Boards Favor Internal Candidates for CEO Role

Greg Lau, a senior member of our Board of Directors Practice, is featured in Tony Chapelle’s latest story examining internal versus external CEO candidates.

Tony Chapelle | Agenda (Financial Times) | http://bit.ly/1AJxqEH

The largest companies in the U.S. chose internal candidates for the CEO role consistently about three quarters of the time over the past five years, Agenda analysis has shown.

In the first nine months of this year, 36 of the 46 CEO transitions at S&P 500 companies saw internal candidates getting the top job. At 78.3%, that was the highest proportion of internal hires over the five years that Agenda analyzed, with the lowest (71.4%) coming in 2013.

Directors almost always favor internal candidates when time and talent are available, according to human resources officers and executive recruiters. This allows for a smoother transition, but times of stress often call for external expertise.

Among the new chiefs who made an early impression on shareholders this year was Rodney McMullen, a 32-year veteran at Kroger. The stock price of the supermarket chain was up nearly 24% six months after McMullen took over on Jan. 1, according to analysis by Agenda. Meanwhile, Microsoft shares gained 16% six months after Satya Nadella moved into the top job last February. Nadella, a former engineer, has worked at the software and browser company for 22 years.

One internally hired CEO who has had a rockier start to his tenure is Victor Luis, who took over at luxury handbag maker Coach, also on Jan. 1. After six months as CEO, and with the share price having dropped 39.3%, Luis announced that the company would close a fifth of its North American stores. Luis, who also serves as a director on the Coach board, has been at the company since 2006 and was previously president and CMO.

But overall, internal candidates hired as CEOs at S&P 500 companies in 2014 saw an average share price growth of 5.2% in their first six months compared to 2.5% for their externally hired counterparts, the Agenda research revealed.

“The big advantage is that you’ll know more about the internal candidate than you’d ever know about an external candidate. If it’s a close call, you’d want to go internal because you know what it’s taken that person to be successful,” says Stephen Cerrone, executive vice president for human resources and communications at Hudson’s Bay Company, the department store conglomerate. Cerrone says when done properly, it can take boards years to ensure a number of internal candidates are ready to step into the CEO role. This can involve exposing candidates to the board and equity analysts and giving them test runs leading various departments and locales.

“It’s risky to hire someone from outside,” explains Greg Lau, a retired executive director of compensation and corporate governance at General Motors Company and now managing director at search firm RSR Partners. “For instance, Juniper Networks hired somebody externally in January, and he’s already out.”

Lau is referring to the abrupt dismissal last month of CEO Shaygan Kheradpir. Formerly the chief technology officer at Barclays, Kheradpir had been brought in from outside to guide Juniper following pressure from activist investors Janus Partners and Elliot Management and an SEC investigation into foreign corruption.

He had led a conference call with analysts on Oct. 30. Yet by Nov. 10, the board had relieved him of his duties. In its 8-K filing, the company said, “His resignation follows a review by the board of directors of his leadership and his conduct in connection with a particular negotiation with a customer. Forbes speculates that Kheradpir offended, and may have jeopardized Juniper’s relationship with, a client in the company’s top 10% of accounts. Kheradpir’s employment agreement calls for him to pay back nearly $2.7 million of a $5 million up-front bonus. A report in the Wall Street Journal said the company will allow Kheradpir two years to repay.

The Juniper board named a 17-year insider, Rami Rahim, as its new CEO. Some industry analysts had expected him to be appointed to the post in January rather than Kheradpir. Recruiters say boards generally flock to external candidates to repair situations like the ones Juniper faced.

For example, Dennis Carey, vice chairman at search firm Korn/Ferry International, says eight of the Fortune 100 companies went outside in 2010 because of “extraordinary needs to change the direction of the enterprise.” Internals are better at maintaining the status quo in times of calm, while externals often are better suited to galvanizing change, he explains.

“Whether you get an inside or outside person depends on whether you’ve prepared the internal talent,” says Charles Tharp, CEO for the Center for Executive Compensation and a former head of human resources at Bristol-Myers Squibb and Saks. “If you haven’t developed potential successors, you don’t have much choice. That takes a long time. So did the company really invest in developing a pool of successor candidates?”

Tharp adds, “Someone inside … helped build the strategy. Unless the world changed … an internal successor … just work[s] out better. They own the culture, and they understand the customers. This is not just for the CEO, but other senior jobs as well.”

Besides putting out fires, external candidates can offer the specialized knowledge needed to alter the company’s course, says Cerrone, formerly human resources chief at Sara Lee before it was acquired by Hillshire Brands. The outside recruit who comes with a disparate set of talents, however, may be assigned to grow the enterprise through mergers or more capital market activity.

All of that comes at a cost. For one thing, the outsider knows that getting fired from the new assignment could happen. Therefore, hiring companies often need to make it worth the incoming CEO’s while to take the risk.

Tharp says typically an externally hired CEO or manager on the next rung down at another company would have to walk away from unvested stock options or performance awards in addition to full retirement benefit pay. To induce the person to leave, the new company would need to make whole the person’s equity long-term incentives, which are usually three years out or more. That likely amounts to 60% to 70% of the executive’s total comp package. Another 20% to 30% of the person’s pay would be made up of short-term incentives such as the annual bonus. The smallest component would be the salary, at about 10%.

“If the board has to go out into the spot market, you’ll have to pay what the candidate wants because you haven’t done a good job of planning and don’t have successors,” says Tharp.

Despite experts’ advice to take the less risky path and attempt to hire from within, Carey says boards need to stay aware of the market for possible candidates. “There should be at least one board member who should be not only part and parcel of the evaluation of internal candidates, but is also key at looking at the external environment,” he says.

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