When looking for a new boss, it can be tempting to give preference to internal candidates on account of their familiarity with how the organization works. Research from Harvard Business School suggests, however, that external candidates may actually be the better option.
The researchers draw inspiration from the private equity industry, where around 75% of new CEOs are drawn from outside the firm, with two-thirds regarded as “complete outsiders”. This is almost the exact opposite of recruitment in S&P 500 firms.
New markets
The data implies a lively market for CEOs, enticed by the prospect of elevated remuneration, reduced public scrutiny, and the operational proficiency that private equity (PE) firms offer. As PE funds confront the challenges posed by inflation and mounting interest rates, which hampered their fundraising, investments, and exits in the previous year, the task of CEO selection may become even more crucial.
Additionally, the findings suggest that specialized knowledge pertaining to a particular firm is not always a prerequisite when seeking the right top executive; industry know-how frequently carries more weight. Many of these leaders possess prior experience in managing public companies, and they generate exceptional returns for both themselves and the PE-backed companies that they are recruited to head.
“You’ve got to learn the specifics of the company, but it’s not as hard as you think,” the researchers explain. “What you really do need is knowledge of that specific industry, whether it’s pharmaceutical or manufacturing or hospitality or rocket science.”
Choosing leaders
The authors examined 193 private equity (PE)-backed companies valued at $1 billion or more, a figure comparable to mid-sized public firms in the S&P 400 Index, that were acquired between 2010 and 2016. The study revealed that approximately 70% of the PE-backed firms appointed new CEOs upon acquisition, with about two-thirds of those top executives being external candidates (although many had general industry expertise).
In contrast to public companies, private firms typically do not divulge compensation details, including a CEO’s stake in the company. To overcome this, the researchers utilized data from Pitchbook, a firm that tracks buyout data for private companies, along with specific CEO data from Capital IQ, LinkedIn, press releases, and company websites. The researchers identified CEOs as external if they had been with the PE-owned company for less than a year from acquisition until the PE fund’s exit.
The study also noted that there were around 30,000 private equity deals with a total value of $4 trillion between 2016 and 2021. This figure is equivalent to the market value of approximately 10% of the S&P 500 and involves a more extensive range of firms, according to the researchers.
Paying off
The advantages of appointing an external CEO for private equity firms are clear, the research suggests. The rewards for both the executive and the firm are substantial. The analysis of PE funds established between 2010 and 2016 found that they outperformed the S&P 500 by a cumulative 22% and an annualized 5%.
Meanwhile, CEOs of PE-funded companies are offered enticing incentives, including up to 10% of equity upside, providing a share of future returns.
The disparity in performance between public firms and PE-funded companies may be attributed to several factors. Public firms tend to be larger and have more internal talent, while board members may lack sufficient stock ownership to fully consider risks.
Conversely, PE executives frequently sit on acquired company boards and have larger financial stakes in their portfolio companies. While the risk may be greater, so are the financial rewards.
“In public companies, the board appoints the CEO, and most board members of public companies are professional board members. And the thing that they care about most is keeping their job,” the researchers explain. “The private equity firm really just cares about improving that company’s performance and making that company work. We know that they’re going to want to hire the best horse for the race.”
Casting a wider net
The recent findings could provide public companies with a new source of potential CEO candidates. The study highlights the example of David Calhoun, former vice chairman of General Electric, who left to lead the much smaller, PE-funded company Nielsen Holdings. After successfully taking Nielsen public, he went on to become a senior executive at The Blackstone Group, overseeing portfolio operations. Eventually, Calhoun became CEO of Boeing.
Traditionally, public companies such as Boeing only seek external CEOs in response to poor performance. However, the research suggests that exploring external CEO options could be a proactive strategy for firms seeking to enhance their performance and leadership.
“Boards need to cast a much wider net, to strongly consider the benefits of bringing somebody with a fresh set of perspectives, somebody with perhaps more drive,” the authors conclude.
