Companies looking for the best possible leaders—and leaders looking to become CEOs—would do well to heed the model of private-equity (PE) backed companies, which often look outside their ranks when hiring for the top job and see excellent results.
Three-quarters of new CEOs at PE-owned companies are external hires, and roughly two-thirds are “complete outsiders,” finds a recent working paper by Paul Gompers, the Eugene Holman Professor of Business Administration at Harvard Business School. In contrast, one recent analysis found that 72 percent of S&P 500 companies drew new CEOs from within their own ranks.
“What you really do need is knowledge of that specific industry, whether it's pharmaceutical or manufacturing or hospitality or rocket science.”
The findings suggest an active market for CEOs, who are lured to PE-owned companies by higher compensation, less public scrutiny, and the operations expertise that PE firms bring to bear. CEO selection may soon become even more critical for PE funds, which have been grappling with inflation and rising interest rates that dampened fundraising, investments, and exits last year.
The research also indicates that firm-specific knowledge isn’t necessary when looking for the right top executive; industry expertise often counts more. Many of these leaders have previous public-company management experience, and they deliver outsized returns for themselves and the PE-backed companies they are recruited to lead.
“You’ve got to learn the specifics of the company, but it's not as hard as you think,” says Gompers, who coauthored the study with Steven N. Kaplan of the University of Chicago’s Booth School of Business and Vladimir Mukharlyamov from Georgetown University’s McDonough School of Business. “What you really do need is knowledge of that specific industry, whether it's pharmaceutical or manufacturing or hospitality or rocket science.”
Cracking the code of PE-backed firms
The authors looked at 193 companies bought by PE firms from 2010 to 2016 valued at $1 billion or more, roughly the equivalent of mid-sized public companies in the S&P 400 Index. Some 70 percent of the PE-backed firms hired new CEOs when they were acquired, and about two-thirds of those new CEOs were outsiders to the company (though many had general industry expertise).
Unlike public companies, private firms typically don’t disclose compensation details, including a top executive’s stake in the firm. So, the researchers turned to Pitchbook, a company that tracks buyout data for private companies. They added specific CEO data from Capital IQ, LinkedIn, press releases, and company websites. Researchers then identified CEOs as outsiders if they had been with the PE-owned company less than a year from when it was acquired until the PE fund’s exit.
Some 30,000 private equity deals valued at $4 trillion took place in the five years ending in 2021, the authors write. That equals the market value of roughly 10 percent of the S&P 500 and includes more firms, the researchers note.
Strategy yields dividends for companies and new CEOs
Choosing an external CEO seems to pay off for both the executive and the private equity firm itself, the research finds.
The average PE fund formed between 2010 and 2016 outperformed the S&P 500 by a cumulative 22 percent and an annualized 5 percent, the authors note. And CEOs of PE-funded companies receive lucrative incentives that can include up to 10 percent of equity upside, a way to take a cut of future returns.
The best horse for the race
Why the disparity? For one, public firms tend to be bigger and may have more internal talent. Board members may also lack enough skin in the game—such company stock ownership—to properly weigh risk, the authors theorize.
“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.”
PE firm executives tend to sit on acquired company boards and own bigger financial stakes in their portfolio companies, the researchers write. So, while the risk may appear higher, 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,” Gompers says. “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.”
What should aspiring executives do?
For executives looking to reach the top spot, a private equity move can be lucrative—and career-boosting. Researchers were able to estimate pay for 41 CEOs of those examined whose companies exited private equity ownership.
Assuming executives held 2 percent of the equity in their respective companies, private equity CEOs earned an average of $9.4 million, the researchers estimate. At stakes of 3 percent and 4 percent, PE-backed CEOs earned an estimated $13.2 million and $17.3 million, respectively. That’s more than twice the pay of CEOs of S&P 400 MidCap companies.
CEOs at private firms may have to answer to their PE owners, but they don’t have public-facing stressors like quarterly earnings expectations from Wall Street analysts and investors, the researchers note.
Public companies should ‘cast a much wider net’
For public companies, the findings offer a fresh look at a potential pool of candidates.
The authors cite Boeing CEO David Calhoun as just one prominent example. Calhoun, who became vice chairman of General Electric after running the aerospace and other divisions, left the company to run the much smaller, PE-funded Nielsen Holdings. After taking Nielsen public, he moved to a senior position at PE firm The Blackstone Group to run portfolio operations. Boeing later named him CEO.
“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.”
Public companies like Boeing typically hire external CEOs only after poor performance, the authors note.
“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,” Gompers says.
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Feedback or ideas to share? Email the Working Knowledge team at hbswk@hbs.edu.
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