Investing in high quality management teams is a crucial part of our Emerging Markets (EM) Equity investment philosophy. Ashna Yarashi-Shah looks at how assessing a company’s strategy – in terms of succession planning – is important in ensuring durability in its business model and continuity in its corporate culture and investments.

Internal versus external

The ideal scenario, in our view, is a smooth transition in leadership: a long-serving management team member leaves the office in a planned succession and is followed by an internal candidate who has been primed to take on the position. A Harvard Business School study on different types of CEO succession across 200 organisations over a 15-year period¹ found that on average, insiders didn’t significantly change their company’s performance. This makes intuitive sense: similar people working in a similar way can produce similar results, thereby ensuring the continuity of business performance.

A planned succession strategy can ensure continuity of a company’s strategy, execution, and corporate culture. Moreover, it can promote internal advancement, recognition of talent and retention of intellectual capital within the firm. Having analysed management transitions within our portfolio, we found successful transitions often stemmed from advance planning and strong internal talent development. Creating a strong internal pool of diverse candidates can offer the board a selection of appropriate options to consider, looking beyond the most probable successors at that time to include high potential candidates who, when subject to proper training and career development opportunities, are well equipped with the skills to prepare them for the potential transition. We think this is particularly important when organisations are looking to improve management diversity over the long term.

One example of a well-planned and articulated succession strategy is that of a Peruvian bank owned in the portfolio. Following the retirement of the CEO, the board appointed an internal candidate who had been at the organisation for over 20 years, serving as the deputy CEO and head of the main subsidiary. Under the new leadership, we saw a seamless transition and continuation of the long-term business strategy and vision.

In another example, we saw a South African packaging company’s CFO assume the role of CEO. Given his deep understanding of the business, its relationship with stakeholders and financial levers for value creation, we also saw a smooth transition in leadership. Having engaged with the CEO on the reasons for the successful transition, he believed that purposefully identifying and developing talent internally is essential and that succession planning should start the moment a new CEO is appointed.

Sometimes, however, hiring an external candidate with strong experience and a proven track record can provide a new perspective to the business and can signal a change in strategic focus. According to a study by Spencer Stuart, when researchers looked at S&P500 CEOs who had led more than one company, they found that 70% generated better performance their first time around². At the same time, however, many experienced CEOs also drove total shareholder return in the first few years by improving operational efficiency and profitability³. This was the case at a Taiwanese semiconductor manufacturer, which hired an executive of a leading global foundry business. Having developed a strong track record of execution, the CEO was able to use his experience to streamline the business and optimise processes, which led to a significant improvement in profitability.

Approximately 78% of our holdings have an internally promoted CEO versus 59% for the MSCI EM Index⁴. In most cases, these CEOs previously served as former executives or divisional heads. Additionally, we found the tenure of the CEO was higher than that of the index.

Transitioning from family led to professionally managed businesses

Founder or family operated companies can often be attractive investments – management think long term, are frugal in their investment decisions, have value-based cultures and strong balance sheets⁵, and can be more aligned with minorities. However, there comes a point in the lifecycle of the business when the family faces the inevitable decision on whether to professionalise the management team. A successful transition can maintain the family’s culture and distinctiveness and grow the business whilst integrating strong systems and organisational structures. In our view, a successful transition to professional management does not involve removing the family from its role in the business. Rather, it involves defining clear roles for the family and for professional managers, such that the family can still have an influence on the long-term strategic direction. As with general succession planning, a successful transition of family to professional management involves advance planning and the cultivation of a strong pool of internal candidates with a powerful understanding of the business and its culture.

After two generations of family leadership, we saw a successful transition to a professional management team at a Filipino conglomerate. Whilst the second generation remain involved as board members, the day-to-day operations are now handled by a professional CEO who has now served in his role for over six years, with prior experience as a leader in various businesses at the conglomerate.

The cost of poor management succession planning

Our experience also suggests that poor management succession planning can lead to a change in the company’s strategic priorities, cause poor capital allocation decisions, damage the company’s culture, and destroy shareholder value. Such implications can sometimes take years to materialise and can have a long-lasting impact on a business franchise. One example of a poor transition, in our opinion, was a South African media conglomerate. After the founder and major shareholder stepped down as CEO, he appointed an internal successor. Whilst we saw an improvement in corporate governance during his tenure, we felt the capital allocation was not as strong. As a result, the stock’s discount to NAV increased over the course of his leadership.

Summary

We believe that factors such as management succession planning are a crucial way of assessing how a business is positioned over the long term. Without planning for the right person at the top, even established companies with solid business models can struggle.

From an investment perspective, we integrate succession planning into our bottom-up investment research and checklist. In general, a large proportion of our portfolio companies have internally promoted management members, and we have noticed consistency in the way the businesses have operated following any management changes. That said, we will continue to regularly engage with our holdings to understand and ensure that the businesses we are invested in have credible succession plans in place.