23 Jul 2001  Research & Ideas

Looking for CEOs in All the Wrong Places

In searching for a new CEO, many companies depend on board contacts to find candidates and diminish the role of search firms. And that may be a big mistake, suggests HBS assistant professor Rakesh Khurana.

 

At a recent gathering of chief executives in New York City, the CEOs of two companies shared pleasant dinner conversation. The first led a large, successful corporation; the second also served as a director of a telecommunications firm that was looking for a new CEO. No mention of the search was made during the dinner; yet within weeks, the first CEO was interviewing for the telecom post, which he had learned about later through a headhunter's phone call. Why did the telecommunications company use a search firm to talk with the candidate rather than take advantage of the personal ties between him and one of its board members?

Understanding the dynamics of the CEO search process, as well as the ways in which chief executive turnover influences corporate performance, has been the goal of recent research by HBS assistant professor Rakesh Khurana. In a recent working paper titled "Three-Party Exchanges: The Case of Executive Search Firms and the CEO Search," he describes how the function of search firms in CEO recruiting differs from the role they perform when recruiting executives at other levels.

Given current trends, Khurana's research seems especially timely. A leading business publication, for example, recently cited a survey that found that two-thirds of the world's largest companies had replaced their CEOs since 1995. More than one thousand left US companies last year alone.

Khurana's interest in CEO recruiting began with work he initiated with HBS professor Nitin Nohria as a graduate student in 1994. To learn the extent to which chief executive turnover affects corporations, they studied the performance of two hundred of the largest U.S. companies before and after chief executive successions. They discovered that what happens to a firm following a turnover is largely determined by two factors: whether the turnover is forced or natural, and whether an internal or external candidate is selected as the successor.

CEO searches, as currently practiced, are likely to exclude many qualified leaders who fall below the sight lines of directors and their personal networks.
— Rakesh Khurana

"While doing that research," says Khurana, "I began to explore the circumstances and processes that surround CEO succession. This led me to investigate the role of search firms as third-party participants." He soon found that existing research on the role third parties play was inadequate in describing the processes at work in the highly specialized CEO market.

The size of the candidate pool, for instance, is often underestimated. If you believe most search firms, in fact, it's a very exclusive club. Indeed, one headhunter told Khurana that the umber of people who can lead the largest organizations in his country is so small that most search consultants can practically recite them by name. By Khurana's reckoning, however, scarcity of CEO talent is hardly the case.

When searching for external candidates, he points out, boards of directors typically limit their pool to current CEOs of organizations that have been performing well and that share a similar status with the hiring company. In addition, many firms pass over talented executives because their directors still perceive organizational performance as a reliable measure of CEO ability, even when experience and academic research have shown that link to be tenuous. Other circumstances such as market conditions and the skills and experience of the company's senior management team can have a profound impact. All these factors conspire to block many talented leaders from being considered when CEO opportunities arise.

To understand better the inner workings of the chief executive change process, Khurana began an extended period of field research. Between 1990 and 1996, he interviewed nearly forty board members of Fortune 500 companies who, together, had participated in more than a hundred CEO successions. Subsequently, he visited leading executive search firms, where he interviewed senior consultants who had significant experience in CEO and director recruiting.

"I was surprised to find," says Khurana, "that the part consultants play in CEO searches is not really that of a broker, as described by existing research on third-party behavior. Rather, their task in fulfilling an assignment at this level tends to be limited to that of facilitator and communicator." It's the company's directors, he explains, who actually develop specifications for the position and then rely on their own extensive personal networks to identify the majority of candidates.

Only when this phase has been completed does the headhunter assemble general background information, initiate candidate contacts, and begin serving as the conduit between the parties. Finally, when the candidate list has been winnowed to a few individuals, the directors again return to the forefront, calling upon their many contacts to provide information about candidates' personal and professional qualifications.

"There are significant risks to the company and candidates during a CEO search," adds Khurana. "For example, a candidate's loyalty and trust would immediately become suspect should his or her employer, investors, or the public learn that discussions were taking place with another company. Using a third party puts distance between the company and the candidate and gives both sides the freedom to discontinue discussions without damaging their egos and reputations."

Another risk directors face, he notes, is a potential decline in their firm's stock price based on their final choice. This often occurs when the media and analysts react negatively to the new CEO. Homing in on a candidate who is likely to gain the favor of these external parties has therefore become important to the process. It also gives these outsiders added sway in shaping the futures of companies and executives.

Khurana believes his findings are applicable to most large organizations (including nonprofits) that are seeking new chief executives. "Perhaps the most important insight," he says, "is that CEO searches, as currently practiced, are likely to exclude many qualified leaders who fall below the sight lines of directors and their personal networks. In these uncertain times, in particular," he concludes, "the stakes are too high for such a narrow perspective."

Used with permission from Working Knowledge: A Quarterly Report on Research At Harvard Business School, Vol. IV, No. 4.

Peter K. Jacobs is a writer for the Working Knowledge: A Quarterly Report on Research At Harvard Business School.