The Case for Insiders

Good news for ambitious CFOs: companies that promote insiders to CEO produce better returns than those that recruit outsiders.

While boards of directors tend to seek sitting chief executives to fill CEO vacancies, new research from Rice University suggests that promoting CEOs from within may be more effective — which could be good news for CFOs who want the top spot.

In a study of 193 chief executives in the industrial sector, Rice associate professor of management Anthea Zhang and Nandini Rajagopalan, professor of management at the University of Southern California’s Marshall School of Business, found that internally promoted CEOs significantly outperformed externally hired CEOs over time.

Both insider CEOs and outsider CEOs made changes upon taking the reins, says Zhang. “A new CEO wants to — indeed has to — make some change, just to signal that his or her era is different from the time of the predecessor CEO,” she says. “Especially when an outside CEO is brought in, it’s the expectation that he will initiate some change.”

But while both types of CEOs institute changes, “CEOs from outside the firm are likely to initiate bigger changes,” says Zhang. “We wanted to know whether bigger change meant better change.” As it turned out, it doesn’t. “If a change is too big, it can take the firm away from its identity and core competencies,” she says.

Companies’ returns on assets relative to their industries are similar during the first three years of a new chief executive’s tenure, the study found, regardless of his or her origins. But after three years, results start to diverge. Outside CEOs, because of the larger changes they tend to undertake, deliver worse results. And the bigger the change, the more damage there is to performance.

“Inside CEOs, because of their deeper roots in the firm, have a better understanding of the firm’s core competencies and key weaknesses,” says Zhang. “They’re more likely to initiate changes that complement the firm’s core rather than damage it.” She theorizes that outsiders might also suffer from a lack of support among employees or their executive teams.

The tendency of boards to prefer someone for the top job who already holds the CEO title is “a problem,” says Zhang. Current top executives within a company, including the finance chief, warrant closer consideration as the board ponders its succession plan, she says. “The most important thing is that boards should not start to look inside the firm at the moment when they need to choose a CEO. You can’t say at the last minute, ‘We need somebody, where is this man or woman?’ You have to start early to groom potential candidates.” This could still mean hiring someone from the outside, but with plenty of lead time.

With plenty of exposure to the board and a broad perspective on the business, CFOs would seem to have a good shot at succeeding their bosses when the time comes. “Increasingly in the past one or two decades, the role of the CFO has become more and more important and includes more strategic decision making,” says Zhang. But she issues a caveat: “If the position remains a specialized job only focused on finance, I would say there is less of a chance that they would succeed.”

 

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