Role of the chair

Organisations seeking cultural change are more likely to appoint an “outsider” CEO who can drive transformation than an “insider”, or so the theory goes.

“If directors want to enhance culture by building on what the organisation already has, an insider CEO appointment makes sense. If they believe the organisation’s culture needs an overhaul, an external CEO appointment might be more appropriate.”

Professor Ian Harper, Dean of the prestigious Melbourne Business School and a Reserve Bank board member, has a different view. He believes organisations wanting to strengthen culture and trust – a governance priority after the Banking Royal Commission – should mostly promote from within.

“When boards appoint a CEO from outside the organisation, they risk damaging the trust and goodwill of high-performing internal teams,” he says. “Ultimately, it depends on whether the board sees the culture as an asset or liability. If directors want to enhance culture by building on what the organisation already has, an insider CEO appointment makes sense. If they believe the organisation’s culture needs an overhaul, an external CEO appointment might be more appropriate.”

The debate between outsider and insider CEO appointments has intensified after the Banking Royal Commission and amid ongoing market disruption in the digital economy.

An outsider CEO can bring new skills and perspectives – and a clean slate if the board wants to shake up the organisation. Also, the CEO might bring along some of his or her team, strengthening executive ranks, and be more inclined to make tough decisions faster.

The outsider CEO appointment, however, is riskier. The board has not seen the outsider close-up in action or built a relationship with the person. Also, an outsider CEO who implements rapid change can create organisation disruption and uncertainty; the chairperson has to spend extra time with the outsider at the start; and higher pay might be needed to recruit him or her.

In contrast, an internally appointed CEO is better known. Effective boards ensure there is a pool of internal CEO candidates, watch them in action through board presentations and other interactions, and build a relationship with them. They know what they are getting.

Because the organisation’s strategy, culture, staff and customers are understood, the insider CEO should be less disruptive. Other executives could stay with the firm because they know the new CEO’s leadership style and have a relationship with him or her. The board, too, might feel it has more influence with an insider CEO who understands the board/management dynamic.

The potential risk is the insider CEO sticking too close to the status quo, making fewer bold decisions and taking longer to implement change. Further, the insider CEO might be less inclined to shake up an organisation culture or business model he or she may have co-developed.

That is the theory. The reality is every organisation, board and CEO is different, and circumstances usually dictate external or insider appointments. A company with a strong pool of internal candidates and a satisfactory culture might see little need to look outside for its next CEO. Another organisation with talent issues – or a need to change how things are done or bring in new ideas – may prefer to look outside.

Boards are well aware that appointing the CEO is their most important governance task and that succession-planning oversight is critical. But even the best succession planning sometimes goes awry if an executive being groomed for the CEO role leaves suddenly.

Global trend towards insider CEOs

The share of incoming outsider CEOs in 2018 was the lowest since 2007 at 17 per cent, found the 19th PwC CEO Success Study of the world’s 2,500 largest companies. Simply, boards globally are increasingly appointing CEOs from within, rather than from other organisations.

That is a suprising result on three fronts. First, CEO turnover worldwide soared three percentage points to 17.5 per cent in 2018, according to PwC. Long-serving CEOs are more likely to recommend the appointment of an internal candidate as their successor to the board, but CEO tenure remains low at about four years and turnover is rising.

Second, CEOs who joined from outside outperformed insider CEOs (by firm performance) in five of the past six PwC studies. That differential might be explained by market disruption, technological advances and other competitive dynamics: an external CEO who is recruited for a specific skill set could have an advantage over internal candidates.

Third, institutions worldwide grappled with “crisis of trust” in recent years, according to the Edelman Trust Barometer. In Australia, the Banking Royal Commission this year and the Australian Prudential Regulation Authority’s report last year on the Commonwealth Bank highlighted shortcomings in organisation culture. At face value, that suggests companies would be more likely to appoint an outsider who can improve organisation culture over an insider CEO.

But Australian companies are defying international trends on CEO appointments. A survey by executive recruiter Robert Half found 35 per cent of ASX 200 CEO appointments were recruited externally. That suggests Australia is ahead of the curve in outsider appointments (compared to PwC’s global finding of 17 per cent), although care is needed in relying on survey results that can be volatile year-on-year, and in comparing studies.

Professor Harper says Australia’s relatively higher rate of outsider CEO appointments is partly because of the internationalisation of business. “More of our companies have sought CEOs with deep experience offshore, to develop and implement international growth strategies. Internally appointed CEOs in Australia mostly have domestic experience but that will change in the coming decade, particularly among younger professionals who understand the need to gain international experience and skills.”

Harper says boards must consider the potential effect of an outsider CEO on culture. “High-performing organisations typically consist of high-performing, autonomous teams who believe in the firm’s wider goals. Boards should think carefully about how an outsider CEO could affect those teams, and staff trust and goodwill in the organisation. Most boards are aware of these challenges and opportunities, but some may not have thought sufficiently about the interplay between organisations culture and the appointment of an outsider or insider CEO.”

External appointments likely to rise

Professor Julie Cogin, Pro Vice-Chancellor Business at RMIT University in Melbourne, says Australia’s largest companies have effective succession-planning practices – a credit to their board. “Approximately 60 per cent of CEO appointments (in Australia) come from within the ranks, which is higher than the US and UK. That suggests our top firms are doing a good job of retaining talent – and are benefiting from shorter adjustment periods and increasing stability during change at the top.”

However, Cogin believes the rate of outsider CEO appointments in Australia will rise. “I’d expect to see a shift towards external CEO appointments due to the acceleration of disruptive innovations caused by technology and globalisation, as well as changing demographics. New business models are being introduced at an ever-increasing rate and with declining costs. Many examples show size and scale are not a barrier to disruptive potential. Boards and CEOs need to be focused on accelerating the speed of execution, as well as their firm’s agility to seize new opportunities.”

An internally appointed CEO can struggle with market disruption, says Cogin. “A high-performing internal candidate for the CEO position is more likely to identify with the existing model, which he or she will have driven and invested in. The candidate may come with overconfidence that the previous way is right, regardless of external changes. There are only a small number of CEOs who have been able to successfully disrupt their own businesses for this very reason. An external appointment brings a fresh perspective to question the status quo, introduces competitive intelligence and access to external talent.”

She says boards of high-performing companies with strong cultures are more likely to appoint an internal candidate, to maintain stability. Macquarie Group’s elevation of Shemara Wikramanayake to CEO in 2018 after Nicolas Moore’s departure is an example.

Cogin says organisation culture will have greater influence on the choice of outsider over insider CEOs. “Research provides evidence that when there is a huge gap between the existing culture and the desired culture, external hiring of senior leaders is the best approach as they will be in a better position to reform the culture. An internal hire is more likely to be subject to the same corporate blind spots as the prior incumbent and unable to eliminate dysfunctional behaviours.”

She adds: “The (Banking) Royal Commission highlighted the need for comprehensive reforms of corporate cultures. The public response to the Royal Commission has confirmed that successful organisations of the future will be those that are trusted by their customers, employees and the community alike. It is going to be challenging to repair trust following breaches with an internal CEO appointment.”

“With greater focus on culture and wide acceptance that culture can impede strategy or create conditions where people thrive, boards will be more interested in external talent than internal candidates to fill CEO vacancies, when significant cultural change is required.”

Effect of industry disruption on succession planning

Professor Michael Gilding, Pro Vice-Chancellor of the Faculty of Business and Law at Swinburne University, says rising Volatility, Uncertainty, Complexity and Ambiguity (VUCA) across global industry will encourage a higher rate of external over internal CEO appointments.

“As markets are disrupted and industry boundaries blur, organisations will need new skills faster than previously. Some will find they don’t have the time or capacity to develop those skills internally and that the quickest way to get them is by recruiting an outsider CEO. Also, volatility will make long-term succession planning harder because markets will change faster, there will be higher executive turnover and more succession-planning surprises.”

Professor Gilding says CEO tenure, already low, has further to fall. “To believe CEO tenure on average is as low as it can go, one must believe volatility will stabilise. I don’t subscribe to that view: as volatility increases, CEOs will come and go at a faster rate. Boards in industries with high rates of disruption will need to be careful if they have a bias towards internal appointments for CEOs; it’s easy to get run over in business when nobody sees the bus coming.”

He says it will become harder for boards to assess the performance of internal and external CEO candidates in volatile markets. “Succession planning will become more challenging because the organisation’s performance will be affected by industry disruption. An external CEO candidate from an organisation that is disrupting markets might have a very different performance on paper to an internal candidate from a company that is being disrupted.”

Dr Terrance Fitzsimmons, a leadership researcher at University of Queensland (UQ) Business School, says care is needed with short-term changes in the rate of outsider over insider CEO appointments. “If you look at long-term trends, about 70% of CEO appointments in Australia are made internally. There’s a good reason for that: boards want a CEO they can work with and are more inclined to choose somebody they are comfortable with and have a relationship with.”

Dr Fitzsimmons says a CEO candidate’s “social capital” has an underappreciated role in his or her appointment. With Professor Victor Callan, AM, also of UQ Business School, he co-authored an important 2016 paper, “CEO Selection: A Capital Perspective”, based on interviews with 120 Chairpersons, CEOs and executive recruiters.

The authors found a CEO candidate’s visibility influenced his or her appointment. “Social capital in CEO appointments has a different role to what most people think,” says Dr Fitzsimmons. “It’s not so much about who you know, but rather about who knows what you know. That is, whether the CEO candidate has enough people who can validate his or her skills and human capital to the board.”

The role of social capital, built in part on the CEO candidate’s visibility, favours the appointment of internal over external candidates. Understandably, boards tend to stick with who they know – or the opinion of those they trust – when appointing CEOs. But they may need to take more risk with CEO selection if market disruption quickens and organisation cultures and community trust in institutions do not improve.