Secession planning

Picture this: a long-serving CEO carefully grooms his or her internal successor. After more than 10 years as CEO, during a period of firm outperformance, he hands over the reins. The new CEO is ideally positioned to maintain growth, but firm performance deteriorates.

The notion of an internal CEO following a long-serving CEO (10 or more years in the job) had special focus in the latest PwC CEO Succession Study. The study, considered a global barometer of CEO turnover and tenure, examines the world’s largest 2,500 companies.

PwC found long-serving CEOs generally deliver higher shareholder return than short-serving CEOs and usually play a key role in arranging their succession to an insider executive. Nearly a fifth of all departing CEOs over 2004 to 2018 had served for more than 10 years in the role.

Strategy& magazine, published by PwC, said successors to a long-serving CEO face a difficult path. “Following a legend is not for the faint of heart. Although they often have much in common with their predecessors in terms of their backgrounds, successors turn in significantly worse financial performance, generally have shorter tenures, and are much more likely to be forced out rather than to depart via a planned succession.“

PwC found the median successor’s annualised total shareholder return was 4 per cent less than his or her long-serving predecessor. Only 12 per cent of successors achieved top-quartile performance (by firm return) compared to 21 per cent of long-serving CEOs.

The data does not show why successors to long-serving CEOs underperform. It is possible that the outgoing CEO has not set up the firm for the same level of growth, possibly because of underinvestment in medium- and long-term initiatives.

“…firms that groomed an internal successor over several years tended to achieve higher returns after the CEO appointment.”

Other theories include: the outgoing CEO maximising short-term performance to boost the value of his or her stock options; investors paying a lower valuation premium for the listed company because the star CEO has left; or the outgoing CEO choosing an inferior successor, or not sufficiently developing the successor, to enhance his or her performance “legacy” and reputation.

Whatever the cause, boards should pay extra attention to succession events involving long-serving CEOs. As Strategy& notes: “Boards need to acknowledge that statistically speaking, successors to long-serving CEOs start with the deck stacked against them. As a result, the board needs to make it clear that the new CEO has its support, and that it is not constraining the successor as he or she is thinking through a plan for the company’s future.”

Boards might find an outsider rather than an insider is better placed to replace a long-serving CEO, given the challenges new CEOs face in following long-serving CEOs.

Transparency on succession planning urged

Research finds more disclosure on process enhances firms’ value.

Few board tasks are more important than CEO and director succession planning. But many organisations have limited disclosure of succession-planning policies and practices, meaning stakeholders have to assume the board is on top of this task.

Overseas investors and proxy advisers have this decade called on boards to improve market disclosure of CEO succession planning. In Australia, the latest ASX Corporate Governance Principles and Recommendations, released in February 2019, says the board should ensure “there are plans in place to manage the succession of the CEO and other senior executives”.

ASX Corporate Governance Principles also recommends how boards approach their own succession planning and the role of nomination committees and skill matrices in this process. But disclosure of board succession-planning processes by ASX 200 companies varies and much of this information in annual reports is generic in nature.

Academic research has found that better disclosure of succession-planning practices can enhance firm value. Simply, firms that are more transparent about how they plan for, and handle, CEO succession events tend to perform better around those events.

Professor John McConnell, of Purdue University in the US, and Qianru Qi, of Fudan University, studied the effect of succession-planning disclosure. Their paper, “Just Talk? CEO Succession Plan Disclosure, Corporate Governance and Firm Value,” was revised in September 2018.

The authors studied a sample of 9,084 CEOs and hand-collected CEO succession-plan information form proxy statements. There were three key findings:

  1. Better corporate governance causes higher CEO succession-planning disclosure. Firms with a higher ratio of independent directors were more likely to include more information on CEO succession planning and related information.
  2. Firms that disclose CEO succession plans are more effective in CEO succession processes. These firms tend to have a larger pool of younger executives suitable for the CEO role; are less likely to search for a successor after a CEO turnover is announced; and experience lower stock-return volatility.
  3. Regulations that require more information disclsoure on CEO succession plans improve firm value.

The lessons for Australian listed companies are clear. Succession planning on its own is not enough. How the organisations disclose their succession processes to the market makes a difference.

Although more succession-planning disclosure is better, there are obvious complications in how much detail listed companies can disclose to the market for competitive and confidentiality reasons about CEO transition planning.

Reducing bias when assessing candidates

Rigorous process sees boards casting their nets wider to make informed choices.

Conventional business thinking suggests the board works with the CEO to ensure there is a succession-planning process and a pool of potential internal candidate for the job. And that the CEO is transparent about succession planning and the board has sufficient information on it.

That is the theory. The reality can be different if a CEO disagrees with the board on the qualities needed in his or her successor or the talents of potential internal candidates. Or restricts information on candidate performance, to influence board decisions on CEO succession.

Professor Donald Schepker of the University of South Carolina and other US researchers examined how boards overcome information barriers in CEO succession planning and how CEOs can influence the process. Their paper, “Planning for Future Leadership: Procedural Rationality, Formalised Succession Processes, and CEO Influence in CEO Succession Planning,” was published in the Academy of Management Journal in 2018.

The study was based on interviews with 50 Chief Human Resource Officers and 22 directors, who were part of CEO succession decisions, mostly for large US listed companies.

The authors note that boards face a difficult task in managing CEO succession processes: “They lack in-depth knowledge of the firm and its executives and must rely on the CEO for information about, and access to, succession candidates.”

Surprisingly, the researchers found CEOs generally have little influence in the succession-planning process – a result at odds with other academic studies that have shown an outgoing CEO strongly influences the choice of his or her successor. The authors found that although the CEO’s input in succession decisions is still critical, boards are exerting their authority on this issue.

The researchers found that the development of formalised succession-planning processes provides a framework for Boards to evaluate internal and external CEO candidates – and reduces the risk of decision-making bias in the current CEO and among directors.

A rigorous succession-planning process helps boards better source data needed to make decisions on candidates and involves a wider range of advice, which typically includes the Nominations Committee, Chief Human Resource Officer, an external search consultancy, the outgoing CEO and the main board. A Chair of a large listed company might also confidentially gauge the views of key shareholders on their assessment of possible CEO candidates.

Boards that do not have formal succession-planning processes, or do not see it as a continuous activity, may rely more on the outgoing CEO’s opinion on his or her successor and have fewer information sources to make that decision.

As the authors note: “Both boards and CEOs are susceptible to decision-making biases (on succession). Instituting formalised processes increases the chances of overcoming informational challenges and socio-political dynamics. For example, it forces board members to evaluate the firm’s strategy and create a profile against which to evaluate candidates. Understanding the needs of the business and identifying successors who can solve future problems seems straightforward, yet, instead, boards frequently become enamoured with celebrity CEOs.”

Fewer financial resources complicate choice of NFP CEOs

Recruiting the right volunteer directors has its own challenges.

Succession-planning studies on CEOs and boards mostly focus on large listed companies or, to a lesser extent, family businesses and other smaller enterprises. Not-for-profit (NFP) enterprises are less examined, even though the NFP sector has specific succession challenges.

Most NFP boards in Australia do not pay fees and rely on volunteer directors. Or the NFP enterprise might have lower financial resources, complicating CEO recruitment.

Macquarie University reseachers Melinda Varhegyi and Associate Professor Denise Jepsen shed light on NFP succession in Australia in their paper, “Director Succession Planning in Not-for-profit Boards,” published in the Asia Pacific Journal of Human Resources.

The authors cited research showing recruitment of directors is recognised as one of the most challenging aspects of volunteer management in the NFP sector. NFP boards, like those in other sectors, need strategic succession-planning processes to overcome this challenge.

Based on interviews and survey responses from directors of registered clubs, the authors found NFP directors showed greater interest in being involved in CEO succession planning than director succession planning. They saw the task of recruiting and assessing director candidates as mostly the Chair’s role and had less interest in board succession planning.

The authors concluded: “The sustainability of not‐for‐profits largely depends on securing voluntary directors. (But) the current director nomination process of many NFP organisations poses threats to the organisation's longevity and sustainability. While this study represents the proverbial tip of the iceberg for NFP director succession planning, it has started the difficult process of unravelling the complex dynamics of NFP member‐based boards.”

They added: “Essentially, without strategic succession planning, the process of nominating and appointing directors appears to be no longer enough to ensure the quality and quantity of candidates in NFP organisations.”

Separating family and business issues on transition events

Formal governance practices smooth CEO succession path.

Family companies are known for dynastic management succession: for example, a family member replacing his or her father or mother as CEO when the time comes. But academic research has found less than a third of family firms manage an effective intergenerational succession event.

Belgian researchers have studied the effect of board involvement in family business-succession events and the influence of the company’s CEO. Their paper, “Succession Planning Practices in Family Firms: family governance practices, board of directors, and emotions,” was published in the Journal of Small Business Economics last year.

Using a sample of 225 family-owned firms, the study found that firms that had formal Family Governance Practices (FGP) had smoother succession events. FGP is the voluntary practice that facilitates the relationship between the family and the business. Larger family companies in Australia may have a “family council”, sometimes moderated by an independent adviser, to separate family and business issues.

The researchers found an FGP stimulates succession planning in family firms, maintains trust and encourages commitment of family members to the process. The study also showed the FGP or family council can influence succession decisions made by the family company’s board.

The take-out for family companies in Australia is clear: establishing a family council, possibly moderated by an independent adviser, can lead to more transparent and effective CEO succession planning.

The family council can also act as a bridge between the family and board on CEO succession planning, reducing emotion that can cloud CEO changes.

Longer the ‘relay’ process, smoother the baton handover

The more extensive the CEO grooming process, the better the chance of a good outcome.

The “Holy Grail” for boards in CEO succession planning is ensuring there is a strong pool of internal candidates and an orderly succession event. But how much value does a strategy of “relay” succession – where an internal heir is groomed for years – add?

Ran Tao and Hong Zhao, of the NEOMA Business School in France, considered this issue in “Passing the Baton: the effects of CEO succession planning on firm performance and volatility.” The journal, Corporate Governance: An International Review, published their paper last year.

Using a sample of 2,542 CEO turnover events from 1991 to 2012, the authors found firms with relay succession events outperformed those without. In other words, firms that groomed an internal successor over several years tended to achieve higher returns after the CEO appointment.

The authors wrote: “The empirical findings in our paper support various theories that a well‐planned CEO succession leads to better turnover performance and lower uncertainty for the firm.” Numerous other studies have also shown internal CEO appointments tend to outperform external appointments (by firm performance).

However, the authors show there is no performance difference between an outsider CEO (recruited externally) and an insider CEO who has had little grooming for the role. What matters is the length of the “relay” – the amount of time the internal CEO candidate is groomed for the role.

The authors found an extra year of grooming makes a big difference to firm performance. The lesson for boards: the longer internal candidates are groomed for the top job, the likelier the positive impact on firm performance after their appointment.