The recent departures of two of the world’s most prominent chief executives in the wake of major financial losses at their firms — Stanley O’Neal of Merrill Lynch and Charles Prince of Citigroup — have focused renewed attention on an important but often neglected component of corporate management: succession planning.

While the boards of both companies conducted internal and external searches to find successors, published reports speculated that they would hire from the outside. On November 14, Merrill Lynch did its part to confirm those rumors by announcing that John Thain, CEO of NYSE Euronext and a former president of Goldman Sachs, will become chairman and CEO of the firm effective December 1. Meanwhile, Citigroup has named former U.S. Treasury secretary Robert Rubin as its chairman while continuing its chief executive search, having tapped Sir Win Bischoff, a London banker who joined Citigroup when it acquired the investment banking operations of Schroeders in 2000, as the company’s interim CEO.

According to Wharton faculty members, hiring CEO successors from the outside isn’t surprising in cases like Merrill Lynch and Citigroup: The financial debacles that led to combined write-downs of more than $15 billion at the two firms, stemming from turmoil in the sub-prime mortgage market, mean that their boards may prefer to start fresh by hiring outsiders. But, they say, companies are increasingly looking to fill top spots with external candidates, while placing less emphasis on grooming employees to fill those roles. 

Indeed, a November 26 Wall Street Journal article, citing a survey conducted by the Center for Board Leadership and Mercer Delta Consulting, noted that “only about half of public and private corporate boards have CEO succession plans in place … even at giant global companies that have thousands of employees and spend millions each year to recruit and train talent.”

“The trend line from 1970 to 2000 shows a slow but steady increase in the number of companies that look to the outside in the case of a departing CEO,” says Wharton management professor Michael Useem, director of the school’s Center for Leadership and Change Management. “At the start of that period, one in seven new CEOs at major companies came from outside the firm; by the end, one in four.”

The ‘Heir Apparent’

According to Wharton management professor Katherine Klein, bringing in an outsider for the top job poses risks. “If you go outside, there’s a huge learning curve to understanding a company’s strategy and culture,” says Klein. “A CEO who comes in from the outside is very dependent on those left in the company for orientation, perspective and information. That’s potentially problematic.”

In general, Klein notes, given the complexities of running a major corporation, “what you would like in an ideal scenario is careful succession planning that grooms people internally. One reason is you want to maintain the intellectual capital of the organization. Another is that you want to motivate people in the upper levels of the company to stay and excel because they might get to lead the company someday. I’d rather see a company have a culture that welcomes newcomers at all levels to maintain freshness and new perspectives — but not bring in someone at the height of a crisis. As important as new perspectives are for a company’s long-term survival, it’s risky to bring in an outsider as CEO when the ship is listing because the learning curve is awfully huge.”

Peter Cappelli, management professor and director of Wharton’s Center for Human Resources, suggests that for many companies, there is “a huge disconnect” between the reality and the intent on the part of people engaged in talent management. And firms often undercut their succession plans by going outside to hire new CEOs when the going gets tough.

“A lot of companies don’t do any planning, period,” Cappelli says. “But in bigger ones, particularly the older companies, they develop people with the assumption that they will advance into top executive positions. I’m not sure all companies designate the heir apparent to the CEO job the way they did in the 1950s, but they’re still plugging away at the process. Yet the odds on the process playing out successfully are so small you have to question why they’re doing it. Every time a company appoints an external CEO, all that internal process is wasted.”

According to Cappelli, a survey of CEOs at large companies found that only 25% had any kind of talent planning past two levels below the CEO — i.e., below the senior vice president level. It is not that companies have abandoned succession planning and other practices and moved to new approaches, he says. Instead, firms appear to have abandoned the systematic management of talent.

Ideally, Cappelli adds, it is not necessary for firms to groom specific people to become CEOs — or, indeed, for any other specific position. It is best for companies simply to “develop people so that their skills continue to improve.

“I don’t think the idea ought to be to develop people for a particular job,” Cappelli says, “because the odds of using them in that way are pretty small. Both the person and the job have to be lined up too exactly for that to happen. Boards of directors ought to be developing people who can fill the executive vice president jobs because there’s some chance those appointments could be internal. Boards also ought to be developing general managers because CEOs sometimes come out of that experience.”

It is true that General Electric, which is widely known for its talent-management capabilities, produced a handful of people who were publicly known to be in the running to replace Jack Welch when he retired as CEO in 2001. When Jeffrey Immelt got the nod, the others left the company to become chief executives elsewhere: Robert Nardelli first became head of Home Depot and is now head of Chrysler, while Jim McNerney went on to spend more than four years as head of 3M and is now CEO of Boeing.

But Cappelli says GE is unusual among large corporations in being able to groom specific successors for the CEO post. “GE is an anomaly because it’s so big. Running a part of GE means running something larger than 98% of the companies in the U.S. The general managers at GE are ready to step into many other jobs elsewhere. GE does invest a lot in trying to develop people internally. One of the reasons for that is they’re a big, diversified and reasonably stable company whose success has allowed them to be internally stable. If performance got bad at GE and they started bringing in outsiders, you’d have to wonder about” the company’s ability to continue the kind of succession planning it has been doing.

John R. Kimberly, a Wharton management professor, agrees that succession planning is just one piece of the much broader endeavor of talent management. “If a company does it right, it’s not just thinking of the top job but is looking down three or four or five levels. Bench strength is the key.”

One company with renowned bench strength is Toyota. “Toyota has lost several very senior people recently, which is unheard of in Toyota. People are starting to raise questions about whether there are cracks appearing in the management structure there,” Kimberly says. “But the CEO, Katsuaki Watanabe, has been very calm about the matter. He has said Toyota hates to lose these people, but that the company has real management depth and that this won’t affect them.”

Indeed, one of those senior executives, Jim Press, who left Toyota after 37 years to become vice chairman and CEO of Chrysler, was replaced within 24 hours by Shigeru Hayakawa, a 30-year Toyota veteran.

Shallow Talent Pools

While a decision by Citigroup or Merrill to hire outsiders as CEOs might send a positive signal to investors, it could have negative long-term consequences by depleting a pool of talent that may already be precariously shallow, notes Wharton management professor Lawrence Hrebiniak.

In looking outside to possibly replace O’Neal and Prince, the boards “realize they might not have the bench strength” to promote from within, he says. “They don’t have people who are general-manger material, but by going outside they make it worse. They are giving signals to [internal] managers that the managers aren’t ready to move into the CEO role. They are going to have even more problems in the future with managers leaving because a person from the outside is going to bring his own people. He’s going to have his own way of doing things. The people inside are going to believe that their career paths are truncated by outsiders coming in.”

Hrebiniak notes that the difficulty of running organizations as complex as Citigroup and Merrill means that their CEOs need to have strategic vision and wide experience. But such talent is often lacking on Wall Street, in Hrebiniak’s view, because the chief executives of financial firms, while successful at trading or money management have little knack for managing large enterprises.

“When you look at firms like Citigroup and Merrill Lynch, for years all their top management people were finance people, numbers people, traders. Years ago, these companies were smaller, so you had a group of people who understood finance and everything was fine. But what’s happened? With mergers and acquisitions and growth, Citigroup and other financial organizations need a whole new brand of management. They have to worry about M&A, integrating companies, building products across firms. They have to worry about general management, but they have had no training at that and aren’t good at it.”

Hrebiniak adds that Merrill and Citigroup, like all Wall Street firms, have been under intense pressure by investors to perform. “The Street has been killing them for lack of performance, so they start thinking short term. They have gotten rid of top people in the past year, or these people have left voluntarily. Why? Investor pressure. The CEOs don’t know how to manage strategically and they are losing talent. The firms [lack] strategic thinking. They might want to find someone internally [to replace the departed CEOs] but now they can’t because they haven’t been grooming new people.”

Finding a Fresh Perspective

Elizabeth E. Bailey, a Wharton management professor who sits on the boards of Altria and other companies, says that even if succession plans have produced insiders capable of being chief executive, the boards of Citigroup and Merrill would have little choice but to select outsiders for their new CEOs.

“The reason [O’Neal and Prince] were asked to leave is because they misestimated the risk of these new types of mortgage securities to a huge degree,” according to Bailey. “My sense is that when there’s a major failure in performance, then you don’t want [to promote] the person you have groomed, even if you’ve done great succession planning. You want somebody with a fresh perspective.”

“Boards go outside for CEOs in situations where things haven’t been going all that well,” agrees Cappelli. “The best way to let people in the investment community know that you didn’t like the way things were going is to get rid of everybody associated with the old approach. In that context, an internal successor has got no prayer of becoming CEO. It doesn’t matter how wonderful the person is; he or she is just tainted by their association with the previous regime. The directors feel the need to signal a change in direction, so pretty much anybody associated with the old regime can’t be advanced.”

Boards that hire outsiders to be CEOs feel that change is more important than continuity, says Kimberly, who is author of the recently published The Soul of the Corporation: How to Manage the Identity of Your Company. “If a board is looking for continuity in the way the firm is managed at the top, they look inside, where there’s deep knowledge, presumably, of the organization’s culture and identity among the heirs apparent. There’s a high likelihood that the new person will build on the past. If the board feels a severe, substantial change of course is required, it makes more sense to go outside.”

How can Citigroup and Merrill — and other companies in similar situations — retain the loyalty of the senior executives passed over for the top post? The Wharton experts say boards often do not worry about smoothing ruffled feathers with sweetened compensation because those senior executives, aware of how rough the game can be at the top, will look for work elsewhere.

In Bailey’s view, the search committees at Merrill and Citigroup are asking themselves: Who is the person best suited to meet the future issues of our firms? “And the issue facing both firms is being able to handle risks well. No one inside had the sense to speak up against the risk that these companies took. The search committees — especially Citigroup’s, which is a very complex company — will make a list of the three or four most important attributes going forward and make sure the successor has the attributes. One is that the successor knows enough about these new, complex financial instruments so that the company doesn’t get sucked into the momentum” that caused their problems in the first place.