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Firms that are most apt to choose an outsider as CEO are the most likely to benefit from an heir apparent

October 1, 2004

For more information, contact: Benjamin Haimowitz, HHaimowitz@aol.com

Grooming period is key to enhanced company performance post succession

Whether the Disney board or others will take it to heart remains to be seen, but a new scholarly study of over 200 CEO corporate successions provides what may be the strongest endorsement to date of "relay succession" -- the practice of promoting an heir apparent to the company's top job.

The grooming period that an heir apparent experiences, the research finds, is "akin to a school, within which a new CEO's education takes place."

According to the study, in the August/September issue of the Academy of Management Journal, relay successions are best not only for companies in general but for those that are doing poorly, the very firms that are most apt to go outside their ranks for a new CEO.

In fact, contrary to conventional wisdom, it is precisely companies that are doing poorly or having a rough time that are most likely to benefit from sticking with an heir apparent, conclude the report's co-authors Nandini Rajagopalan of the University of Southern California and Yan Zhang of Rice University. As they put it, "there is a stronger positive relationship between relay succession and post-succession firm performance when pre-succession firm performance is low than when it is high."

The key to this enhanced performance, they conclude, is not the mere fact that the new CEO is a company veteran but that he or she has had the benefit of an extended period of grooming for the top job. This learning experience, they write, "is particularly important under conditions of poor pre-succession firm performance and/or high post-succession strategic and industry instability...The grooming phase is likely to equip the heir successor with the skills necessary to cope better with these challenges."

The importance of grooming emerges from the study's finding that companies with non-relay inside successions -- that is, in which the CEO is chosen from among a number of competing company executives -- do no better in the three years after turnover at the top than companies that bring in an outsider.

In other words, other things being equal, post-succession financial performance is significantly better in companies with relay successions than in firms that select an outsider as CEO or choose from among insider candidates.

The study's findings are based on data from 184 large manufacturing firms that had one or more CEO turnovers from 1993 through 1998. Of a total of 204 turnovers, 75 were classified as relay successions, meaning that the successor was with the company at least two years and held the title of president or chief operating officer; 53 were non-relay inside successions; and 76 were outside successions, in which the new CEO had less than two years' tenure with the company.

The professors also assembled data on companies' financial performance in the three years following succession, as well as on factors that might bear on that performance, including how firms did financially in the three years before the turnover and whether departing CEOs were dismissed or not.

For the sample as a whole, Profs. Zhang and Rajagopalan found that, all else being equal, relay successions had a significant positive effect on companies' post-succession financial performance, a combined measure of return on assets, return on sales, and the ratio of market value to the book value of shareholders' equity.

Unsurprisingly, they also found that poor financial performance significantly increased the likelihood that companies would select outsiders as their new CEOs.

But, in doing so, they were very likely pursuing a misguided strategy, since struggling companies proved to gain more from relay successions than companies that were doing swimmingly. The exception to this pattern was in unstable industries, where relay successions offered no advantage over outside succession in terms of post-turnover financial performance, and both led to better performance than non-relay inside successions did.

"Outside successors are usually prized for their new skills and perspectives and their willingness to initiate changes," the authors observe. But this willingness notwithstanding, "outside successors are more likely to lack firm-specific knowledge [so that] it is harder for them to formulate and implement appropriate strategic change. In addition, outside CEO successions often disrupt firms, and outside successors find it more challenging to get support from other senior executives."

In sum, Zhang and Rajagopalan see an heir apparent's grooming period as "akin to a school, within which a new CEO's education takes place. In contrast, without a grooming period, a new CEO's education is likely to take place after succession and impose higher costs on a firm."

The Academy of Management Journal, a peer-reviewed publication now in its 47th year, is published every other month by the academy, which, with about 15,000 members in 90 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the Academy of Management Review, the Academy of Management Executive, and Academy of Management Learning and Education.

Media Coverage:
CNBC. Closing Bell. (Wednesday, October 06, 2004).
Reuters. Heirs apparent seen as best choices for CEO: study. (Monday, September 27, 2004).
The Economist. October 16-22, 2004. Passing the Baton. (Saturday, October 16, 2004).
USA Today. You want me to be your CEO? No way!. (Wednesday, October 06, 2004).

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