
