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  • Writer's pictureTeam Rubicon

Improving CEO Selection and Hiring

Though board directors adopt many diverse philosophies on management and corporate governance, most agree that the single most important element in determining the success of the firm is its people.

Nowhere is this more important than when considering the office of the Chief Executive Officer. And yet, average CEO tenures are declining, resulting in organizational disruption and in correlation with sustained, negative financial performance.

Given its importance, why do so many boards struggle to recruit and retain effective, long-term CEOs and avoid bad hires?

This is a confounding question.

To frame the solution, it helps to begin by observing the current state of CEO tenure relative to earnings and enterprise value creation.

Market-wide, US stocks have gained over 250% in value since the start of 2010, including reinvested dividends. Despite record-high earnings and enterprise valuations of recent years, CEOs are departing more quickly than ever from their posts. Indeed, long-tenured CEOs are becoming yet another effervescent vestige of a bygone era of labor, a hallmark of which was widespread, long-tenured service from employees at all levels.

According to a recent Korn Ferry analysis, the average tenure of CEOs has now dipped to 6.9 years in 2020, down from 8.0 years in 2016—a dramatic 14% drop-off. Experts agree that this trend is only accelerating. A separate investigation from PwC discovered that the average turnover rate of CEOs across all industries and geographies, as measured by the percentage of CEOs who depart for any reason during any one year period, has increased from 12.9% to a historic high of 17.5%. (figure 1a).

Figure 1a: global CEO turnover rate (as a % of companies in industry and region)

What’s more, during that same period, the percentage of planned CEO turnover as compared to forced successions (where the board remedies a “bad” hire by terminating a CEO) or M&A-related departures has nearly doubled from 6.4% to 12.0%.

This is notable because it illustrates how, despite a significant increase in planned successions, boards are increasingly struggling to appoint CEOs who will stick around. In other words, if the uptick in planned successions were successful, we’d expect CEO tenure to increase, not decrease. Instead, we observe the opposite.

Beyond being a compelling organizational development quandary, this is economically provocative because, according to the Harvard Business Review, many CEOs experience their best value-creating periods in years 11 to 15 on the job. Considering the fact that most Americans own investments comprised primarily of stock in US firms, the discovery that most US CEOs don’t occupy their offices long enough to deliver peak value-creation for their investors (to be clear - that’s you and me) should be cause for alarm.

Figure 2a: the stages of CEO value creation in relation to time on the job (years)

Among the reasons for CEO turnover, forced succession is by far the most value-destructive and produces particularly bad results for shareholders.

Most visibly, we see the fallout of bad CEO hires present as operational setbacks or forgone value creation. By one measure, the cost to shareholders from boards making ineffective CEO hires is a whopping $112 billion per year.

$112 billion per year!

That’s more than the Nominal GDP of Ukraine. And 60 other countries.

To understand why CEO tenure is declining and formulate a solution, it’s worth considering the current business environment.

At least some responsibility can be assigned to the unintentional fallout created by the meteoric rise in popularity of hyper-growth-at-all-cost culture. Pushing for rapid organic growth makes sense from an investor perspective. High growth firms are more value generative for investors, producing higher shareholder returns than those whose growth relies more heavily on acquisitions.

Figure 3a: excess shareholder returns relative related to organic and inorganic growth

But rapid growth firms are difficult environments to survive for founder/CEOs and professional CEOs alike.

Following the ever-accelerating pace of change, many CEOs must stretch to transform themselves as leaders more quickly than possible, resulting in some firms “outgrowing” their CEOs. This is especially punctuated in the startup scene, where successful founding CEOs can find themselves graduating from operating out of their garage to having thousands of employees only a few years later – a job that most of these CEOs are not prepared for. Eventually, many CEOs who are not able to flex up to meet the challenges of a rapidly changing business get terminated.

Even though boards are acutely aware of the accelerating incidence of firms “outgrowing” their CEOs, and the positive correlation between high CEO turnover and lost shareholder value, they continue to struggle with appointing CEOs who will stick around longer and drive more value for the firm.

Today, more than ever, it’s of paramount importance that boards reduce CEO turnover, make fewer bad hires resulting in forced successions, and retain great CEOs for longer tenures.

In response to these realities, boards must improve their internal governance processes to hire better CEOs.

Dear boards, respectfully, here’s what you need to do:

1) Beware of extroverts

Interestingly, and perhaps contrary to popular wisdom, extroverts are not always the best leaders. A study by the University of San Diego of nearly 5,000 CEOs discovered that firms led by charismatic, extroverted CEOs tend to exhibit a 20% lower valuation and have a higher cost of equity capital than firms led by introverted CEOs. Why? Simply put, extroverts take bigger risks that fail more often. The implied conclusion here isn’t to avoid appointing extraverts as CEOs, rather, to keep their appetite for risk in check. Further, don’t discount the value of appointing an introvert as CEO.

2) Prioritize integrity

Too many boards over-index candidates’ professional profiles and under-index interpersonal characteristics like personal character, behavioral integrity, and emotional intelligence. Behavioral integrity, in particular, is associated with trust. To be an effective leader of people, CEOs must engender trust throughout the ranks. This is especially vital for new appointments and first time CEOs. A Yale investigation of 30,000 shareholder letters linking behavioral integrity to earning performance concluded that firms whose CEOs had high behavioral integrity performed better financially in the next business year. And pedigree is overrated; among effective CEOs, it turns out that the path to the executive office is much more diverse than expected. Even among Fortune 100 companies, only 11% of CEOs went to an Ivy League school.

3) Refresh the board

Directors learn from their experience just like everyone else. Evidence suggests that directors who’ve experienced the pitfalls of high CEO turnover carry those lessons forward with them to future board positions. Owing to their experience, they become more diligent monitors of recruiting and succession planning processes. This is great news, however, this is only helpful if board members circulate onto other boards. This is another solid argument for imposing reasonable term limits for each board seat.

4) Take more time to align

Annually, the average board only convenes 4.5 times, 2 of which are by phone or otherwise remotely hosted, for a half or full-day session. What’s more, under pressure to guide their firms through rapid change, boards often fail to align internally on succession planning. Not only do boards need to spend more time on succession and recruiting, but they also should, along with the CEO and management, aim to jointly articulate the firm’s purpose and lead its long-term strategy, ensuring that the firm only pursues sustainable value creation activities.

5) Hire for diversity

Don’t hire for diversity for the sake of it – hire for diversity because its effective. Diverse leadership teams produce 19% more revenue over time than peer firms without the same levels of diversity. Boards in the US are incredibly homogenous and they are notorious for hiring in their own image. Only 2% of S&P directors are younger than 45 and 21% are over the age of 70. Harvard Law found that only 10% of Russell 3000 directors are ethnic minorities, only 19% are women, and board seat renewal rates continue to increase, effectively perpetuating the homogeny of some boards. Make a point to provide all board members with formal training on diversity and inclusion.

The above may not guarantee investors will avoid lower potential enterprise values and recoup that lost $112 billion per year, but it’s a great start.

As the role of boards of directors continues to evolve, so must their introspection on self-governance. As stewards, boards may only reasonably demand transformation by first leading by example.

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