When two successors are better than one
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The reason why corporate successions generally fail has been best summarized by Warren Buffett. He says of a newly promoted chief executive officer (CEO), “It's like you played the piano all the way to Carnegie Hall and then they handed you a violin.” A CEO is expected to not just be operationally well versed but also be a ‘capital allocator,’ a job that a typical operational manager would probably never have done before. Therein lies the dilemma faced by corporate succession planners. Maybe the solution is to split the roles?
When a founder starts a business, she usually has more ambition than capital. She may eventually succeed and the business becomes self-sustaining in terms of capital requirements. The founder is then faced with the next challenge of finding a successor. The successor, she knows, would inherit a fine operational business that would be generating more cash than the needs of the business. The new CEO, probably chosen from within the ranks, has no experience to fall back upon when deciding what to do with the surplus money.
To complicate the matters further, CEOs are typically rewarded using stock options. Given that these options are at a fixed price and have a fixed tenure, a CEO whose options are yet to vest may not be inclined to declare large dividends as she would herself get none and it would reduce the present earnings. Instead, she may either keep it in an interest-bearing bank deposit which will boost profits and the share price. Similarly, the CEO could also try and buy or merge with another company, which may also help boost profits and cause the share price to go up. It is, therefore, more rewarding for the CEO to use the surplus cash to increase earnings either by mergers and acquisitions (M&A) or by just keeping the surplus cash in the bank instead of giving it back to shareholders.
Shareholders who typically give leeway to the promoter in terms of capital allocation, now change their attitude and seek either return of capital or a judicious use of the capital. They start abhorring the practice of the business having idle cash.
What seems rational from the CEO’s point of view becomes intolerable to the shareholders. All along, the operations of the business remain unaffected and continue doing well. Hence, in a sense the CEO succeeds in her area of expertise—running a business—but fails predictably in an area where she has no expertise—capital allocation. There may be a way to solve this problem by using a model borrowed from the banking world. Typically, at a bank people on the asset side are charged a notional cost of capital by the people on the liability side to ensure judicious use of funds. Similarly, the new CEO—who is chosen because of her exemplary performance in running the business—should not be given the task of managing the surplus capital that the business generates. Instead, the CEO’s performance should be evaluated after considering the cost of capital that is required for running the business. That way the CEO will only use the capital in a way that justifies the cost. The cost of capital, in turn, can be decided by another person who has his interests completely aligned with the shareholders. Such a person would set the benchmark cost of capital based on what the expectations of shareholders are.
Who may such a person be? To ensure complete alignment with shareholder interests, this person should have a good understanding of the business and also have a significant portion of her own wealth in the company. The reason for the latter is because she will suffer the most if capital is injudiciously deployed. Many others would argue that such a person should be a representative of a large shareholder. That may not be the right approach as such a large shareholder can be an institution, which may have only a tiny percentage of its funds deployed in the company. Such an institution’s fortunes may not be significantly linked with the fortunes of the company. Hence a person who can ‘lose it all’ if the company fails may fit the role perfectly.
Empirical observations show that successful corporate successions have happened when this split in roles is clearly defined. For example, there are companies in India where the founders are present on the board of the company, while the CEO is a professional. Such founders, who have most of their wealth in the company (even if they individually are small shareholders), work hard to ensure there is no wrong capital allocation. The CEO, on the other hand, focusses on what she knows well—running the business. It has also worked in cases where the erstwhile founder(s) may have transferred their stake to a philanthropic organization. In such cases, the company has to ensure that a certain amount of dividends are regularly paid so that the legacy of the founder, pertaining to philanthropy, is not jeopardized and simultaneously ensure that capital is used sensibly by the business.
Many Indian companies are now at the cusp of management change and it would be appropriate to think about succession in terms of two roles instead of one. One who is in-charge of the asset side of the business focusses on extracting the most returns out of fixed assets, working capital and any inorganic opportunities. The other who is in charge of the liabilities focusses on keeping the interests of the shareholders paramount.
Huzaifa Husain is head-equities, PineBridge Investments, India