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Ever since Booz Allen Hamilton's much cited 2005 study of the performance of companies that hired CEOs from outside vs. the performance of those that promoted from within, a vigorous debate has taken place over the merits of each practice. Examining shareholder returns from 1995 to 2005 for 1,595 companies around the world, the consultancy found that outside CEOs in their first few years typically produce returns four times higher than those achieved by insiders. But in the second half of their tenures, outsiders posted declines of 2.6% in yearly returns, while insiders produced annual increases of 1.1%.
Although those results provide no clear argument in favor of one group over the other, they have framed much of the subsequent discussion of CEO succession in those terms. In the debate, examples of spectacularly successful outsiders like Lou Gerstner at IBM (IBM) compete with examples of equally unsuccessful external hires. Dueling examples of successful and unsuccessful insiders are also plentiful.
Outsiders, it is said, can shake things up, introduce new ideas, and galvanize the organization. Yes, but they lack institutional memory, comes the reply. They can cause the flight of top internal talent that has been passed over, and they often run aground on the company's culture.
Insiders understand the company's business and its industry, already enjoy strong alliances throughout the company, and have the trust of the board. True, but radical shifts in the terms of competition may render their experience moot. And if the succession is unplanned, they can have serious gaps in their development.
These arguments have it backward. The real issue is not whether a new CEO should come from inside or outside but what competencies the company needs and whether anyone who has them can be found anywhere. Strictly following the implications of the study would dictate the highly dubious practice of hiring an external CEO every few years.
When considering CEO succession, the first place to look is neither inside nor outside but into the future. The goal of the board is to arrive at a deep understanding of the company's likely strategy and business challenges at the projected time of the CEO transition. Of course, if the succession is unexpected, as in the case of death or sudden departure, the company's current to midterm strategy is what is most relevant. There may therefore be an internal candidate who is both thoroughly at home with the strategy and ready to lead.
But that choice would be driven not by the fact that the candidate is internal, but by the strategy and the candidate's fitness. The strategy and business challenges will, of course, differ from industry to industry, company to company, and within a given company depending on the time frame of the transition.
For example, whether a company is pursuing growth organically or through acquisition would help determine who is the proper choice, as each requires different strategies and expertise on the part of leaders. Other companies may face operational challenges or need turning around, in which case they need a leader who is adept at cost-cutting and efficiency. It is in turnarounds that companies most often go outside for CEOs (and in bankruptcy, must do so) because it is presumed that insiders have brought on the problems. But even in such circumstances it is the candidate's competencies and experience that are paramount, not location.
The needs of companies in heavily regulated industries will differ from those in unregulated environments. Strategies in sectors where innovation is paramount will differ sharply from those in sectors where asset management rules.
The permutations of all of these strategies—say, an innovation strategy driven by key acquisitions in a regulated industry—are nearly inexhaustible. That's why succession planning should begin with broad agreement on precisely what the company's quite specific mix should be in the near, medium, and long terms. It will then become clear what kind of leader will be needed in each of those time frames, with what experiences, leadership competencies, and personal characteristics.
While the substance of experiences and performance, either inside or outside the company, is certainly relevant to meeting that job specification, where the next CEO comes from shouldn't be part of the specification itself.