CEO Replacement Demystified

Most of us have been employed by an organization that has replaced its CEO. Or, where we believed it was necessary to change the CEO, but it didn’t happen. This article provides some insights into the decision-making process that has historically underpinned this critical dilemma. The contents of this article are a synthesis of more than thirty separate research studies into this specific topic.

Financial Performance as a Decision Escalator

There is sufficient research evidence to support the idea that the need for a CEO transition is most often escalated to Board-level prominence due to financial underperformance. A study of CEO transitions from 1971 to 1995 found that the vast majority of the 1,344 U.S. public company transitions, which occurred during this period, did so based on declines in the financial performance of the organization. It is not just Boards of Directors that exert pressure to change, but corporate debt holders also hold significant sway. In fact, organizations that perform more than a single standard deviation below the average performance of the industry have been shown to have the highest CEO turnover rates, primarily due to pressure from external stakeholders. To illustrate this: if the industry is growing at 1% per year, with a standard performance deviation of 3%, a company consistently performing at -2% or lower would historically be a candidate for a CEO change.

The consistent track record of replacing CEO’s based on poor financial performance likely exists because most CEO change events have actually been found to result in performance improvements. However, despite the tendency toward positive performance outcomes, company debt is often increased to fund the turnaround efforts, resulting in little improvement in overall enterprise value. The alternative option of holding on to an underperforming CEO (at more than -1 s.d. versus the industry) has historically resulted in diminished enterprise value. Yet, CEO replacement can also have disastrous outcomes, where the rule of a poor replacement decision is an accelerated performance decline and bankruptcy. The lesson, positive outcomes resulting from a CEO change are not a foregone conclusion.

Determinants of a Successful Outcome

What the financial evidence suggests is that Board’s are quite adept at determining when to make a CEO transition decision. The fact that most result in performance improvements has seemingly reinforced the desire to make this change, and over time success and failure in such decisions has led to the development of tacit knowledge, amongst senior leaders, about when best to do so. For example, CEO turnover has been linked to subsequently poor performance when succession planning is limited and the replacement is ill suited to the challenges of the organization. Seasoned Board’s implicitly seem to understand this, and as a result, recent research suggests that they appear to contemplate this decision, and research replacements, for a longer period of time than they did twenty years ago.

Organizational performance improvements generally only occur when the Board has a clear sense of the challenges and strategic opportunities that exist in the marketplace. In particular, it has been found that moving away from current thinking, through a strategic repositioning of the organization, is the primary driver of post-change performance improvement.  Yet, given the considerable risks associated with both CEO and strategic change, it must be concluded that a precondition for this decision is the belief that important opportunities exist, which could not be captured by the incumbent CEO. In this regard, it has been posited that the failure of a CEO to cognitively adapt to the evolving environmental challenges that the organization faces, is the primary reason for underperformance and subsequent CEO replacement.

Underpinnings of Cognitive Entrenchment

If Boards, who are often made up of sitting and former CEO’s, have developed an understanding of when best to make a replacement decision, why do incumbent CEO’s fall victim to such issues? I think this is an interesting question given that almost all CEO’s have exhibited success in their industries prior to reaching the point where their performance starts to decline. The research literature suggests that the antecedents of underperformance are predominantly psychological. For example, there is considerable support for the idea that CEO’s reach a point where holding on to power becomes more important to them than taking short-term risks to gain the longer-term benefits, which can come from the pursuit of strategic change initiatives.

As a means of maintaining power, CEO’s start to slow organizational change efforts and consolidate decision-making into a select group of individual supporters. This then leads to groupthink, as this group becomes more and more isolated and entrenched in their own beliefs. Bazerman and Moore, in a 2008 research paper, call the resulting effect “bounded awareness”. It is through the limiting of perspectives of one’s own abilities, and the reality of the situation being faced by the organization, which leads otherwise competent executives to fall into this decision-making and leadership trap. Seldom does retaining such leadership result in an organization that can ultimately break free from these decision-making encumbrances.  

Summary

The decision to replace a sitting CEO is a perilous one. Yet, there is considerable evidence to support the need to make this change when certain performance and strategic criteria have been met. Specifically, consistently underperforming the industry by more than one standard deviation, or failing to adapt strategies to the changing environment, are the primary determinants of CEO replacement. What is interesting in the research findings is that CEO change is very rarely undertaken for any other reasons. Being a horrible person, being borderline abusive, violating the employee handbook, being a poor developer of people, having high employee turnover, none of it really seems to matter compared to the ability to deliver results and navigate the organization through the evolving marketplace.

In general terms, CEO replacement is only successful when the replacement candidate is fully knowledgeable of the industry and of the challenges that need to be faced. It is also imperative that the Board has issued a clear strategic change mandate. In almost all other cases, CEO change has been found to accelerate the performance declines and threaten the survival of the organizations involved.

I hope this article is enlightening for any CEO’s, employees or Board members who may be pondering their current situation. Please share it with anyone whom you believe may gain some useful insights. Please also feel free to message me if you would like to receive any of the research references used to compile this article, or if you would like to discuss any of the insights provided or implied.