The Performance Impact of New CEOs

It's been all over the headlines in the last few years: Boards of directors and shareholders at corporate giants such as Procter & Gamble, American Express, IBM and AT&T have ousted incumbent CEOs in the hope of improving company performance. But is CEO turnover an effective mechanism for boosting performance? According to Harvard Business School professors Rakesh Khurana and Nitin Nohria's new study “The Performance Consequences of CEO Turnover,” it depends on the circumstances.

Previous studies provided few definitive answers on the relationship between CEO turnover and subsequent company performance. Khurana and Nohria's research differs from those studies in that it links the two fundamentals of turnover: the circumstances of a CEO's departure and whether successors come from inside or outside the company. Khurana explains, “Research on the subject has tended to produce conflicting results, in part because it has treated turnover as two independent events: the departure event, when a CEO either willingly retires or is fired, and the succession event, when either an insider or an outsider is hired. In fact, the two are closely intertwined.”

The researchers examined CEO turnover at Fortune 200 companies from 1980 to 1996 and used annual operating returns to chart changes in company performance. They divided turnover into four categories: the voluntary, or “natural,” departure of a CEO who is then succeeded by an insider; natural departure followed by an outsider; forced departure followed by an insider; and forced departure followed by an outsider. They found that when a natural departure was followed by the promotion of an insider, no change of any statistical significance occurred in company performance. “Replacing a retiring CEO with an insider represents support for the status quo, so performance tends to remain even,” Khurana asserts.

Neither did performance change when a CEO's forced departure was followed by an insider filling the position. Firing a CEO signals a mandate for change. But an insider, linked to the political and operational status quo, rarely has the skills or the maneuvering room to make the kinds of dramatic strategic changes — such as downsizing or taking on substantial debt — that affect performance. However, when an outside hire replaced a fired CEO, company performance rose by more than 4% during the three-year period following the change. Nohria explains, “Our results show that to improve a company's performance, an outsider should be brought in following a forced departure. Lou Gerstner at IBM is a prime example. Outsiders have the skills and capabilities to make good on the change mandate — and they lack the ‘baggage’ that tends to cripple insiders.”

One recipe for failure, apparently, is to replace a retiring CEO with an outsider. The study registered a nearly 6% drop in performance under that condition. The CEO's natural departure fails to provide the outsider — who has the skills and capacity for making the kind of strategic changes that would improve performance — with the clean slate to take action. “Outsiders often face opposition from the incumbent senior management team when they replace a retiring CEO,” comments Nohria. “Consider, for example, the case of AT&T. John Walters was hired from the outside to replace the retiring CEO Bob Allen. Walters didn't last long. Only after Walters' firing was a new CEO, [C. Michael] Armstrong, able to come in and effectively make changes.”

CEO turnover is not a simple solution to a company's problems. “We live in a society that is quick to praise or blame individuals without looking at the context in which they operate,” says Khurana. “Boards of directors and shareholders need to create conditions in which their CEOs can succeed. They need to ask themselves such questions as: Is the top management team willing to support the new CEO and the changes he or she might implement? And if not, does the CEO have the freedom to select supporting players who will?”

When Gillette and Xerox fired their CEOs last year, the companies embarked on a long search for replacements. If they and companies like them are seeking improved performance, the course is clear: Hire an outsider and clear away any obstacles to change.