When a company hires a new CEO from outside the firm or even from another industry, the move is often greeted with fanfare and high hopes that significant changes will soon follow.
Whether those changes will be for the better may depend on an unexpected factor that two ASU researchers have identified: Is the CEO’s new board of directors as diverse as his or her previous board?
When the two boards are similarly diverse, turnover among CEOs and directors is less likely, and the company is more likely to reap the benefits in improved financial performance, says Associate Professor of Management David Zhu and Professor of Management Wei Shen. Conversely, dealing with more diverse boards can mean greater conflict between CEOs and the directors who advise and monitor them, costing both sides time and energy, slowing significant changes at the company, and setting the stage for turnover and poorer performance.
“Some CEOs can work very well with a diverse board. When that happens, their productive relationship will evolve, and directors’ different backgrounds will help a firm improve decision-making and lead to better performance,” Zhu says. “In contrast, when a CEO is not comfortable working with a diverse board, the conflicts created will severely limit the board’s ability to improve performance.”
The issue melds the interests of Zhu, who focuses on the decades-long trend toward increasing diversity of boards of directors, and Shen, who studies the challenges CEOs face.
Conventional wisdom on board diversity suggests that directors with varying backgrounds and expertise will be better at advising and monitoring CEOs than directors who are more homogenous, Zhu says. However, studies are still mixed on whether that diversity leads to better financial results.
The business world also believes that CEOs hired from outside can bring many changes to their new companies, Shen says. But some new CEOs are better able than others to meet the challenges that come with being an outsider, and research on CEO successions is still trying to understand why.
Seeking reasons for success vs. failure
Zhu and Shen wondered whether those differing outcomes are related to the relationship that outside CEOs have with their new boards of directors, especially given increasing diversity among directors. “If they want to succeed, it’s pretty important for the CEO to have a good working relationship with the board. If there is a lot of tension and conflict at the top, it’s not going to work out,” Shen says. “We thought we could see whether board diversity could have some effect on performance through the relationship between the CEO and the board.”
Other researchers have suggested that CEO-board conflicts arise out of political or economic differences, but Zhu and Shen saw another possible source. “Our study took a behavioral approach,” Zhu says. “There seems to be plenty of anecdotal evidence that suggests new CEOs can get into big trouble if they don’t manage relationships with the board. It seems like the diversity of directors’ backgrounds ought to play an important role.” Zhu and Shen thought that a CEO’s experience with his or her previous board could be a good predictor of his or her effectiveness with the board at the new company.
For example, a CEO used to a homogenous board that doesn’t challenge decisions or doesn’t monitor things closely will have a rough time with a board that does. A director who tends to watch the CEO and refuses to rubber-stamp decisions may resign instead of keeping up the fight. On the other hand, a CEO experienced with diverse boards could be more aware of the challenges ahead and could have developed the necessary relationship-building skills.
“We’re not saying a homogenous or diverse board is better than the other,” Shen says. “It’s more about whether the CEO has experience with boards of a similar level of diversity.”
The two researchers focused on outsider CEOs, reasoning that insider candidates are more likely to have interacted with directors and to be familiar with their operating styles. To test their ideas, Zhu and Shen used a sample of 188 cases between 1994 and 2007 in which an outside CEO joined a Fortune 500 company. To each company’s board of directors, they applied seven measures of diversity that have been shown to affect board decision-making. Beyond the common factors of age, gender, and ethnicity, the measures included directors’ education level, functional area of expertise, industry background, and any Ivy League history.
Zhu and Shen scored the CEO’s new board and his or her former board on the diversity measures. They used the difference in the two scores to examine the likelihood of CEO turnover within three years, the risk of director turnover within three years, and the company’s financial performance compared to its industry peers over a three-year period. They also looked at which diversity measures played the biggest roles in turnover and performance.
Difference in boards’ diversity has impact
The results showed that when a new board is more diverse than a CEO’s previous one, a company’s high expectations of significant change and improved performance might not be realized. Specifically:
- A CEO who experienced the largest increase in board diversity are 9 percent (or 19 percent) more likely to experience a quick turnover than a CEO who experienced an average (or minimum) increase in board diversity.
- A CEO who experienced the largest increase in board diversity are 17 percent (or 37 percent) more likely to see directors leaving the board soon (i.e., within three years) than a CEO who experienced an average (or minimum) increase in board diversity.
- A CEO who experienced the largest increase in board diversity will deliver a ROA that is 18 percent (or 38 percent) lower than a CEO who experienced an average (or minimum) increase in board diversity.
Zhu says the results show that it’s important to consider directors’ diversity on a broad range of dimensions, not just gender and ethnicity. “Diversity brings increases in the potential,” Shen added, “but whether that can be fully realized depends on how to manage that diversity.”
The results suggest several avenues for future research, the two says. Further studies could uncover why certain measures of diversity matter more than others and whether the findings apply to small and mid-size firms. They also could delve into how the differences cause conflicts in the boardroom and whether CEOs who build relationships with activists, institutional investors, and other stakeholders can apply that experience to improving their relationships with more diverse boards.
The bottom line
Zhu and Shen say the research has these real-world implications for various stakeholders:
- For new outside CEOs: You likely have experience leading a diverse team, but now you must get used to reporting to one. Be aware that the trend is away from homogenous boards of directors and toward diverse boards, and consider getting coaching in how to work well with a diverse board.
- For directors: When you belong to a diverse board that is seeking an outside CEO, pay attention to whether candidates are used to homogeneous boards or are experienced with diverse ones.
- For shareholders: Encouraging diversity among directors is only one part of a complicated process. You also want a CEO experienced in working with diverse boards, or you might end up having to choose to back the CEO or the board when conflicts arise. To predict financial performance under new outsider CEOs, look at the outsiders’ prior experience with diverse boards.
- For aspiring CEOs: Master the skill of managing diverse teams, and develop your skills at reporting to diverse teams by working on cross-functional teams or reporting to multiple managers with different perspectives. Serving on a diverse board at a non-profit or a smaller firm can add to your experience.
- For employees: If the new CEO can’t work with the board, expect more turmoil. Top executives who didn’t get the job are likely to challenge the troubled outsider or leave the company.
- For rival firms: When an outside CEO takes over at a competitor with a diverse board, examine the new CEO’s prior experience with such boards. If his or her experience is limited, conflicts could limit your competitor’s ability to change and improve its performance. If the CEO has previously teamed well with a diverse board, consider taking your competitor more seriously.