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The Irrational Quest for Charismatic CEOsSeptember 16, 2002

by Martha Lagace, Senior Editor, HBS Working Knowledge

The cult of the CEO is complex andpersistentand usually not good for business, saysHBS professorRakesh Khurana. Khurana recentlyfielded questions from HBS Working Knowledgesenior editor Martha Lagace in an e-mail interviewabout his new book, Searching for a CorporateSavior: The Irrational Quest for Charismatic CEOs

(Princeton University Press, 2002).

Lagace: CEOs are suddenly very much in thespotlight, but you have been studying the dynamics

of CEO successions for a number of years. What drove you to examine this topic in such depth?What surprised you most in your research?

Khurana: I guess one could have accused me of being opportunistic in writing this book, but thefact is the book was finished last year and is only now getting published. I actually wrote my

dissertation in 1998 on this topic.

The common thread that got me started on studying CEOs is evident in my body of work in

exploring the forces that govern the process of CEO change. I have conducted research in fourinterrelated areas: factors that lead to vacancies in the CEO position; factors that affect thechoice of successors; the role of market intermediaries such as executive search firms in theCEO search; and the consequences of CEO succession and selection decisions for subsequentfirm performance and strategic choices.

What surprised me most was that the CEO labor marketis not a market in any traditional sense of the term.Rather, it resembled more of a closed ecosystem inwhich selection decisions were based on highly stylizedcriteria that often had little to do with the problems a firm

was confronting.

Although I did not at first believe the results, the evidencewas overwhelming and not pretty. The rise in the powerof institutional investors has led to the creation of an"external" market for CEOs that is wracked with irrationaldecision making. Increasingly, the emphasis was more on bringing in a ruthless outsider to boostthe performance of an under-performing company than on grooming leadership within thecompany. A famous CEO was preferred over a low-profile CEO, as the former was seen as a

boost to public and investor confidenceand share pricesfast.

Companies reflexively look to charismatic CEOs to save them, and that's a bad

idea, says HBS professor Rakesh Khurana. In this excerpt from his new book andin an e-mail interview with HBS Working Knowledge, he explains how the CEO cultarose.

Industry wisdom,

company relationships,and technological

expertiseall matterinour new knowledge-based

enterprises.

Rakesh Khurana

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Q: What consequences do you see in bringing in CEOs from the outside, both to a company itself

and to business at large? Which of these strike you as most pernicious?

A: I think several of the consequences are now becoming evident. When everyone sees what'sgoing on with Enron, the escalating CEO paywhich continues to go up despite a dramatic dropin corporate performanceand the issues about how top executives seem to be getting a

different kind of deal than employees get, there is a fundamental cynicism about the freeenterprise system. The closed CEO labor market and the consequences it has wrought

fundamentally threaten the integrity of our corporations.

And not just in the U.S. The rise of the charismatic CEO, escalating pay, and the consequencesof Tyco or Global Crossingthese have reverberations across the world. It undermines themedium-term and long-term prospects of countries that are now just embracing a free enterprisesystem.

Q: What accounts for the social fiction, as you call it, that there are very few qualified CEO

candidates available?

A: There are two big factors that have influenced this. Thefirst is the rise of the institutional investor. Before this,managers were fairly autonomous from shareholdersbecause shareholders were a diffused group. Institutionalinvestors have gone from owning only 5 percent of the totaloutstanding equity to 60 percent, which is a significant jumpand gave them a lot of power. Basically, institutional investorsbegan exerting their muscle, after a very significant decline in

corporate performance in the United States, in the 1980s. They started exerting direct pressure

on the boards to remove the management of under-performing companies.

By the early 1990s, we saw a further rise in institutional investor power and their willingness toexercise it. As they had become such large percentage holders of equity in the U.S., they couldn't

just sell the shares in their companies, and the only vehicle through which they could exercisetheir vote was through their voice. They pressured directors to remove CEOs at under-performingcompanies. Now, this is a good thing; but very soon this started having some serious unintendedconsequences, one being the fiction that there is actually a real CEO labor market.

Let me elaborate.

It is natural to wonder why boards routinely bypass thousands of internal candidates for the ninetyor so CEO positions that come open in a given year. Certainly the usual reasons have becomeclichs: Disruptive technologies, emerging global competitors, changing workforce expectations,and heightened investor concerns over immediate stock price have put pressure on boards to findreassuring, battle-tested candidates for top jobs.

Boards reason that a firm in need of transformation may not have the internal talent ready tomake the change. Internal candidates are assumed to be part of the problematic old culture.Perhaps most importantly, CEOs have become "branded" like jeans or cola. Investors arereassured when they see management falling to familiar faces.

It's true that sometimes going outside is the right way to go. The strategic transformation at IBMrequired someone like Lou Gerstner to challenge the complacency. The Home Depot board feltjustified in turning to outside CEO Bob Nardelli, assuming that the founders' charismatic influence

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may not have nourished an internal candidate needed to take the firm past its early,

entrepreneurial stage.

Yet how do other boards justify turning reflexively tositting CEOs with supposedly proven track records? The

pool of these marquee names is limited. Such scarcitynaturally drives up wages; the compensation of the tenhighest paid CEOs has soared 4,300 percent during thepast twenty years, the same period that outside hires

grew from 7 percent to 50 percent.

The cost of creating this closed ecosystem of top-tierexecutives is more than the price of CEO compensationand searches. It is also the cost of the failed messiahs

who could not deliver the promised results.

Industry wisdom, company relationships and technological expertise all matter in our newknowledge-based enterprises. Perhaps Apple's John Scully should have remained at Pepsi;

Kodak's George Fisher at Motorola; H-P's Carly Fiorina at Lucent; and Xerox's Richard Thomanat IBM. But as boards routinely bypass their internal management, the message to talent is to

look elsewhere.

Q: How do you think companies should revamp their thinking and their procedures when they

replace a CEO? How hopeful are you that the "closed shop" for CEOs will open up in time?

A: I am not optimistic about the near term. The problem is that the board's selection process isembedded within a larger system of analysts, institutional investors, etc. They also believe in fastresults; they also make the attribution that if a firm is not doing well, it must be because of theCEO; and if it is doing well, it must be because of the CEO.

They live in a society that has always treasured the image of a cowboy, the Lone Ranger, orPrince Valiant coming in to clean up the town or rescue the distressed. So, in many ways they are

just as much embedded in this larger kind of cultural construct.

If you look at business magazines, for example, it seems the only explanation you need for GE'sperformance is Jack Welch. But that would mean the future of American corporations is incloning. Rather, people should ask: What are the systems by which a company like GE has, formore than a century, produced good managers? Systems like: hiring internally, investing heavilyin the training of its people, rotating them, developing them, putting them in challengingassignments.

Those are things you can actually do something about. What I am saying is that companiesshould clone the processes in developing effective leaders, not hope for a messiah to swoop in

and save them.

The closed CEO labor

market and the

consequences it haswroughtfundamentallythreaten the integrityof our corporations.

Rakesh Khurana