Long-term Play

Choosing a CEO is considered to be the most important role of the board, but succession planning doesn’t stop with a new appointment.

Choosing a CEO is considered to be the most important role of the board, but succession planning doesn’t stop with a new appointment, writes David James.

One of the most important functions of a board is its choice of CEO. Choose a poor leader and the company will probably struggle. Choose a good leader and the company is more likely to perform to its capacity. However, neither is it just about choosing one person. It is, as Michael Robinson MAICD, director of Guerdon Associates, comments, a “multi-person event” that involves all levels of senior management, the board, and the enterprise’s future culture.

High levels of uncertainty have increased the pressure to get succession planning right, according to Paul Kerin, head of the School of Economics at the University of Adelaide. “Succession planning is even more important than in the past,” he says. “It is also more difficult. The environment is changing more quickly and this generates more uncertainty about the future. Ideally, a board should be forward-looking and say: ‘What is the environment we are going to face, what are the key challenges for the company?’ And then try to match internal and external candidates with the environment. It is hard to pick five or ten years out.”

If higher levels of volatility have put pressure on boards to make the right choice, there is increasing sophistication in the tools being used. Robert Webster MAICD, head of Korn Ferry’s global board services for Australia and Asia, says board atmospherics have altered greatly.

“There have been huge changes in the last decade. I guess succession planning wasn’t foremost on the minds of most boards. They generally allowed nature to take its course and if the CEO wasn’t performing, or the CEO retired, they would mostly go to a headhunter and look to someone outside. That wasn’t the case with every company but it was certainly the case with many,” he says.

Webster adds: “In recent years, boards have seen it as their most important duty to appoint the CEO and as soon as a CEO is appointed, they put the pressure on the CEO and themselves to put succession planning into place. As a consequence of that, companies like ours have become much more focused and much more scientific about the whole succession planning issue: the assessment of candidates, working out ways in which candidates can develop and improve skill sets, their personalities, the way they make decisions, the way they think, their learning ability and their mental agility. There has probably been a bit of a spike in turnover of CEOs in recent times because of poor company performance.”

Succession phases

Boards have gone through three phases in relation to managing CEO succession, according to Neil Waters, a partner with Egon Zehnder. “In the bad old days they would wait until they fired the CEO before they did anything and then it would be reactive,” he says. “Then there was a phase when it was seen as a human resources problem, something the board was interested in, but which they outsourced. Now, boards think about it in a much more sophisticated way as a rule. It is much more development focused, long term, and at the heart of the board agenda.”

One issue facing boards is whether to choose an internal contender, or look outside the firm. Robinson says about 70 per cent of CEOs are chosen from inside the firm, with the remainder external. “If a company goes external, it may be an indictment on the board that they haven’t done their job,” he says. “Going outside is a risk. Most of the research indicates that the most successful CEOs have been appointed from within.”

A 2006 study in the Journal of Corporate Finance by Anup Agrawal, Charles Knoeber and Theofanis Tsoulouhas found that outsiders are “handicapped”, implying that they should only be chosen if they are “markedly better than the best insider”. In particular, they argued, an insider’s experience of being a divisional head is good preparation for becoming a CEO.

But it is impossible to generalise about whether choosing externally or internally is better. Everything depends on the specific situation of the enterprise. Dr Meredith Doig FAICD, a former facilitator of the Company Directors Course for the Australian Institute of Company Directors and a professional director, says to make the choice of whether to go outside or choose internally, it is necessary for the board to “understand strategically what it wants to achieve and be very careful about damaging the company’s culture as opposed to just shaking it up.”

Kerin believes that because of the greater uncertainty in the operational environment boards should “make option plays” and create a wider range of potential choices. He says there is a case for having more people in the succession game, giving them different challenges in different parts of the company and weeding them out through that process. “On the other hand, because of the changing environment and challenges it is more likely, on average – still only in a minority of cases – that an external successor is going to be the right option. There are pluses and minuses there.”

Charles Macek FAICD, a professional director who was formerly on the boards of Wesfarmers and Telstra, provides two examples of how the choice of an internal or external successor will depend on the specific situation of the firm. He says companies typically look for an external appointment when the organisation needs a shake-up.

“In contrast, and I will use Wesfarmers as an example, when you have a very strong performance culture, which is an integral part of continuing corporate success, you don’t need to bring in outsiders. Part of reinforcing that culture is nurturing internal people as part of succession planning.

“But back in my Telstra days, when Sol Trujillo was appointed, the organisation in the mind of the board needed a shake-up, particularly in the area of strategy. There was a large pool of very talented young people that Ziggy Switkowski had brought in, which was his lasting legacy to the organisation. He recruited exceptionally talented people – but at that particular point of time none of them was deemed by the board to be ready for the CEO role. Thus an external appointment was inevitable. And, because of the specific challenges to that industry, telecommunications, if the individual wasn’t already in Telstra then they weren’t in the industry in Australia. So it was inevitable that it was likely to be an overseas appointment,” he says.

Having made the external appointment Telstra’s then-board set about working on the next succession, says Macek. “There was a recognition at the time of Sol’s appointment that there was a large pool of talented young executives within the firm, and the board made it clear that it wanted to see a number of those people developed to the point where they could be considered to be his successor. Thus succession planning in that instance started literally at the very moment of appointment of the new CEO.” When Trujillo left, he was replaced by an internal candidate, David Thodey FAICD.

Long-term view

The lesson is that succession should be considered in the context of the whole firm. Doig points to the importance of fostering the abilities of employees. “The other side of the coin of succession planning is talent management: getting talented young graduates into the organisation and then making sure they get a variety of experiences as they are promoted through the ranks. This sort of talent development takes 15 to 25 years, so tends to be restricted to the larger and more long lasting companies.”

Robinson says the incentive structures should be crafted so they encourage existing executives to think of succession. He says the boards that handle succession well have some key differences. Most long-term incentives tend to lapse if someone leaves, and “these executives are not focused on the long term in terms of who their successor is going to be.”

“But if their incentives remain on foot, as in, ‘OK, I am retiring now, but the incentives remain subject to performance conditions,’ they will be much more motivated to make sure their successor is a good one. It is very unfortunate that many companies and boards still haven’t cottoned on to this yet. Many CEOs are not particularly motivated to find their successors because they are not being given the incentive to do so. If you look at the next level down, it is the same for them. If their incentives remained on foot, they would be keen to make sure there is a pipeline of successors who can do their job at least as well as, if not better, than they have, so their incentives eventually pay out. It goes all the way down.”

How do boards know they have chosen well? To some extent an assessment relies on a counterfactual: knowing what would have happened if another person had been chosen. The most used measure is unsurprising: financial performance. “At the end of the day it boils down to dollars and cents, to a large extent,” says Webster. But he adds that boards also monitor the effect on the culture, using techniques such as employee engagement surveys.

Waters says there is a much greater acknowledgement that the perfect person does not exist, and the aim is to get an accurate picture of the candidates’ strengths and weaknesses. Then this is monitored. “Different executives will be on very different development paths. Part of it is directors recognising their own bias. Almost every director has prejudices but not all of them are conscious of them. The great ones are very conscious of their own preferences, such as the views they have on people. It can be very simple things. Research shows the average CEO is considerably taller than the average person, for example.”

A 2014 study of CEO performance and turnover by Shane Dikolli and William Mayew in the Review of Accounting Studies found that CEO survival is closely linked to the early period of performance. Board scrutiny declines over a CEO’s tenure.

Kerin says about two-fifths of CEO departures are forced by the board.

“A lot [of forced departures] are in the first two or three years. Boards recognise that there is uncertainty; you can never do due diligence perfectly. So they monitor a new CEO a lot more carefully. And they try to weed them out. After that they are more confident and they monitor less – provided the company is performing well.”

Another way of assessing the board’s choice of CEO is to “take a helicopter view” and assess whether the company has improved. Macek says a good CEO leaves the organisation in better shape than when they began the role. “That is the most objective criteria of a CEO’s success. At Telstra, all three CEOs, even though they were very different individuals – Ziggy Switkowski, Sol Trujillo and David Thodey were three different people in terms of style and perspective – [each] left the organisation in better shape than when they went into the role. Each of them has left a positive lasting legacy. The boards involved in those three appointments can reflect and say they have done a good job.”

Succession Planning

Key points

1. Choosing a CEO is now acknowledged as the most important task of the board.
2. It is important to structure incentives so that executives are encouraged to plan for the long term.
3. There is no general guideline about when to choose from outside or inside. It depends on the company’s specific circumstances.
4. As soon as a new CEO is chosen, boards should start planning for the next succession.
5. The flip side of succession planning is talent management.