An increasing number of CEOs are exiting their positions prematurely. The reason, according to Rice University’s Yan Zhang, may be rooted in the effects of information asymmetry — where one party has more inside information than the other — at the time of CEO selection.
The forced or sudden resignation of the preceding CEO, the selection of an outside candidate with no inside experience, and a board of directors with too many internal ties or external distractions — these business scenarios are at the heart of many faulty CEO selections, said Zhang, an associate professor at Rice’s Jesse H. Jones Graduate School of Management. Recent research by Zhang points to information asymmetry at the hiring stage as an explanation for the false start of many new CEOs, and shows how companies can keep their executive searches balanced and companies stable well beyond the leadership transition.
Poor company performance and CEO dismissal — you might think the two go hand in hand, but it’s not always that simple, according to Yan Zhang, an associate professor at Rice University’s Jones School of Management. “The general conclusion of prior research is that when a firm is not performing well, you change the leader,” she said. “However, in recent years, we have observed many new CEOs being fired, say, 11 months, 15 months, or two years after assuming the top post.”
In fact, the dismissal of new CEOs is becoming increasingly common, Zhang said. Upon analyzing the cases of 204 new CEOs who took office between 1993 and 1998, Zhang discovered a significant proportion of them were dismissed within three years after taking office. Of the 204 company chiefs, 55 left within three years of being hired, and approximately half of those executives (26) were dismissed. Poor firm performance can’t explain the dismissals of these newly appointed CEOs, Zhang said, because the executives likely did not have enough time to implement strategic decisions that could have adversely affected firm performance. She analyzed the data and discovered a different reason for these dismissals — information asymmetry.
Zhang describes information asymmetry as a situation where one party knows less inside information than the other. In the instance of CEO selection, the board of directors of the hiring firm knows less than the CEO candidates regarding their true competencies. As a result, it is very possible that the board makes a faulty hire and then dismisses the CEO shortly after the succession.
There are three instances of how unbalanced information can negatively impact the selection of a new chief executive. The first concerns the origin of the new CEO — whether he or she was an internal or external candidate. The second is the context of the preceding CEO’s departure — whether it was a voluntary departure or a dismissal. And the third is the composition of the board of directors’ nominating committee — whether they are primarily in-house or independent directors, and whether they serve on a number of other boards.
The origin of the new CEO is important, Zhang said, because inside candidates are typically already CFOs, COOs, or EVPs with the company. “They would have had numerous opportunities to interact with the board members,” she said. “The board has a great opportunity to know inside candidates, thus reducing information asymmetry between the board and inside candidates.” Meanwhile, the board is less likely to know outside candidates and more likely to make a poor hiring decision in outside successions.
Circumstances of the preceding CEO’s departure also play a tremendous role in the success of the next chief executive, Zhang said. Because many companies institute mandatory retirement ages, planned succession can help ease a seamless transition, as a company can groom an heir apparent before the CEO departs. Also, if the company doesn’t have a good pipeline of talent, the board can search in advance of the retirement — making it more likely that a comprehensive internal and external search will turn up higher-quality candidates. However, if the preceding CEO is dismissed, then inadequate preparation means higher information asymmetry and a higher likelihood that the board will make a poor hiring decision, Zhang said.
Finally, the composition of the board’s nominating committee may have an influential effect on early CEO dismissals. Nominating committees that are primarily independent (not consisting of company executives) are better than those with internal directors, because the latter may perceive themselves as contenders for the position, Zhang said. “They’re not going to bring objective evaluations to the CEO selection process,” she pointed out. However, independent board members come with risks. “If a company has outside directors on the board, but if those outside directors are too busy — having too many other directorships — then the nominating committee is not effective,” she said.
“Of course it’s good to hire a GE CEO or a Proctor & Gamble CEO — very visible people — to be your outside directors,” Zhang said. “They not only bring in knowledge and expertise, but also visibility to your company.” Yet if they are too busy to find viable CEO candidates, they may only bring about more instability moving forward.
For more information, contact Yan Zhang at firstname.lastname@example.org or Laura Hubbard of the Jesse H. Jones Graduate School of Management at email@example.com.