The Critical Impact of CEO Succession

June 6, 2014 – For CEO succession planning to be truly impactful in today’s complex corporate environment, companies require a greater understanding of the distinctions between seeking top leaders from outside the organization or when promoting from within is the best option. Global executive search firms like Egon Zehnder, with extensive business expertise in CEO succession and executive talent management and assessment have worked with the world’s leading companies to identify top talent, formulate best-in-class succession efforts and develop and assess the next generation of leaders. This experience has yielded their keen understanding of “What good looks like” when faced with the most critical of leadership change decisions.

“The 2012 Chief Executive Study,” conducted by Booz & Company, examined the world’s top 2,500 public companies, and sought to understand the reasons why the trend to seek external CEO leaders is increasing. According to the Booz study, “In 2012, 27.1 percent of S&P 500 companies that faced a CEO succession hired an outsider for the top job. While the rate confirms a trend recorded since the 1970s, it is much higher than the 19 percent reported in 2011. This finding may suggest that there is a need to continue to strengthen companies’ leadership development practices. The heated pay-for-performance debate of the last few years has induced boards of directors to increase the rigor of their CEO selection process: the growing percentage of outsiders chosen as new CEOs may show that directors don’t always like what they find within the companies’ ranks. Moreover, a number of companies that underwent a succession event in 2012 selected a director from their own board as the new CEOs. The director-turned-CEO succession model provides companies with a chief executive who is familiar with corporate strategy and key stakeholders, thereby reducing leadership transition risk.”

But why is CEO succession so much more scrutinized today? The 2002 Sarbanes-Oxley Act began to place more pressure on CEOs and CFOs of publicly-traded companies to certify the appropriateness of their financial statements and disclosures and to certify that they fairly represent their shareholders’ interests. Furthermore, the continued turnover of CEO leadership, particularly within large multinational companies, has caused boards to look more carefully at who will occupy the CEO chair in the future. The recent economic downturn has also created key CEO vacancies. In the same Booz study, 15 percent of CEOs left office, up from 14.2 percent in 2011. This is the second-highest rate of CEO successions since Booz has conducted its review.

In the following interview, Karena Strella, a partner with Egon Zehnder in San Francisco and leader of the firm’s management assessment capability, provides an in-depth examination of CEO succession in today’s complex business environment. She discusses the changing market dynamics, which affect tenure and transitions in the C-suite, and the challenges faced by both leadership teams and their boards in examining and establishing best-in-class succession processes and protocols. She speaks too about identifying the next generation of leaders by looking at both experience and underlying potential for future success, drivers that together establish the best assessment elements for establishing an executive’s success in a future role.

Karen Strella serves clients in a variety of industries on topics including CEO succession, talent management and human resources. Having business leadership experience across the life sciences industry, she has a strong track record of serving clients across the Fortune 500 as well as start-ups in the U.S., Europe, and Asia Pacific. Through her talent management work, she has assessed and benchmarked several hundred individuals and has focused on building teams for growth, innovation, and operational excellence. Ms. Strella has led a number of succession planning, talent benchmarking, and development activities for a variety of entrepreneurial and multinational companies. She is formerly the co-managing partner for Egon Zehnder U.S. and the global practice group leader for life sciences.

Prior to joining Egon Zehnder, Ms. Strella developed and managed corporate venturing activities for The Permanente Company. As a consultant with BDC Advisors, she created solutions for growth and revenue generation for her clients. Ms. Strella led marketing and product development at Johnson & Johnson.

Historically speaking, were companies in the past better prepared to handle CEO succession or are there factors that make today’s companies better equipped?

Today’s ever-changing economic, geo-political, and technological disruptions, along with multiple other unknowns make current conditions more difficult to predict a company’s exact evolutionary point at the time of CEO transition. Many boards are using greater discipline in selecting and preparing successors. There is also a better understanding of the global talent pool, which allows for a stronger set of possible candidates.

What specifically has changed to shift this to improve or move backwards?

There is more market visibility of the “successors in waiting” today. The best candidates are in very high demand for CEO roles. Potential CEO’s don’t necessarily have to wait for the right timing in their own company. Companies have to work harder to retain their key successors. The best boards are accurately evaluating internal candidates, gaining the right exposure to both internal and external succession candidates and constantly refreshing their immediate and longer-term successor slate.

I recently read a survey by Stanford conducted in 2010 which revealed more than half the companies today cannot immediately name a successor to their CEO. Why is this? Is that surprising to you or do you think it is the norm today — or has it always has been the norm?

Indeed. We find this situation with several companies. The issue boils down to uncertainty. The over-arching operating environment for the company is uncertain. A candidate succeeding as CEO is uncertain. It’s a role where selection is often a bet on potential, not necessarily past experience. Secondly, there has been some confusion about whose job it is to ensure CEO succession: the CEO or the board. Lastly, until recently there haven’t been robust templates to help the board think about the myriad criteria they should be evaluating as they plan for CEO succession. Trying to solve for what the company will need, how to assess potential and who should advise them is difficult for even the most sophisticated board. The tide has turned with a push for good governance with more and more boards holding themselves accountable to ensure a robust CEO succession plan, including emergency succession.

Do you see this more with publicly traded companies due to the pressure of the bottom line and the stockholders versus private companies?

We see it where it is most difficult. And most difficult are heavily matrixed organizations that have not built true P&L successors. There are only a few P&Ls and they tend to be large enough that any mistakes have an enormous negative impact on the business. In the past P&Ls were smaller, and new leaders had a chance to gain experience in new areas without risking significant impact to the overall corporate profit. Organizations with multiple P&L roles, where individuals have gained experience rotating between functional and general management positions have the most, well-rounded successors. Private family companies tend to have generational succession in mind very clearly.

I think the family companies are more the exception than the rule. That same Stanford survey revealed that 39 percent of companies today said that they had zero viable candidates. Do you find this figure surprising? That’s a large figure.

Companies more than ever before are far more complex and working hard to refine their succession, ensure people get the proper experience and measure results appropriately. Multiple factors drive short rather than long term focus, so building overall bench-strength throughout the company for the long term is somewhat rare. Most companies are very good at understanding someone’s performance in their current job; but it is the individual’s potential that tends to be misunderstood. All organizations have some form of succession planning. But, if you ask an organization how effective that succession planning has been when the time presents itself to make a nomination to the chief executive’s team, in my experience at least 50 to 60 percent of our clients say they have made a different decision than the individual designated on the succession plan.

There is a common discussion today that boards of directors and nominating committees are not as involved in succession planning as they should be. Is this true, and if so, why is this?

I think the question is more about timing. When do they believe succession planning should start? The most forward thinking boards believe it starts the day they name the new CEO. Others wait until they know they must make a change. The board members we work with are all very aware of their fiduciary responsibility. Often the timing is viewed differently by the current CEO and the board which can lead to an uncoordinated approach. What’s interesting is that most boards simply don’t have experience in conducting CEO succession. They try to do it the best they can but many would be well advised to hire a firm to help. There have been recent, high-profile missteps where one might conclude that since the big board wasn’t involved with the succession then it must mean most boards aren’t as involved as they should be. I don’t think that is accurate. But it is a wakeup call for boards and CEOs to take a critical look at their approach.

I think with more scrutiny today there is less and less of this. Whereas before there were instances where they might not have been involved as much as they should have but today’s scrutiny has forced a lot of companies to really engage their boards and nominating committees in a much more substantive fashion.

I think it is interesting to look across the board landscape at how many board members have actually been actively involved in CEO succession. I think you will find a number that is more surprising than the other numbers you mentioned. Anecdotally, most board members have never been involved in CEO succession. This lack of experience can create a desire to engage in the process and learn how to do it well. In other cases they don’t know it should be an ongoing activity for the board.

In what percentage of CEO succession assignments does the next CEO come from within the company or externally? Of course this comes to the heart of a lot of this.

Based on the 2011 Booz study which looks at CEO succession among the top 2,500 global companies, 22 percent of the CEO’s hired were external hires, up from a few years ago when that number was 14 percent. We like to start working with our clients at least three years in advance of the anticipated need for a new CEO. When you start far enough in advance the vast majority of the new CEOs will come from within. If the company waits until the last year before a CEO is retiring then it’s more common that an outside candidate will be placed.

How far down the ladder do you look at internal candidates? Is there a specific cutoff or does it change from company to company?

It changes from company to company and relates to how far in advance the company is looking for the next CEO. For example, we are conducting an assignment right now for a CEO successor five to eight years in advance, and assessing the talent pool with a long-term focus on CEO potential. We will develop five-year development plans for each internal successor and continue working with the company on a variety of development activities to ensure the successors are ready for the jump to CEO. In that case we are looking two to three levels down from the CEO because the immediate direct reports to the CEO will be at or beyond retirement age in that five to eight year period. And while they aren’t in the mix for development, they will be assessed to rank them as emergency successors. It really depends again on two things: is the time horizon sufficient to develop successors; and how robust have the company’s development activities been for CEO succession. Back to the earlier comment on developing true bench-strength: too many companies focus on one level at a time, and look at only performance without effectively assessing potential. They risk only considering someone to be a CEO successor later in their career. Interestingly, we have a client that is looking at their high potential pool for who could be their next CEO. They are looking at the entire organization from recent MBA hires to the C-suite. If you use potential as a guide it allows you to place bets more accurately on your talent. Looking for future CEO potentials from their earliest hires is as far down in an organization that I have ever experienced in succession planning.

It’s interesting to see how many CEOs come out of a certain functional discipline. There are not many CEOs today that come up through the ranks of human resources, but that will probably change. But certainly others tend to come out of more functions than others. I’d be curious to know which functions really yield the best candidates, especially when you’re looking at an internal situation.

The majority of CEOs who stay in the CEO role longer than the usual three-year window have typically served both in a functional role and in a large scale general management position. Now, with some companies the CFO position is an important slot as a path to the CEO seat. Whereas those companies that are more consumer facing often pull from the chief marketing officer, chief customer officer and other similar top positions. Some believe that the chief digital officer or chief big data officer will be the CEO of the future. What is true is that the age old COO role as a direct step to CEO seems to be diminishing quickly.

That’s surprising a little. Why is that? You would think that would be an ideal position from which to come.

There appears to be a growing reluctance to position “the anointed one.” Once they do that the rest of what used to be the peer-set no longer consider themselves to be in contention for that CEO role. The most ambitious ones will leave and the organization has placed all of their bets on one possible successor instead of having a broader set of candidates. A different approach takes many forms including: CEO project teams – a special project for the company sometimes with board members as sponsors – board members then get visibility to the management team in a way they haven’t before; rotational assignments that are designed to fill experience or knowledge gaps before taking on the CEO role; and placing the most likely successors into the parts of the business that are most important for the future so that they tie directly to the future success of the business. These approaches can help ameliorate the rapid exits of those who knew they were a candidate but are not selected.

In what instances is it best to identify an external CEO? Is it always due to a lack of qualified internal candidates or are there other factors in play?

There are many factors. If there is a significant strategic change that might require an external point of view or, in some cases, the company is seeking a CEO candidate who has “already done it before.” Another reason is where there is a need for a significant cultural shift and it is actually more difficult if the successor comes from inside. There is of course the situation where there has been some sort of negative activity with the company and the best solution is to bring in a CEO from the outside who has not been associated with any of the negative events. But with any of these examples one should never assume that if the company hires an external CEO that there were not qualified internal candidates. It simply depends on the circumstances which can be different or unique to that company at the particular moment in time.

Have you found that CEOs that are identified and groomed for the CEO position are more successful because they understand the company’s culture better than somebody from the outside?

Yes, internally groomed successors have been associated with the culture for years and have a deep understanding of the business which is advantageous. It is always harder for an external CEO who must get up to speed and learn the culture. Another key issue with internal CEO candidates is trust. Those candidates that come from within are known to everyone, and their track record and leadership approach is known, so there is a comfort level that helps garner trust. With an internal successor, there tends to be less disruption even if some of the others who were also viable candidates for that same CEO role decide to leave. You can gain a lot of good will. Whereas, if the successful CEO candidate comes from outside the organization there is a ramp up stage and it is harder to keep the momentum moving in a forward direction. Slowing down is natural for a little while before the new CEO comes in, and for a little while after the person has arrived, as people wait for priorities to be specified and organizations to be defined.

But there are certain circumstances where companies really do need to bring in new blood into the CEO position.

It is absolutely necessary in some instances. Companies require an external CEO when they require a new capability to successfully execute their strategy. That capability could be a key strategic experience, customer focus, emerging market expertise or global mindset. So as a company goes through their different evolutionary stages it is sometimes necessary to bring in a new CEO who has “done it before” with their former company versus, perhaps, an internal CEO candidate who might be driving some of those same initiatives with no prior experience.

What specific benchmarks do you employ to assess an internal candidate(s) against the position?

We look at the overall trajectory of someone’s career and capability – how far can they go and how fast can they get there. And to do that we separate “potential” from “performance” which is something that many organizations confuse by combining them. For example, in some organizations if you are a high performer, you are considered high potential, which is not necessarily true. Understanding potential is critical because it allows us to understand how much someone can develop and in what way. Our research has shown that potential for CEO comes to four things: a purposeful insatiable curiosity, the ability to derive insight from complex information, authentically engaging with others and an open-minded, disciplined determination. If we separate potential from current and past performance, we have a set of specific criteria we can examine for readiness. Readiness is what it sounds like, an indicator of how ready they are for the role being considered. It includes skills, experience and leadership competencies that you exhibit today in relation to what is needed in the role. When you then look at potential, in relation to those, you can clearly see how much of one’s potential he or she is using today and how easily they can close any obvious gaps needed for the next job(s). We evaluate internal candidates using the same assessment tool that we use for the external candidates. It is important to evaluate based on the same criteria if there is to be a fair comparison. We then benchmark against those who have been successful in similar situations. In some situations we also help the company understand the impact of the appointment or what we dub ‘appointability.’ In those situations we delve into market valuation comparisons and how well the investment community and other stakeholders react to the person being considered.

How often do you see situations where there is a difference of opinion between the CEO and the board as to who should be the next CEO or who should be considered in this role?

I would say about half the time. For internal candidates, the CEO has had nearly daily exposure to the CEO candidates. The board’s exposure might be limited to board presentations or information provided in the talent updates and may not actually have seen the person in action. Often, when we encounter a different point of view it’s because they are each using their own criteria for what makes a great CEO. Our model allows those mental checklists to come into the open and augments their view based on research into what makes a great CEO. Using the model allows management and the board to evaluate the same criteria and weigh things in a way that makes sense for the company. They can then more easily get aligned regarding the next best CEO.

When assessing both internal and external candidates today, how often do they include women and minorities and how has this balance shifted in recent years?

Our client companies always require a diverse pool of candidates but they ask us to bring world-class talent in whatever form it comes. We always have a diverse slate of candidates. But you are right that broader, more diverse slates of candidates have been growing for at least the past five to 10 years. However, in my view there still aren’t enough diverse candidates.

Has diversity been more successful in certain industries like healthcare, which has always embraced women versus, or perhaps industrial which, has not been as welcoming, particularly at the C-level.

I have been pleased to see that more women have gone into manufacturing and engineering, for example, as opposed to 10 years ago. But you are right, it does vary by industry and some are lacking. Some industries are still struggling with this: they want female leadership from a particular or very narrow segment of the marketplace. But when women or people of color are not landing those key roles it’s harder for them to then rise in the ranks. And, if they aren’t rising, then they aren’t able to pull others up with them.

When do you think we are going to see a real shift to really more women running large corporations?

In my view it will occur when there is a more level playing field. For years we have gravitated towards leaders who look and act more like us. The same upbringing, background, same schools and similar kinds of experiences. But the field is shifting dramatically and now includes people who might not fit the traditional mold. Therefore if we remove some of the barriers and provide everyone an opportunity to perform, it will go a long way to eliminating the barriers that, to date, have kept women and other diverse professionals out of the CEO seat. That said, not everybody wants what comes with being a CEO: working a 24/7 job, being in the public eye, and the challenges of work/life balance. But we at least have to create an environment where all people have that choice. When that occurs we will see a more diverse group of professionals running large companies. But, for women, it’s been a challenge and it’s partly due to their approach. Men have no trouble saying, “I want to be CEO.” But women have traditionally been more tentative – which may be due, in part, to the fact that they have had to transition and balance their personal lives with their corporate lives. Women also look at the CEO role and ask, “Well, what impact would I have on the company and should I consider this over time?” Men are more assertive. There has also been a long history of supporting men at work and they tend to not have the multiple balance issues women face. But I do see this changing in the next few years – we will see more female CEOs running large companies.

How do you see the role of women in your own firm at Egon Zehnder? What dynamics have you seen change? I think that the women in your firm, yourself included, have made a major impact at Zehnder.

I appreciate that, thank you. When I joined the firm in 2001, there were no women partners in the U.S; no women running practice groups in the U.S; no women running practice groups globally. There were a few running offices but there were no women on the executive committee and no women on the board. If we fast forward to today, Egon Zehnder has women on the board; women on the executive committee; women running global practice groups and women running some of the largest regions of the firm. It hasn’t taken very long for the mix in the firm to be much more diverse.

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