Business Review

Executive Summary

Rarely do people ask, “How many people can actually run a large, publicly traded company?” The answer to this question is critical in determining whether CEO pay is excessive, because an important part of the value equation for any CEO position is how many well-qualified executives make up the labor pool of viable candidates.s will drive pay higher, just as it does in other professions. To better understand the size and quality of the labor market for CEO talent, we surveyed 113 nonexecutive directors of Fortune 250 companies. We found overwhelming evidence that directors believe that the CEO job is very difficult and that only a handful of executives are qualified to run companies in their industry. This has important implications. First, the labor market for CEO talent might be inefficient; second, scarcity is driving CEO pay up;  third, directors’ performance evaluations might not be objective; forth, succession-planning is critical; finally, grooming internal candidates to succeed is likely inefficient.

Outrage over CEO pay is widespread. With a typical CEO of an S&P 500 company earning $11 million in total compensation, many consider CEO pay to be “out of control.”

However, rarely do people ask, “How many people can actually run a large, publicly traded company?” The answer to this question is critical in determining whether CEO pay is excessive, because an important part of the value equation for any CEO position is how many well-qualified executives make up the labor pool of viable candidates. If CEO talent is plentiful, the price for the talent resource will be efficiently set in arm’s-length bargaining. If CEO talent is scarce, then it makes sense that competition to hire those individuals will drive pay higher, just as it does in other professions. The answer to this question also has important ramifications for how directors evaluate performance, develop future talent, and plan for succession.

To better understand the size and quality of the labor market for CEO talent, we surveyed 113 nonexecutive directors of Fortune 250 companies. We found overwhelming evidence that directors believe that the CEO job is very difficult and that only a handful of executives are qualified to run companies in their industry.

Almost all directors in our study (98 percent) describe the CEO job at their company as extremely or very challenging. Practically none (2 percent) believe it is moderately, slightly, or not at all challenging.

When asked to estimate how many executives are capable of stepping into the CEO role at their company and performing at least as well as their current CEO, directors estimate that fewer than 4 executives have the requisite skills. Their assessment of a small labor market is not confined to their own company and extends to other companies in their industry. When asked how many executives could step into the CEO role of their biggest competitor and perform at least as well as that company’s CEO, directors estimate that only 6 executives would be qualified. They also believe that only 9 executives would have the skills needed to turn around a company struggling in their industry. These are shockingly small numbers.

Fortune 250 directors strongly agree that CEOs in their industry have “specific skills that are extremely hard to replicate.” Furthermore, they believe having top talent is critical for their company’s overall success, agreeing that “it is impossible to be the top company in our industry without having the top CEO in our industry.” On average, directors believe that “it is difficult to evaluate prospective CEO talent during a search process because a candidate might meet all the criteria in terms of previous work experience but it is still hard to tell whether he or she would be a successful CEO.”

In aggregate, these findings suggest that the labor market for outstanding CEO talent is significantly tighter and more competitive than governance experts might realize. This has important implications:

• Labor market for CEO talent might be inefficient. Given the perceived scarcity of outstanding CEO talent among large corporations, it is unlikely that the labor market for CEOs functions efficiently. That is, the matching process for linking qualified talent with suitable job opportunities likely does not occur as economically as it does for other job types. With an inefficient labor market, management might face less pressure to perform and distortions can arise in the balance of power between the CEO and the board, and in compensation.
• Perceived scarcity of talent is likely driving pay higher. A tight labor market for CEO talent might help to explain high compensation levels, particularly among the largest U.S. companies. If only a limited number of executives are qualified to run these companies—and if outstanding CEO talent is critical for their success—then it is reasonable to expect that boards will offer large sums of money to attract their top candidate or retain their current CEO. The cost of losing him or her to a competitor would be too high.
• Performance evaluations might not be objective. Directors’ view that capable CEO candidates are extremely scarce is likely to color their assessment of their CEO’s performance as any evaluation that implies that the CEO should be replaced requires the board to take on the risk associated with finding a replacement.  This risk aversion may encourage boards to tolerate both performance and behavior that would be not be acceptable if they perceived the existence of a large pool of highly qualified candidates.
• Succession planning is critical. If directors believe that executives require special and rare attributes that are difficult to identify (including the right set of functional, industry and managerial experience combined with leadership qualities and cultural fit), identifying these candidates prospectively becomes even more important and reinforces the need for rigorous succession planning.
• Developing internal candidates is likely more efficient. Internal executives continue to be a promising source of candidates for most companies when it comes to future succession. Given the board’s familiarity with them, the visibility of their track record, and their tested cultural fit, it might be more economic for most companies to invest in—and retain—their best internal talent.

At the same time, these survey results serve as a warning to directors to double check their assumptions about the scarcity of CEO talent to make sure this perception isn’t distorting decisions they are making about pay, performance, talent development, and succession planning.