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McKinsey on Finance

Number 36, 2 10 25
Summer 2010 The five types McKinsey Five ways CFOs
of successful conversations with can make cost cuts
Perspectives on acquisitions global leaders: stick
Corporate Finance David Rubenstein of
and Strategy The Carlyle Group

8 21 32
A singular moment Why Asia’s banks The right way
for merger value? underperform to hedge
at M&A
McKinsey on Finance is a quarterly Editorial Board: David Cogman, Copyright © 2010 McKinsey & Company.
publication written by experts and Massimo Giordano, Marc Goedhart, All rights reserved.
practitioners in McKinsey & Company’s Bill Huyett, Bill Javetski, Timothy Koller,
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publication offers readers insights Dennis Swinford to be used as the basis for trading in
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1

McKinsey on Finance
Number 36, Summer 2010

2 8 10
The five types of A singular moment McKinsey
successful for merger value? conversations with
acquisitions global leaders:
Corporations have a rare
David Rubenstein of
Companies advance chance to reestablish
The Carlyle Group
myriad strategies acquisitions as a powerful
for creating value with strategic tool. A founding managing
acquisitions—but director of The Carlyle
only a handful are likely Group reflects on the
to do so. future of the private-equity
industry, China’s role
in a rebalancing global
economy, and the leader-
ship gap between the
public and private sectors.

21 25 32
Why Asia’s banks Five ways CFOs can The right way
underperform make cost cuts stick to hedge
at M&A
Successes in cost cutting Deciding how and what
Why do Asian banks erode with time. Here’s to hedge requires a
create less value with how to make them last. company-wide look at the
acquisitions than total costs and benefits.
nonbank investors do?
2

The five types of successful


acquisitions
Companies advance myriad strategies for creating value with acquisitions—but only
a handful are likely to do so.

Marc Goedhart, There is no magic formula to make acquisitions not even be the real one: companies typically talk
Timothy M. Koller, successful. Like any other business process, up all kinds of strategic benefits from acquisitions
and David Wessels they are not inherently good or bad, just as that are really entirely about cost cutting. In the
marketing and R&D aren’t. Each deal must absence of empirical research, our suggestions for
have its own strategic logic. In our experience, strategies that create value reflect our acqui-
acquirers in the most successful deals have sitions work with companies.
specific, well-articulated value creation ideas
going in. For less successful deals, the stra- In our experience, the strategic rationale for an
tegic rationales—such as pursuing international acquisition that creates value typically conforms to
scale, filling portfolio gaps, or building a at least one of the following five archetypes:
third leg of the portfolio—tend to be vague. improving the performance of the target company,
removing excess capacity from an industry,
Empirical analysis of specific acquisition stra- creating market access for products, acquiring skills
tegies offers limited insight, largely because of the or technologies more quickly or at lower cost
wide variety of types and sizes of acquisitions than they could be built in-house, and picking
and the lack of an objective way to classify them by winners early and helping them develop their
strategy. What’s more, the stated strategy may businesses. If an acquisition does not fit one or
3

more of these archetypes, it’s unlikely to create that of a high-margin, high-ROIC company. Consider
value. Executives, of course, often justify a target company with a 6 percent operating-
acquisitions by choosing from a much broader profit margin. Reducing costs by three percentage
menu of strategies, including roll-ups, points, to 91 percent of revenues, from 94 per-
consolidating to improve competitive behavior, cent, increases the margin to 9 percent and could
transformational mergers, and buying cheap. lead to a 50 percent increase in the company’s
While these strategies can create value, we find value. In contrast, if the operating-profit margin of
that they seldom do. Value-minded executives a company is 30 percent, increasing its value
should view them with a gimlet eye. by 50 percent requires increasing the margin to
45 percent. Costs would need to decline from
Five archetypes 70 percent of revenues to 55 percent, a 21 percent
An acquisition’s strategic rationale should be reduction in the cost base. That might not be
a specific articulation of one of these archetypes, reasonable to expect.
not a vague concept like growth or strategic
positioning, which may be important but must Consolidate to remove excess capacity from
be translated into something more tangible. industry
Furthermore, even if your acquisition is based on As industries mature, they typically develop excess
one of the archetypes below, it won’t create capacity. In chemicals, for example, companies
value if you overpay. are constantly looking for ways to get more produc-
tion out of their plants, while new competitors
Improve the target company’s performance continue to enter the industry. For example, Saudi
Improving the performance of the target company Basic Industries Corporation (SABIC), which
is one of the most common value-creating acqui- began production in the mid-1980s, grew from
sition strategies. Put simply, you buy a company 6.3 million metric tons of value-added commodities—
and radically reduce costs to improve margins such as chemicals, polymers, and fertilizers—
and cash flows. In some cases, the acquirer may also in 1985 to 56 million tons in 2008. Now one of the
take steps to accelerate revenue growth. world’s largest petrochemicals concerns, SABIC
expects continued growth, estimating its annual
Pursuing this strategy is what the best private- production to reach 135 million tons by 2020.
equity firms do. Among successful private-equity
acquisitions in which a target company was The combination of higher production from
bought, improved, and sold, with no additional existing capacity and new capacity from recent
acquisitions along the way, operating-profit entrants often generates more supply than
margins increased by an average of about 2.5 per- demand. It is in no individual competitor’s interest
centage points more than those at peer com- to shut a plant, however. Companies often find
panies during the same period.1 This means that it easier to shut plants across the larger combined
many of the transactions increased operating- entity resulting from an acquisition than to
profit margins even more. shut their least productive plants without one
and end up with a smaller company.
Keep in mind that it is easier to improve the
performance of a company with low margins and Reducing excess in an industry can also extend to
low returns on invested capital (ROIC) than less tangible forms of capacity. Consolidation in
4 McKinsey on Finance Number 36, Summer 2010

the pharmaceutical industry, for example, has sales in some emerging markets, Gillette in
significantly reduced the capacity of the others. Working together, they introduced their
sales force as the product portfolios of merged products into new markets much more quickly.
companies change and they rethink how to
interact with doctors. Pharmaceutical companies Get skills or technologies faster or at lower cost
have also significantly reduced their R&D than they can be built
capacity as they found more productive ways to Cisco Systems has used acquisitions to close gaps
conduct research and pruned their portfolios in its technologies, allowing it to assemble a
of development projects. broad line of networking products and to grow very
quickly from a company with a single product
While there is substantial value to be created line into the key player in Internet equipment. From
from removing excess capacity, as in most 1993 to 2001, Cisco acquired 71 companies,
M&A activity the bulk of the value often accrues at an average price of approximately $350 million.
to the seller’s shareholders, not the buyer’s. Cisco’s sales increased from $650 million in
1993 to $22 billion in 2001, with nearly 40 percent
Accelerate market access for the target’s (or of its 2001 revenue coming directly from these
buyer’s) products acquisitions. By 2009, Cisco had more than $36 bil-
Often, relatively small companies with innovative lion in revenues and a market cap of approx-
products have difficulty reaching the entire imately $150 billion.
potential market for their products. Small pharma-
ceutical companies, for example, typically Pick winners early and help them develop their
lack the large sales forces required to cultivate businesses
relationships with the many doctors they need The final winning strategy involves making
to promote their products. Bigger pharmaceutical acquisitions early in the life cycle of a new industry
companies sometimes purchase these smaller or product line, long before most others recognize
companies and use their own large-scale sales that it will grow significantly. Johnson & Johnson
forces to accelerate the sales of the smaller pursued this strategy in its early acquisitions
companies’ products. of medical-device businesses. When J&J bought
device manufacturer Cordis, in 1996, Cordis
IBM, for instance, has pursued this strategy had $500 million in revenues. By 2007, its revenues
in its software business. From 2002 to 2009, it had increased to $3.8 billion, reflecting a 20 per-
acquired 70 companies for about $14 billion. cent annual growth rate. J&J purchased orthopedic-
By pushing their products through a global sales device manufacturer DePuy in 1998, when
force, IBM estimates it increased their revenues DePuy had $900 million in revenues. By 2007, they
by almost 50 percent in the first two years after had grown to $4.6 billion, also at an annual
each acquisition and an average of more than growth rate of 20 percent.
10 percent in the next three years.2
This acquisition strategy requires a disciplined
In some cases, the target can also help accelerate approach by management in three dimensions.
the acquirer’s revenue growth. In Procter & First, you must be willing to make investments early,
Gamble’s acquisition of Gillette, the combined long before your competitors and the market see
company benefited because P&G had stronger the industry’s or company’s potential. Second, you
The five types of successful acquisitions 5

need to make multiple bets and to expect that higher revenues than individual businesses can.
some will fail. Third, you need the skills Service Corporation’s funeral homes in a given city
and patience to nurture the acquired businesses. can share vehicles, purchasing, and back-office
operations, for example. They can also coordinate
Harder strategies advertising across a city to reduce costs and
Beyond the five main acquisition strategies raise revenues.
we’ve explored, a handful of others can create
value, though in our experience they do so Size per se is not what creates a successful roll-up;
relatively rarely. what matters is the right kind of size. For Service
Corporation, multiple locations in individual cities
Roll-up strategy have been more important than many branches
Roll-up strategies consolidate highly fragmented spread over many cities, because the cost savings
markets where the current competitors are too (such as sharing vehicles) can be realized
small to achieve scale economies. Beginning in the only if the branches are near one another. Roll-up
1960s, Service Corporation International, strategies are hard to disguise, so they invite
for instance, grew from a single funeral home in copycats. As others tried to imitate Service Corpo-
Houston to more than 1,400 funeral homes ration’s strategy, prices for some funeral
and cemeteries in 2008. Similarly, Clear Channel homes were eventually bid up to levels that made
Communications rolled up the US market for additional acquisitions uneconomic.
radio stations, eventually owning more than 900.
Consolidate to improve competitive behavior
This strategy works when businesses as a group Many executives in highly competitive industries
can realize substantial cost savings or achieve hope consolidation will lead competitors to
6 McKinsey on Finance Number 36, Summer 2010

focus less on price competition, thereby off the $7 billion Ciba Specialty Chemicals
improving the ROIC of the industry. The evidence business in 1997. Organizational changes included
shows, however, that unless it consolidates to structuring R&D worldwide by therapeutic
just three or four companies and can keep out new rather than geographic area, enabling Novartis to
entrants, pricing behavior doesn’t change: build a world-leading oncology franchise.
smaller businesses or new entrants often have an
incentive to gain share through lower prices. Across all departments and management layers,
So in an industry with, say, ten companies, a lot Novartis created a strong performance-oriented
of deals must be done before the basis of com- culture supported by shifting from a seniority-
petition changes. to a performance-based compensation system for
managers.
Enter into a transformational merger
A commonly mentioned reason for an acquisition Buy cheap
or merger is the desire to transform one or The final way to create value from an acquisition
both companies. Transformational mergers are is to buy cheap—in other words, at a price below a
rare, however, because the circumstances company’s intrinsic value. In our experience,
have to be just right, and the management team however, such opportunities are rare and relatively
needs to execute the strategy well. small. Nonetheless, though market values revert
to intrinsic values over longer periods, there can be
Transformational mergers can best be described by brief moments when the two fall out of alignment.
example. One of the world’s leading pharma- Markets, for example, sometimes overreact to
ceutical companies, Switzerland’s Novartis, was negative news, such as a criminal investigation of
formed in 1996 by the $30 billion merger of an executive or the failure of a single product
Ciba-Geigy and Sandoz. But this merger was much in a portfolio with many strong ones.
more than a simple combination of businesses:
under the leadership of the new CEO, Daniel Such moments are less rare in cyclical industries,
Vasella, Ciba-Geigy and Sandoz were transformed where assets are often undervalued at the bottom of
into an entirely new company. Using the merger a cycle. Comparing actual market valuations
as a catalyst for change, Vasella and his manage- with intrinsic values based on a “perfect foresight”
ment team not only captured $1.4 billion in model, we found that companies in cyclical
cost synergies but also redefined the company’s industries could more than double their shareholder
mission, strategy, portfolio, and organization, returns (relative to actual returns) if they acquired
as well as all key processes, from research to sales. assets at the bottom of a cycle and sold at the top.3
In every area, there was no automatic choice for
either the Ciba or the Sandoz way of doing things; While markets do throw up occasional opportu-
instead, the organization made a systematic nities for companies to buy targets at levels below
effort to find the best way. their intrinsic value, we haven’t seen many cases.
To gain control of a target, acquirers must pay its
Novartis shifted its strategic focus to innovation shareholders a premium over the current
in its life sciences business (pharmaceuticals, market value. Although premiums can vary widely,
nutrition, and products for agriculture) and spun the average ones for corporate control have
The five types of successful acquisitions 7

been fairly stable: almost 30 percent of the collect because publicly available data are scarce.
preannouncement price of the target’s equity. For Private acquisitions often stem from the
targets pursued by multiple acquirers, the seller’s desire to get out rather than the buyer’s
premium rises dramatically, creating the so-called desire for a purchase.
winner’s curse. If several companies evaluate
a given target and all identify roughly the same
potential synergies, the pursuer that over-
estimates them most will offer the highest price. By focusing on the types of acquisition strategies
Since it is based on an overestimation of the that have created value for acquirers in the
value to be created, the winner pays too much— past, managers can make it more likely that their
and is ultimately a loser. 4 acquisitions will create value for their
shareholders.
Since market values can sometimes deviate
from intrinsic ones, management must also beware 1 Viral V. Acharya, Moritz Hahn, and Conor Kehoe, “Corporate

governance and value creation: Evidence from private


the possibility that markets may be overvaluing equity,” Social Science Research Network working paper,
a potential acquisition. Consider the stock market February 19, 2010.
2 IBM investor briefing, May 12, 2010 (www.ibm.com/investor/
bubble during the late 1990s. Companies that events/investor0510/presentation/pres3.pdf).
3 Marco de Heer and Timothy M. Koller, “Valuing cyclical
merged with or acquired technology, media, or
companies,” mckinseyquarterly.com, May 2000.
telecommunications businesses saw their 4 Kevin Rock, “Why new issues are underpriced,” Journal of

share prices plummet when the market reverted to Financial Economics, 1986, Volume 15, Number 1–2, pp. 187–212.

earlier levels. The possibility that a company


might pay too much when the market is inflated
deserves serious consideration, because M&A
activity seems to rise following periods of strong
market performance. If (and when) prices are
artificially high, large improvements are necessary
to justify an acquisition, even when the target
can be purchased at no premium to market value.
Premiums for private deals tend to be smaller,
although comprehensive evidence is difficult to

Marc Goedhart (Marc_Goedhart@McKinsey.com) is a consultant in McKinsey’s Amsterdam office, Tim Koller


(Tim_Koller@McKinsey.com) is a partner in the New York office, and David Wessels, an alumnus of the
New York office, is an adjunct professor of finance at the University of Pennsylvania’s Wharton School. This article is
excerpted from Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value
of Companies (fifth edition, Hoboken, NJ: John Wiley & Sons, August 2010). Tim Koller is also coauthor, with Richard
Dobbs and Bill Huyett, of a forthcoming managers’ guide to value creation, titled Value: The Four Cornerstones
of Corporate Finance (Hoboken, NJ: John Wiley & Sons, October 2010). Copyright © 2010 McKinsey & Company.
All rights reserved.
8

A singular moment for


merger value?
Corporations have a rare chance to reestablish acquisitions as a powerful
strategic tool.

Anish Melwani Consider this: market valuations are attractive by the economy, the reputation of business, and
and Werner Rehm absolute and relative standards, large corpo- shareholders.
rations across many sectors have the financial and
operating firepower to launch bids, and the First, the market value of many companies is closer
deleveraging trend now under way has left several to their estimated intrinsic value than it has
of the more conspicuous private-equity players been at any time in the past two decades. Right
licking their wounds after years of overindulgence. now, for instance, the aggregated market value
In these circumstances, something more than of the S&P 500 is roughly $11 trillion. We estimate
just another turn in the acquisition cycle may lie that this figure is comfortably justified by
ahead. The basics are in place for a period when expected cash flows—the best barometer of value—
mergers and acquisitions reassert their fundamental given a return to historical average levels of
purpose: enabling strong corporate performers earnings growth and returns on equity. Market
to match their acquisitions to their long-term stra- values rarely fall below intrinsic value or
tegic goals and to drive out weak, inefficient even come as close to it as they have over the past
managers. Such a period not only would be ripe 18 months. Assets may not be as cheap as
with opportunity but also could hugely benefit they were 18 months ago, but corporate buyers
9

in today’s environment need to find only enough Furthermore, we estimate that about half of the
synergies to justify the purchase premium, S&P 500’s $1 trillion in cash holdings lies outside
rather than also having to recoup the cost of buying the United States. Clearly, the better choice
in an overvalued market. for value creation is investing this cash in global
growth acquisitions rather than taking a tax
Second, these synergies exist. Strong corporate hit when repatriating the earnings to buy back
performers that can exploit strategic and operational US-held shares.
synergies should be able to outbid rational
private-equity players that rely only on operational Private equity, which holds about $500 billion in
improvements and more costly leverage. Across investible assets, will no doubt reassert itself
all sectors of the economy, the median operating where it can show that it adds value. But its impact
margins of companies with more than $5 bil- on M&A pricing should remain subdued for a
lion in market capitalization are 5 to 20 percent while as tight credit compresses leverage ratios for
higher than the operating margins of small buyouts. The deals that emerge in an environ-
ones, with only a few exceptions, such as basic ment without cheap credit will mark a return to
materials and energy. In some sectors, the fundamental purpose of M&A: seizing
including IT hardware, health care products, and opportunities when a combination of assets can
trucking, this gap in operating margins is create value for shareholders by driving out
expected to widen over the next two years. We real inefficiencies and benefiting from scale or
have found that a mere 1 percent increase in scope. This wave of acquisitions therefore
the operating margins of an acquired business can will favor corporate buyers with good strategies
create as much as 10 percent more value. and great deal execution.

Third, large corporations have the currency, The trick will be to act quickly and decisively:
in both cash and shares, to pursue acquisitions. during any M&A wave, asset prices will go up and
Outside of the financial, food, pharma, semi- returns to acquirers will go down. As compet-
conductor, and telecommunications sectors, the itors start to pick up attractive targets, large com-
return to shareholders of a median large-cap panies will have to act or they won’t be able
company in the S&P 500 was 5 to 10 percent higher to take advantage of this unique opportunity, when
than that of its small-cap equivalents from market values and fundamental performance
January 2007 to this April. Large companies support good returns on M&A. At some point, the
therefore have relative currency for deals. market may overheat again, but for now the
landscape for strategic acquirers hasn’t looked this
promising in decades.

Anish Melwani (Anish_Melwani@McKinsey.com) is a partner in McKinsey’s New York office, where Werner Rehm
(Werner_Rehm@McKinsey.com) is a consultant. Copyright © 2010 McKinsey & Company. All rights reserved.
10

McKinsey conversations with


global leaders: David Rubenstein of
The Carlyle Group
A founding managing director of The Carlyle Group reflects on the future of
the private-equity industry, China’s role in a rebalancing global economy, and the
leadership gap between the public and private sectors.

Richard Elder David Rubenstein, a founding managing director of The big picture: Global rebalancing
The Carlyle Group, one of the world’s premiere
private-equity firms, has built a career on assessing McKinsey on Finance: People would say we’re
companies across industries and around the at a fledgling recovery. You travel the world;
globe. In the latest installment of our interview series you have investors around the world. What are your
McKinsey conversations with global leaders, perspectives on how you see the recovery
Rubenstein shares his insights on how to manage playing out?
a diverse and decentralized organization, how
to identify the markets of greatest potential in a David Rubenstein: Very few people predicted
changing world economy, and how to attract how serious the recession would be or exactly
leaders who are both intelligent and “have their its timing or its length. And therefore, any prediction
ego in check.” He also discusses the new eco- about how great the recovery will be or how it
system he sees developing for the private-equity will occur probably should be taken with a grain of
industry as pressures build for some of its salt. Nobody really knows, is the point.
largest players go public. Richard Elder, a director
in McKinsey’s Washington, DC, office, conducted My perception, though, is that the recovery is
the interview. under way in different ways around the world. The
11

United States is recovering nicely but not have three regular funds, a buyout fund, a growth
as great as we would like. We’ll probably grow at fund, a real-estate fund, and now two renminbi
2 to 3 percent this year. I believe that we will funds—so I don’t think you can deploy too much
have very serious problems, though, with our debt. money in China.
We still have $14 trillion of debt coming out
of this recession. We have an annual deficit of I don’t really want my competitors to come there
$1.6 trillion. We have unemployment that and realize that, but right now it is a little bit
is stated to be 9.7 percent but that is actually more competitive than it has been in the past. And
about 16.5 percent, if you count people who the competition is not just from global private-
are looking for full-time jobs who have part-time equity firms or American private-equity firms
jobs. And we have a serious problem with investing there. Indigenous Chinese firms
our currency. are probably now our biggest competitor in China.

In Europe, I think growth is probably going to McKinsey on Finance: Given all the changes
be even less than it is in the United States. that have happened—especially outside the United
The northern European countries by and large, States—and what regulation might or might not
with the exception of England and Ireland, come, has Carlyle rethought how it assesses risk?
perhaps, are growing quite nicely. I’m not sure
there’s going to be any real growth in the David Rubenstein: Political risk is something
southern European countries; and as a result, that’s on your mind all the time when you’re
the growth overall on year will probably be investing overseas. To be honest, the greatest
2 to 3 percent at best case. Maybe 1 to 2 per- political risk that I see is the United States.
cent overall. In other countries around the world, sometimes
you have a better sense of what they’re going
Asia and the other emerging markets that have to do and they’re more consistent than the United
become very important of late are probably States. But sure, you do have political risks in
going to grow anywhere from 5 to 10 percent a all countries. You never know what a government
year. And as a result, that’s where many of the might do at a change of power in a country.
investors around the world really want to put a lot
of their money. So China, India, Brazil, Turkey, We have people around the world who help us
Saudi Arabia, South Korea, and Taiwan assess risk, and we actually have a lot of
are all great emerging markets, and I think people who are specializing in government and
they’re all likely to go pretty well. understanding government and who help
our investment teams assess whether or not the
We find the greatest single emerging market in investment makes sense.
the world in China. There’s nothing close to it
because of its size and entrepreneurial spirit, the McKinsey on Finance: How do you then think
encouragement of private equity, the great about some of the developing markets?
growth opportunities we see all throughout the
economy in China. We have 45 full-time David Rubenstein: Well, in the year 2014 the
Chinese natives working for us now in China doing emerging markets will surpass the developed
deals through various funds that we have. We markets in GDP. And therefore, it’s not really fair
12 McKinsey on Finance Number 36, Summer 2010

to call some of these markets emerging any management skills. What they would like to do
longer. If China, by the year 2035, is the biggest is to have the private-equity skills and techniques
economy in the world, how much longer can and contacts of Western firms come to China,
you call it an emerging market? teach the Chinese how these things are done in the
West, and then when those skills are imparted,
India will probably be the second biggest economy probably the Chinese will be able to do some of the
in the world at that time. How much longer same things we’ve done in the West. So they
can we call that an emerging market? The emerging- don’t really need our capital so much, but they toler-
market concept is a little dated, and I think we ate our capital in order to get the other things
really have to bifurcate emerging-market countries that I think they would like.
that have emerged—like China, India, Brazil,
Turkey, South Korea, Taiwan—and those that are
much smaller and are not likely to emerge as
great economic powers for some time. In the industry: Private equity

Right now, we think that the greatest emerging McKinsey on Finance: As the private-equity
markets are China, India, Brazil, Turkey, Taiwan, industry continues to evolve, are you seeing that
South Korea, Saudi Arabia. Countries in Africa there will be fewer larger firms such as Carlyle,
have great appeal to people like us. I don’t think Blackstone, and KKR and that the middle tier might
you can deploy that much capital there in sub- get squeezed out? Or are you seeing a proliferation
Saharan Africa or in South Africa, but we do think of funds—and therefore companies—going forward?
that the opportunities will be considerable
as those countries begin to develop further their David Rubenstein: I think it’s very difficult to
natural resources. get a new fund or firm off the ground today.
On the other hand, I don’t think a lot of the funds
McKinsey on Finance: One country you or firms that went into business years ago
haven’t mentioned is Russia. How do you think are going to implode or go out of business. Some
about Russia? may. Some may have track records that are
so damaged as a result of the recession they can’t
David Rubenstein: We opened in Russia twice raise a new fund.
and we closed in Russia twice. I don’t think
that the opportunities are as great there for Western I think what you will begin to see is some of these
private-equity capital as for other countries. smaller firms in certain niche areas be acquired
And one of the reasons is, there is a fair amount of by larger firms, and I do think that some firms will
excess capital in Russia, certainly held by the probably not be as dominant in their area as
oligarchs, and they don’t really need our capital they once were because their track record isn’t as
to develop deals. good or they can’t raise as much money as
they once did.
I would say that countries like China don’t really
need our capital either. At this point, I think On the other hand, I do think that the large private-
what China really wants is expertise, contacts, equity firms, the largest ones—KKR, Blackstone,
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group 13

“Countries like China don’t really need our capital.


At this point, I think what China really
wants is expertise, contacts, management skills.”

Carlyle, TPG, Apollo, Bain—will aggregate even a Second, the currency will enable you to retain and
larger percentage of capital that’s available, recruit employees and, particularly if
because their brand names, I think, give investors your competitors have those currencies to offer, you
some comfort. These firms all survived the need to do that. And third, the monetization of
recession in reasonably good shape and are going the founders is an important factor that shouldn’t
to become what I’ll call “alternative investment- be ignored. Most of the founders of these global
fund managers.” They won’t just be private-equity private-equity firms are probably between 55 and
firms. They’re now going to expand their offer- 65. And at some point, they want to monetize
ings so they have not only private-equity funds what they have built, and I think the IPO helps
but also real-estate funds, infrastructure funds, monetize it. It also helps to reduce the share
distressed debt funds, and credit funds, and just the founders have and probably spreads the wealth
all kinds of different funds—hedge funds, hedge within the firm, and maybe that’s a healthy thing.
fund of funds, private-equity fund of funds. So they So I think for all these reasons, we’ll probably see
can use their brand name and help sell those funds these firms go public in the not-too-distant future.
around the world but also acquire very talented
people who could manage these funds. I think McKinsey on Finance: Do you find that when
virtually all of these funds and firms will probably you talk to a lot of other private-equity firms,
be public entities within five years or so. and certainly the banking industry, that Asia is
the next big run?
McKinsey on Finance: When you say a public
entity, how much of it do you think will be David Rubenstein: All of the large, global
public? Is there a certain amount that you would private-equity firms are more or less American.
say is probably always going to be retained I don’t know if that can continue forever,
within a small group of founders? because at some point other parts of the world will
say, “We should have global dominant private-
David Rubenstein: Well, I think that the equity firms here.”
large, global private-equity firms—most, again,
of which are American—will go public in part The United States, right after World War II, was
because having currency to make acquisitions of 48 percent of the world’s GDP. We’re now about
the kind of firms I think they can acquire to 22 percent. So the world may say, “Why is it, with
expand their offering base will be possible with just 22 percent of the world’s GDP, that all the
the currency of a public stock. global private-equity firms are based in the
United States?” That probably will change. At
14 McKinsey on Finance Number 36, Summer 2010

David Rubenstein
Vital statistics Career highlights Fast facts
Born in 1949, The Carlyle Group Chairman of the
in Baltimore, Maryland Cofounder and managing John F. Kennedy Center
director (1987–present) for the Performing
Married, with 3 children Arts, president of the
Shaw, Pittman, Potts Economic Club of
& Trowbridge (now
Education Washington, and regent
Pillsbury, Winthrop,
Graduated with a bachelor of the Smithsonian
Shaw, Pittman)
of arts and science in Institution
Lawyer (1981–87)
1970 from Duke University
Member of the board
Earned a law degree in Deputy assistant
of directors or trustee
1973 from the University of to the president
of Duke University,
Chicago Law School for domestic policy
the University of Chicago,
(1977–81)
the Lincoln Center
for the Performing Arts,
US Senate Judiciary
and Johns Hopkins
Committee’s
Medicine
Subcommittee
on Constitutional
Amendments
Chief counsel (1975–76)

Carlyle, which is an American firm, we started David Rubenstein: All of us who are doing
out just investing inside the United States. this are kind of making it up a bit on the fly.
Now we invest more money outside of the United Obviously we’re looking at other global firms and
States than inside the United States; we what they’ve done. In our case, what we
have more people outside the United States than tend to do is control all the investment decisions
we have inside the United States investing. centrally, so we have centralized investment
committees—not one committee, but several
different committees, that approve the deal.

Management lessons: The art So to make sure we have quality control,


of the deal all the deals have to be approved centrally and
by experienced people who are serving on
McKinsey on Finance: Over time, Carlyle those committees. Second, we do have extensive
has gotten bigger and bigger and therefore more training programs to give people a sense of
geographic, with more people, more systems, what we are about, how we regard ethics as an
et cetera. How do you manage a company that important part of our business, and to make
started with just a few of you and now is a sure there’s a common culture in the firm.
very, very diverse, very decentralized global firm?
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group 15

We call it One Carlyle. Everybody is part of Without conceding that we’re going to go public or
one firm. No matter what part of the firm you’re at, even saying that we will, if we were to go public I
you’re part of Carlyle. It’s One Carlyle. We also suspect we might have to change our model a bit and
try to make sure that the people in the firm have either a CEO or designate one of us to be the
get together on a regular basis at conferences or at CEO—or find someone else within the firm to do it.
training sessions and retreats to make sure they
understand who they’re working with. And we also There’s no doubt that, as long as the three founders
incent people. Those people who cooperate with are there, it’d be difficult for somebody else to
other people in the firm, no matter what part of the completely be the CEO, but we recognize that we
firm they’re with, we take note of it and we reward might have to step back a bit if somebody else
people in bonuses and other types of compensation. were the CEO. We just haven’t decided that yet, in
So, through many different ways, we try to incul- part because we haven’t yet decided if we’re
cate and manage a common culture. We do manage going to go public.
things centrally a bit by the investment approval
process, and the hiring process is largely central McKinsey on Finance: What have you learned
as well. from the different management styles and the
different types of companies you all have owned,
McKinsey on Finance: Carlyle has always and how has that changed over time?
had the famous “DBD” [David Rubenstein,
Bill Conway, Dan Daniella]. You’ve been very David Rubenstein: First, you don’t really know
vocal that you don’t necessarily socialize how good a company is going to be when you buy it.
outside of the firm but that you actually work Ninety-five percent or more of the projections of
extremely well together inside. what you’re going to earn are wrong. We’re just not
right on how good companies are going to be
David Rubenstein: There are three people or how bad they might be. Second, when you don’t
who really have been running Carlyle for most of its have a good manager at the outset, you need to
history, and we do get along quite well, in part get one. And if somebody is not a very good manager
because we have different areas of responsibility. in the first year or so, he or she is probably not
Bill Conway tends to oversee most of the invest- going to get much better, so you probably should
ment activity. Dan Daniella oversees a lot of the make a change.
operational activities, as well as our real-estate
energy businesses. And I tend to oversee fund-raising You should be very careful about the assumptions,
and probably recruiting a bit and somewhat in terms of the economy, that you get in your
the strategic vision of the firm. I have been more or projections. Some people often assume the econ-
less the face of the firm because I’ve been willing omies are going to go very well all the time,
to do interviews and make speeches. But all of us and that’s probably a mistake. Buying companies
are equal partners and all of us consult regu- that really have a good culture is extremely
larly on all matters, even though one person may important. Making certain that the people in your
be taking the lead. firm know how to add value—that’s also very
important. Making certain that the numbers you
If you’re a public company, it’s difficult to say that see when you do the due diligence are accurate,
you have three CEOs. And we recognize that. and making sure the accounting that you look at
16 McKinsey on Finance Number 36, Summer 2010

when you’re buying a company works. I’d say One of the reasons private-equity deals tend to
generally there are many different mistakes we’ve work out to a higher extent than venture-
made, and I think we’ve probably made every capital deals do is you have a long amount of time
mistake you can make, but actually we’ve generally to do the due diligence. You’re looking at predict-
done pretty well. able cash flows, existing management structures.
Venture capital, typically, is much less
We’ve averaged about 30 percent gross internal developed in terms of the management structure,
rate of return on all the money we’ve invested— and the idea may not actually work out, and
almost $60 billion of equity over the 23 years or so the cash flow may not really be there.
of the firm. So we’ve been right more than we’ve
been wrong. And I like to focus a bit more on our So that’s why venture capital deals tend not to
mistakes, because I like to look at what we did do as well, in terms of numbers. Eight out of every
wrong—and the deals we should have done that we ten may not work in venture capital. Two may
didn’t do, or the deals we shouldn’t have done work. Whereas in buyouts, I suspect nine out of
that we did do. And I tend to focus on that. But every ten probably work.
obviously, the deals we’ve done that have
worked out have been much greater than deals McKinsey on Finance: One of the hot topics
that we’ve had that didn’t work out. right now for most businesses is organic
growth. How do you proactively think about
McKinsey on Finance: How do you actually the innovation that is required within
get that level of insight into what really makes a these companies to create that organic growth?
company tick before you commit the capital?
David Rubenstein: Well, when you’re looking
David Rubenstein: The gestation period from at an emerging company—a growth company
the beginning of looking at a deal to the closing or an emerging growth company or something like
of a deal is probably about six months. Now if you that—you are looking at whether they are
had a year or two to look at a company, you’d going to be innovative enough to actually grow a
probably know even more, but six months is an business from a relatively modest business
average gestation period. So during that to a real earnings business.
period of time, we are retaining consultants. It
might be an accounting firm, it might be a law And at those kinds of companies, you are looking
firm—specialized insurance analysts, and all kinds at innovation—whether they have one or two
of different experts who can give us some sense ideas that are really going to take this to the next
of what the firm is like. level. In more mature buyouts, you tend not
to be looking as much for innovation as for more
Obviously we spend a lot of time with management efficiency. You want to make the company
as well. We talk to competitors. We talk to operate more effectively. Maybe they could reduce
customers. There’s no foolproof way, and obviously their costs in some ways. Maybe they can do a
some people do make mistakes. But more often bolt-on acquisition. You tend not to focus as much
than not, buyout deals, private-equity deals, will on innovation in some of the larger companies,
work out; and that’s in part because of the extensive and maybe to some extent we’re doing that now.
amount of due diligence.
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group 17

But I think you see the innovation much more in people on the centralized investment committees,
these emerging companies where you have they presumably won’t debate with their own
$10 million to $40 million of revenue, maybe very CEOs, and that’s not a good thing.
modest amounts of earnings—but they are to
the point where they really can grow to a major
company if, in fact, they have one or two
innovations that will take effect. And what we Business in society: Redefining
tend to do is spend a lot of time in the due- public service
diligence process assessing whether these inno-
vations they have on the drawing boards are McKinsey on Finance: As you think about the
likely to happen. private-equity industry, how do you think
about the societal or environmental implications
McKinsey on Finance: When you think about of the investments that you are making?
all the different companies you own, especially
around the world—obviously a lot of different David Rubenstein: Well, there’s no doubt that
local cultures, a lot of different practices, et cetera— many private-equity investors focused for
how do you balance between the local autonomy many years on getting good rates of return and
for the deal team there, even though the ultimate just telling their investors about those good
approval is done centrally here, and all those rates of return, and then getting more money from
different nuances and everything else that require those same investors. I think increasingly we’ve
you to make the right decisions? recognized that if you only focus on internal rates
of return, you’re probably going to do a dis-
David Rubenstein: The deal teams tend service to yourself. Because in the end, other
to generate their own ideas. You can’t completely people who are stakeholders in what you do
control everything centrally, because the more are not going to be happy.
and more you control centrally and squeeze your
local people, they will not be happy. If you have We need to make a better case that we are
a very, very dedicated, talented team of people and paying taxes, we are sensitive to environmental
they’re very good at negotiating deals, they are concerns, we are sensitive to socially respon-
people who want some freedom. sible investment principles. I think the private-
equity industry may be a little late to that
And if you get people who just don’t want any game, but it’s now catching up, and I think we’re
freedom and who will do whatever you tell them doing a much better job. In our own case at
centrally, they’re not the kind of people you Carlyle, we’ve been very careful to invest in certain
want representing you, because, presumably, in areas and not invest in other areas. We have,
negotiating deals with the people they’re for example, not invested in tobacco. We haven’t
trying to buy things from they’ll be as weak as invested in alcohol. We haven’t invested in
they might be in dealing with you. gambling. We haven’t invested in hand-guns,
things like that. We’ve been careful about
So you want strong people. You want people who investing in certain areas that we just are not
are willing to argue with you and debate with happy about and don’t want to be associated with.
you, because if they’re not willing to debate with
18 McKinsey on Finance Number 36, Summer 2010

Generally, we try to invest in companies we I do encourage people to go into public service.


think are going to add some productivity to the I think it’s easier to do it early in life—when
economy that’s relevant, and add jobs. We’re you can have more responsibility, probably, in the
not interested in buying companies where we’re government than you would in the private
only going to make our money by destroying sector—and then come out and make money, if you
jobs, or taking them offshore. can, and then perhaps later in life you can do
things in public service.
McKinsey on Finance: Can you describe what
social responsibility means to you personally? But the important thing from the time that I
went into government to now is this: when I went
David Rubenstein: When I turned 54, I read into government in the 1970s, if you wanted to
that a person my age probably would live, on serve your country, typically you did it in govern-
average, another 27 years, and therefore I realized ment. You might be in the military, the Peace
I had lived two-thirds of my life, and I didn’t Corps, or in federal-government service. Now there
want to spend the other third of my life just acquiring are many NGOs—nongovernmental organiza-
more money and waiting for my heirs to give tions—that are providing extensive public services
it away. to our country, that you can serve in these
NGOs and do a very good job, or create your own
So I concluded I would try to give away as NGO. And so, I think many people who want to
much as I could while I was alive. And therefore, go into public service today don’t feel they have
I decided to get deeply involved in a lot of to go into government. And I encourage them to
philanthropic areas, particularly ones that were not necessarily go into government if they want to do
helpful to me: schools that were helpful to something in public service.
me, causes that were helpful to me, things that
were important to my community. Everybody has a social responsibility to make
the earth a little bit better than when you came
I’m deeply involved in education, deeply into it. And so, when I die, I hope people will
involved in performing arts, deeply involved in say that I did something to make the world a little
medical research, and deeply involved in a bit better in one or two areas. And I hope my
number of other areas that I think are important children will take the same kind of responsibility
to our country. I think at a younger age, people in whatever wealth they may get and use it in
still are very interested in going into public the same kind of useful ways.
service. And I have underwritten a program at
Harvard Business School where people
who get a joint MBA and MPA degree from the
Kennedy School get scholarships. And that On leadership: Mending the
program is designed to encourage people to go into public–private divide
business at some point in their career and to go
into public service. And it’s designed to show that McKinsey on Finance: What are your
you can mix these two types of careers. thoughts on leaders and leadership, in terms of
today’s business context?
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group 19

David Rubenstein: Well, clearly there are qualified for. But it gave me a great thrill working
fewer individuals around the country to look up to in the White House, advising the president
as leaders in the business community, for of the United States. And I did learn much more
example, than may have been the case years ago. about public policy and about the world than
We did, in the 1970s and ’80s, begin to make I would have if I’d been practicing law at that time,
rock stars of our CEOs. But I don’t think that today which was probably the alternative.
there are as many leaders in the financial-
services community as I wish there were, because As I look at myself now as a man of 60 years old, I
so many of them had problems in the recession. think that experience was very good in shaping
my perspectives and making me understand how
I do feel, unfortunately, that we’ve demonized government works, how our country relates
business leaders to some extent. I think the to other countries. And I wouldn’t have traded those
government of the United States, to some extent, four years in the White House for anything else,
has in effect implied that if you make too no matter what else I might have had in terms of
much money, if you’re too highly compensated by financial opportunities at the time. I’m very
the government’s standards, you must have glad that I did it. On the other hand, I don’t lust
done something wrong. And as a result of that, to go back into government.
very few business leaders are as willing to be
engaged with government as they were in the past. McKinsey on Finance: When you go through
the talent and hiring process, do you look
One of the strengths of the US government system for people who have actually had some kind of
has been that people who have private-sector public-service background?
experience can go freely in and can go freely out. I
think our government has benefited by having David Rubenstein: Private-equity firms have
people with extensive private-sector experience. gotten a little bit into a rut of hiring people
And I think our private sector has benefited who have gone to very good colleges, spent two
from people with government experience going years in an investment-banking firm, then
into the private sector. Now, at the senior gotten an MBA, and then spent either a year or two
levels of government, people who are willing to go in private equity, and then come to them.
in from the private sector are fewer and fewer.
The most talented people in the business world And I think we are now increasingly looking
that I know today wouldn’t consider going for people that have operational skills, as well as
into government. It’s unfortunate. finance skills. And because government is
increasingly an important part of our lives, we’re
McKinsey on Finance: How were you shaped probably going to have people with more
by your time in public service? government skills. Right now, I spend more time
dealing with governments around the world
David Rubenstein: Well, I was very fortunate. than I did 10 or 15 years ago, because governments
I was a young man. I became, at the age of 27, are increasingly looking at what private-equity
deputy domestic policy adviser to the president of and investment firms are doing.
the United States—a job that I probably wasn’t
20 McKinsey on Finance Number 36, Summer 2010

And I think understanding what governments are McKinsey on Finance: What’s some of the best
thinking and how they relate to private-equity advice that you have received in your career?
firms is important. So I do look at those kinds of
skills as well. But generally, I’m looking for David Rubenstein: I would say the advice that
people who have good overall qualities. And if you I’ve pretty much tried to stick to is: Try to make
are a talented person and you’re willing to work yourself indispensible in the organization. Master
hard, whether or not you were in the government one subject, make sure you know it better than
doesn’t make that much difference to me— anybody else. Keep your ego in check. Make sure
particularly when I’m hiring somebody under the you get along with other people. Try to share
age of 30. Now, if I’m hiring somebody who’s the credit. Make sure that you are not focused on
40 years old, 45, 50 years old, they’re more fully the wrong things—you don’t want to make
formed, in terms of their career. Then I’m going money for the wrong reasons.
to assess whether their government connections
and their government responsibilities and their And make sure that when you do have some
government knowledge is really going to be helpful financial success, you give back to the community.
to our firm, or whether it really wouldn’t be as Make sure that you are making the community
helpful as having somebody the same age that had a better place because of the wealth that you have.
private-sector experience. I’ve tried to do some of those things, perhaps
imperfectly, but I’m trying to do a better job as I
I tend to look for people who have certain skills go along.
that transcend what part of the government they
serve in. I’m looking for people who are
intelligent, but not geniuses. Geniuses are difficult
to deal with. Looking for intelligent people,
people who are hardworking, people who know
how to get along with other people, people
who have their ego in check, people who want to
create wealth—people who want to create
wealth but not necessarily spend a lot of money,
but create wealth for other purposes—people
who want to be part of a bigger system than just
their own entity. I’m looking for people who
really have their egos in check but also want to
make something with their lives and really
make themselves productive citizens in our country
by creating some wealth but also giving that
money away, ultimately, to good social causes.

Richard Elder (Richard_Elder@McKinsey.com) is a partner in McKinsey’s Washington, DC, office. Copyright © 2010
McKinsey & Company. All rights reserved.
21

Why Asia’s banks


underperform at M&A
Why do Asian banks create less value with acquisitions than nonbank investors do?

Ploy Jensen, Compared with Europe and the United States, The study found that acquisitions by principal
Conor Kehoe, Asia emerged from the global downturn a winner, investors generate a median annual internal rate
and Badrinath with its economies continuing to post higher of return (IRR) of 22 percent, compared with
Ramanathan
growth rates and its banks suffering far less damage –7 percent for strategic investors. This finding holds
from the credit crisis. But if Asia’s financial true for deals of similar sizes, across time and
institutions thought that the region’s good fortunes across Asian countries—before, during, and after
were sufficient to provide a competitive edge, the global financial crisis.
they ought to think again. When it comes to M&A,
for example, acquisitions by the region’s banks Why such a gap? For one thing, principal
have significantly underperformed those investors have been sharper at picking the right
by what we call principal investors—a group that geographies. For another, Asian banks appear
includes private-equity firms and sovereign- not to capitalize as much as they could on their
wealth funds—even in a rapidly growing market. industry expertise; principal investors get
more mileage from an active approach to ownership.
That is among the findings of a recent McKinsey Finally, they seem to be better at parlaying
analysis of financial-sector M&A in Asia.1 their ownership to build earnings and create value.
22 McKinsey on Finance Number 36, Summer 2010

MoF 2010
Asian FIG
Exhibit 1 of 3

Exhibit title: Principal investors earn more

Exhibit 1 Strategic deals by Asia’s financial institutions produce lower


returns than deals by principal investors do.
Jan 2002–Jun 2009

Strategic investors completed more deals . . . but earned less than principal investors
in lower-return markets like Japan . . . in both developed and emerging markets.

% of deal value by country,1 $ billion Median internal rate Developed Developing


of return, % markets markets

100% = 48 400 Other 34


1 8 6 Taiwan
6 South Korea
10 7
13 2 India
9
Southeast Asia
16 18 China
–8 –12 2
24
51 Japan
28
Number of deals 22 65 47 39
Principal Strategic Principal Strategic
investors2 investors investors2 investors

1Includes only those with deal value >$50 million; figures may not sum to 100%, because of rounding.
2Private-equity firms and sovereign-wealth funds.
Source: Asian Venture Capital Journal database; Dealogic; McKinsey analysis

• Principal investors have done a better job at • Once deals are complete, strategic players
selecting the right geographies. Despite the higher appear to gain less advantage from their
risk profile associated with opportunities deep industry expertise than principal investors
in emerging markets, these investors completed do from an active approach to ownership.
more deals in the Asian ones, such as China, In developed Asia, as much as 46 percent of the
India, and Indonesia. The deals generated signifi- value in acquisitions by principal investors
cantly higher returns than did those in more comes from improving the earnings of the com-
developed markets, such as Japan and Taiwan. panies they invest in. In contrast, the earnings
In contrast, strategic investors—the financial performance of the strategic players declined,
institutions—completed more deals in the low- cutting their IRR in developed Asia by 31 per-
return developed markets. While principal cent. Among deals in Asia’s emerging markets,
investors outperformed strategic investors every- both types of players earned comparable
where, this difference in geographic focus returns from earnings enhancement.
played a significant role in creating the perfor-
mance gap.
Why Asia’s banks underperform at M&A 23

MoF 2010
Asian FIG
Exhibit 2 of 3

Exhibit title: What drives returns?

Exhibit 2 As much as 46 percent of the value in acquisitions by


principal investors comes from improving the earnings of
the companies they invest in.

Weighted average internal rate of return (IRR) for markets in Asia,1 %


Positive driver
Negative driver
IRR Deals Sample Deals Sample
drivers by principal size by strategic size
investors investors
Developed Earnings growth +46 –31
markets
Multiple expansion2 –45 +15
6 28
Dividend payout +6 +2
Total 7 –14

Emerging Earnings growth +34 +31


markets
Multiple expansion2 +18 –8
37 33
Dividend payout +1 +4

MoF 2010 Total 53 27

Asian FIG
1 Only includes deals with positive net income at times of deal announcement and deal exit (or, if not exited, June 30, 2009) and only those
Exhibit 3 of 3
with deal value available; assumes cash out on June 30, 2009, at market value; uses change in fiscal-year net income as measure for
earnings growth and change in P/E multiple (deal value or exit value ÷ net income) as proxy for sector multiple expansion or compression.
2Increase (or decrease) in P/E ratio.
Exhibit
Source: Asiantitle:
VentureActive ownership
Capital Journal database; Bloomberg; Dealogic; McKinsey analysis

Exhibit 3 Principal investors were able to put their controlling stakes


to better use than financial institutions were.
Internal rate of return (IRR), Jan 2002–Jun 2009, %

Deals by strategic Deals by principal


investors investors
Median IRR, Sample Median IRR, Sample IRR
full sample size full sample size differential
Full Control1 2 44 23 32 21
sample
Noncontrol2 –7 134 21 55 28

Excluding Control1 1 39 21 30 20
China
and India Noncontrol2 –13 108 –4 16 9

Advantage
of active
ownership

1 Deals in which the acquirer holds controlling stake (ie, ≥ 30%) after transaction.
2Deals in which the acquirer holds noncontrolling stake (ie, < 30%) after transaction.
Source: Asian Venture Capital Journal database; Bloomberg; Dealogic; McKinsey analysis
24 McKinsey on Finance Number 36, Summer 2010

• In deals where principal investors have strategic 1 F rom a set of more than 2,000 deals by principal and

strategic investors announced from January 2002 to June 2009


control, they are better able to use it to create and valued at more than $50 million, we screened out the
value, with a median 23 percent IRR, compared completed deals for which financials are publicly available. The
returns analysis on these 86 deals by strategic investors
with 2 percent for strategic players. Certainly, and 87 by principal investors is based on dividends paid since
in countries such as China, India, Malaysia, and the completion of the deals and on changes in market
capitalization from the date they were announced and
Vietnam, regulatory restrictions make it June 30, 2009.
difficult for foreign players to gain control of
financial entities. Deals without a controlling stake
may be riskier, yet they can make sense if a
general rerating of market multiples is expected
(as in China and India) or if the acquirer can
find ways of exerting influence, such as controlling
board seats, influencing changes in manage-
ment, or bringing in experts to improve business
operations.

Ploy Jensen (Ploy_Jensen@McKinsey.com) is a consultant in McKinsey’s Hong Kong office, Conor Kehoe
(Conor_Kehoe@McKinsey.com) is a partner in the London office, and Badrinath Ramanathan (Badrinath_
Ramanathan@McKinsey.com) is an associate principal in the Singapore office. Copyright © 2010 McKinsey & Company.
All rights reserved.
25

Five ways CFOs can make


cost cuts stick
Successes in cost cutting erode with time. Here’s how to make them last.

Ankur Agrawal, Optimism is on the rise that a solid economic On either schedule, any programs initiated in the
Olivia Nottebohm, recovery is taking hold around the world, but the early months of the downturn are already beginning
and Andy West
cost cutting so prevalent during the recent to fail—just as savings would be most useful to
recession looks to remain a strategic priority for finance growth. Sales, general, and administrative
some time. Indeed, the number of executives (SG&A) costs prove to be particularly intransigent.
reporting steps to reduce operating costs in the While manufacturing efficiencies have enabled
next 12 months increased significantly from an average S&P 500 company to reduce the cost of
February to April, even as confidence in the goods sold (COGS) by about 250 basis points
economy grew.1 Yet any successes companies have over the past decade, SG&A costs have remained
at cutting costs during the downturn will at about the same level (Exhibit 1).
erode with time. Many executives expect some
proportion of the costs cut during the recent Why is it so difficult to make cost cuts stick? In most
recession to return within 12 to 18 months2—and cases, it’s because reduction programs don’t
prior research found that only 10 percent of address the true drivers of costs or are simply too
cost reduction programs show sustained results difficult to maintain over time. Sometimes,
three years later.3
26 McKinsey on Finance Number 36, Summer 2010

McKinsey on Finance #36


Granularity of cost
Exhibit 1 of 2

Exhibit 1 While total costs of goods sold have declined over time, sales,
general, and administrative costs have not.

Median cost of goods sold (COGS) and sales, general, and administrative
(SG&A) costs for S&P 500 companies,1 % of revenue

64.5
64.0
63.5
63.0
62.5
62.0
–2.7%
61.5
61.0 COGS

22.5
22.0 SG&A
–0.1%
21.5
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

1 S&P 500 index as of 2008; SG&A includes R&D expenses.

managers lack deep enough insight into their own on how they cut costs, drawing an explicit
operations to set useful cost reduction targets. connection to strategy, and treating cost reductions
In the midst of a crisis, they look for easily available as an ongoing exercise.
benchmarks, such as what similar companies
have accomplished, rather than taking the time to Assign accountability at the right level
conduct a bottom-up examination of which costs Few would dispute that the support of top exec-
can—and should—be cut. In other cases, individual utives is necessary for cost-management efforts to
business unit heads try to meet targets with succeed. Involved CEOs and CFOs, in particular,
draconian measures that are unrealistic over the can help mediate the inherently political nature of
long term, such as across-the-board cuts that such exercises and provide critical energy and
don’t differentiate between those that add value or motivation. Yet in our experience, the involvement
destroy it. In still others, managers use inaccurate of top managers is not by itself sufficient—
or incomplete data to track costs, thus missing especially in a period of growth, when they
important opportunities and confounding efforts naturally turn their attention to other initiatives.
to ensure accountability.
Instead, most cost innovation happens at a very
While there’s no single silver bullet to ensure that small and practical level. Breaking costs out in this
cost-management programs will stick, large, way helps managers to find the specific groups or
multibusiness unit organizations can better their individuals responsible for them and to identify and
chances by improving accountability, focusing deal swiftly with pockets of expense mismanage-
Five ways CFOs can make cost cuts stick 27

ment. Take, for example, the cost-cutting program to travel to one client meeting in person, while
at one multinational high-tech company. Initially, conducting another by videoconference. Such
the CFO had little actionable information on who informed cuts are more likely to endure because
was responsible for which costs. Profit-and-loss the people responsible for them can be held
(P&L) statements were reported only for product- accountable through appropriate incentives, such
based business units, even though geographic as performance evaluations, that consider both
sales units had higher costs. This lack of detail made costs and business performance.
it very difficult to assign responsibility for
overall cost reductions. For instance, if freight costs Focus on how to cut, not just how much
for a business unit increased from year to year, Cost reduction programs often lose effectiveness
it was difficult to determine whether this happened over time because top management kicks off
because of shipping behavior by factories or the effort with broad cost reduction targets (“How
costs incurred by the sales organization in deliver- much do we want to save?”) but then leaves
ing third-party parts to customers. decisions on how to meet those targets to individual
line managers. The presumption is that they
To resolve these issues, the company redefined the have a more detailed understanding of their partic-
way it collected and reported information, to ensure ular area of the business and will take the right
that costs were broken out for each of 100 orga- actions to control costs. While this is true in
nizational units. That helped managers quickly some instances, we have seen too many cases where
identify two headquarters units and a sales managing to a number has resulted in flawed
organization that were responsible for large cost decisions, such as delaying critical investments,
increases. Together, the managers came up with a shifting costs from one accounting category to
plan to control future costs. Among other another, or even cutting costs in a way that directly
things, the plan assigned cost accountability to undermines revenue generation. Clearly, the
the company’s more than 60 separate organi- benefits of such cost cuts are likely to be illusory,
zational units. This approach ensured that the short lived, and at times damaging to long-
people managing costs were those closest to term value creation.
the decisions, who could ensure that cost manage-
ment was not hurting the business. A more enduring approach includes changing
the way people think about costs by, for example,
Importantly, the process planners who run such setting new policies and procedures and then
programs as Six Sigma improvement efforts modeling the desired behavior. If a company
are generally the wrong choice to manage cost- announces, say, a new travel policy, senior managers
cutting programs. They typically lack both need to set the tone with their own actions—for
the content expertise and authority to make difficult example, by aggressively using videoconferences
trade-offs in areas that often require more instead of travel or eliminating catering for
detailed knowledge of where costs occur and the in-person meetings. Even something as simple as
ability to make keen subjective judgments about no longer providing sandwiches for lunch
which costs to cut. Only someone at the level of, say, meetings can be part of a pattern of behavior that
a sales manager has the detailed knowledge signals real and enduring change. And since
and authority to decide whether it’s really necessary backpedaling on this kind of behavior when the
28 McKinsey on Finance Number 36, Summer 2010

economy picks up again would send the reverse changed travel behavior across the entire
message, managers should model only cost cuts organization as subunits shared best practices.
they intend to stick with. If they know they’ll
eventually restore catering for in-person meetings, Don’t let P&L accounting data get in the
it could well be better not to cut it in the first place. way of cost reduction
CFOs often manage cost reduction efforts by
Benchmarks matter. External ones on some tracking accounting data in their companies’ P&L
measures may be difficult to get, but where they statements. These can be a useful starting point
are available—for example, on travel expenses— in a crisis, if other data are unavailable. But over
they can enable managers to compare performance the long term, P&L categories, such as overall
across different units and identify real differences, SG&A costs, don’t give the kind of per-unit insights
as well as trade-offs that may not be in line that help focus cuts in, say, travel expenses
with the organization’s overall strategy. Internal on the units that can best afford to cut them.
benchmarks are easier to access and provide
great insights, especially because managers are Unfortunately, few companies have the kinds of
more likely to understand and adjust for systems they need to track costs at a fine-grained
differences among their company’s organizational level—and they face a number of challenges
units than among different companies repre- in establishing them. Multiple data systems may
sented by external benchmarks. make it difficult to aggregate and compare data
from different geographies. Inconsistent accounting
One multinational capital goods manufacturer practices between businesses or time periods
combined the two perspectives, analyzing may lead to significant distortions. Changes in
the major categories of expenditure and developing organizational structure (as a result of acqui-
targets based on both internal and external sitions, divestitures, or even changes in the
benchmarks. Using external ones for travel spending, allocation of overhead costs) may similarly distort
managers found that the company’s travel tracking. Finally, onetime expenses in either
costs were higher than those of any peer—both per the baseline or the tracking period may become
employee and as a percentage of revenue excuses for deviations from the plan. As a
(Exhibit 2). They then set an aggressive target to result, business or functional managers often
reduce travel expenses—and, to make the use data issues to divert attention from their
effort stick, instituted new travel policies on booking lack of progress.
hotels and airfares. By examining internal
benchmarks across suborganizations (such as Indeed, one medical-product company experienced
departments, business units, or locations), all these issues simultaneously in the initial stages
managers also identified which executives needed of its cost transformation program. Business unit
to do a better job of educating their organizations heads objected that tracking numbers from the
on travel policy. In addition, they increased central financial database were flawed because of a
accountability by tracking each unit’s performance range of factors.4 As a result, the company couldn’t
on a monthly basis to measure compliance and reduce costs during the first several months of its
encouraged underperforming divisions to manage program, and discussions focused on the integrity
their travel costs more aggressively. The effort of the data rather than on potential initiatives.
Five ways CFOs can make cost cuts stick 29

To resolve the problem, companies must continually controller received a standardized template to
track, in some detail, the expenses behind the record any adjustments affecting the baseline,
P&L to identify areas of underperformance, without along with exact amounts, periods, and offsetting
worrying about the formal accounting of the adjustments. The CFO then aggregated the
costs. Identifying, measuring, and controlling their data into a simple cost-tracking report that he
most important drivers is more important shared with all involved.
than how the savings are booked and reported. To
manage
Web 2010costs at the necessary level of detail, After two months, the increased transparency
the CFO of the
Granularity of costs company above gave each business eliminated all data disputes—and the organization
unit head
Exhibit 2 ofand
2 controller full access to a central- met its full-year cost reduction target in just
ized cost
Glance: Usingdatabase
external linked to the official
benchmarking, P&L. Each
one multinational six months.
capital goods company Two
foundby-products
that its were increased
travel costs were higher than those of any peer company.
Exhibit title: Benchmarking costs

Exhibit 2 Using external benchmarking, one multinational capital goods company


found that its travel costs were higher than those of any peer company.

For a multinational capital goods manufacturer

Part I: Travel expenditures benchmarked against peers


of a multinational capital goods manufacturer
Average = 1.2
8,000 Company’s peers
Company
6,000

Travel expenditures Average = 4,650


4,000
per employee, €

2,000

0
0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Travel expenditures as % of company revenues

Part II: Internal benchmarking of travel expenditures to


find areas of opportunity within the organization

20,000 Business units

15,000
Travel expenditures
per employee, € 10,000

5,000

0
0 1 2 3 4 5 6 7 8

Employees, thousands
30 McKinsey on Finance Number 36, Summer 2010

standardization of internal accounting and the products. Consequently, the effort led to the
a dramatic reduction in several cost categories loss of accounts and market share.
bucketed under “other costs.” By getting the
data right and moving quickly beyond questions To create value through cost cutting, managers
about data integrity, the organization signifi- need to understand the best ways to allocate
cantly simplified the effort of cost reporting, making operating expenses, such as selling costs and R&D.
it much easier to maintain the cost program To do so, they must understand, at the most
over time. detailed possible level, the return on invested
capital (ROIC) and the growth of the markets
Clearly articulate the link between cost in which a company plays. Mapping costs against
management and strategy business units and geographies will reveal
Strategy must lead cost-cutting efforts, not vice both opportunities for cost reductions and areas
versa. The goal cannot be merely to meet a bottom- in which the business should increase its invest-
line target. Indeed, among participants in a ments to take advantage of growth opportunities
November 2009 survey, those who worked for or to “double down” in high-ROIC businesses.
companies that took an across-the-board At a high-tech company, for example, the granular
approach to cost cutting in the recent downturn mapping of R&D spending by product families
doubt that the cuts are sustainable. Those who identified some that despite their aging techno-
predicted that the cuts could be sustained over the logical and growth profiles were still receiving
next 18 months were more likely to say that their R&D and marketing investments. Clearly, these
companies chose a targeted approach.5 low-ROIC businesses did not warrant a high
level of new resources. Management could redirect
Yet in our observation, many companies do not them to growth units because it was able to map
explicitly link cost reduction initiatives to broader costs at a very granular level.
strategic plans. As a result, reduction targets
are set so that each business unit does “its With such insights, managers will also be able
fair share”—which starves high-performing units to deliver a consistent message on how cost
of the resources needed for valuable growth reductions would make a company stronger—a
investments while generating only meager improve- message reducing short-term resistance and
ments at poorly performing units. Moreover, even inspiring the organization to support the
initiatives in one area of a business often have effort. Moreover, once these practices are baked
unintended negative consequences for the into the company’s standard operating practices,
company as a whole. For example, a global low- cost reductions will become a more enduring part
tech medical-device company’s initiatives to of its strategy for long-term health.
reduce manufacturing and product costs were led
at the plant level, without input or customer Treat cost management as an
insights from sales and marketing teams. The ongoing exercise
leaders of the cost-cutting effort in manufac- Most companies treat cost management as a one-
turing nearly rendered several products defective off exercise driven by the need to manage short-
because they did not know how customers used term profit targets—and some of these exercises do
Five ways CFOs can make cost cuts stick 31

succeed in the short term because of constant ably removed from the cost base. Toward the end
pressure from the CEO or CFO. Yet such hasty cost- of the third fiscal quarter of the effort, detailed
cutting activity typically goes into reverse once plans for building upon and sustaining the initiative
the pressure is removed and rarely results in through the next fiscal year were developed
sustainable changes in cost structure. In our expe- and vetted. These plans and practices enabled the
rience, the reason is that one-off exercises don’t company to manage costs in the long term.
require internal capability building.

A better approach is to use the initial cost


reduction program as an opportunity to build a Companies must improve their processes and
competency in cost management rather than capabilities if they hope to reduce or contain costs
in mere cost reduction. Cost-management programs in a sustainable manner. Rethinking common
need to be scoped as two- to three-year initiatives practices in cost management should help to realize
rather than as immediate-term efforts with one-year this goal. In particular, achieving a more fine-
horizons. Also, effective cost-management grained perspective on where costs occur should
programs, by their very nature, include plans for be a centerpiece of any successful cost-
dealing with changing business conditions— management program.
for instance, by adjusting for activity-level changes,
competitive drivers, or both.
1 F ifty-four percent of the executives surveyed in April

indicated that they would take steps to reduce operating costs


In the case of the multinational manufacturing in the next 12 months, compared with 47 percent in
company, many of the processes introduced February. In April, two-thirds of the respondents rated
economic conditions in their countries as better than
as part of the cost reduction initiative became the they had been six months previously, and another two-thirds
basis for ongoing cost management. The finance expected further improvement by the end of the first half of 2010.
See “Economic Conditions Snapshot, April 2010: McKinsey
and accounting group created a system for Global Survey results,” mckinseyquarterly.com, April 2010. The
monitoring costs at a detailed and accurate level, online survey (in the field April 5–9, 2010) received
responses from 2,059 executives representing the full range of
where none had existed before. Managers industries, regions, functional specialties, and tenures.
2 See “What worked in cost cutting—and what’s next: McKinsey
encouraged greater communication between finance
Global Survey results,” mckinseyquarterly.com, January 2010.
3 Suzanne P. Nimocks, Robert L. Rosiello, and Oliver Wright,
and accounting, the business units, and func-
“Managing overhead costs,” mckinseyquarterly.com, May 2005.
tional groups such as IT. Better communication 4 These included changed accounting practices that shifted

uncovered inconsistencies in accounting costs from one P&L category to another, the transfer of a shared
cost center from one business unit to another, changes
practices. Changes in performance-management in allocations of corporate overhead, and special onetime
systems and incentives further promoted the initiatives, such as product launches.
5 See
 “What worked in cost cutting—and what’s next: McKinsey
cost-management approach. Purchasing managers Global Survey results,” mckinseyquarterly.com, January 2010.
found clear areas of waste that could be sustain-

Ankur Agrawal (Ankur_Agrawal@McKinsey.com) is a consultant in McKinsey’s New York office, Olivia Nottebohm
(Olivia_Nottebohm@McKinsey.com) is an associate principal in the San Francisco office, and Andy West
(Andy_West@McKinsey.com) is a partner in the Boston office. Copyright © 2010 McKinsey & Company. All rights
reserved.
32

The right way to hedge


Deciding how and what to hedge requires a company-wide look at the total
costs and benefits.

Bryan Fisher and Hedging is hot. Shifts in supply-and-demand destroy more value than was originally at risk.
Ankush Kumar dynamics and global financial turmoil have created Perhaps individual business units hedge opposite
unprecedented volatility in commodity prices in sides of the same risk, or managers expend too
recent years. Meanwhile, executives at companies much effort hedging risks that are immaterial to a
that buy, sell, or produce commodities have company’s health. Managers can also under-
faced equally dramatic swings in profitability. estimate the full costs of hedging or overlook natural
Many have stepped up their use of hedging hedges in deference to costly financial ones. No
to attempt to manage this volatility and, in some question, hedging can entail complex calculations
instances, to avoid situations that could put a and difficult trade-offs. But in our experience,
company’s survival in jeopardy. keeping in mind a few simple pointers can help
nip problems early and make hedging strategies
When done well, the financial, strategic, and oper- more effective.
ational benefits of hedging can go beyond
merely avoiding financial distress by opening up Hedge net economic exposure
options to preserve and create value as well. Too many hedging programs target the nominal
But done poorly, hedging in commodities often risks of “siloed” businesses rather than a
overwhelms the logic behind it and can actually company’s net economic exposure—aggregated
33

risk across the broad enterprise that also includes Companies can be exposed to indirect risks
the indirect risks.1 This siloed approach is a through both business practices (such as
problem, especially in large multibusiness organi- contracting terms with customers) and market
zations: managers of business units or divisions factors (for instance, changes in the com-
focus on their own risks without considering risks petitive environment). When a snowmobile manu-
and hedging activities elsewhere in the company. facturer in Canada hedged the foreign-exchange
exposure of its supply costs, denominated in
At a large international industrial company, for Canadian dollars, for example, the hedge success-
example, one business unit decided to hedge fully protected it from cost increases when
its foreign-exchange exposure from the sale of the Canadian dollar rose against the US dollar.
$700 million in goods to Brazil, inadvertently However, the costs for the company’s US
increasing the company’s net exposure to fluctu- competitors were in depreciating US dollars. The
ations in foreign currency. The unit’s managers snowmobile maker’s net economic exposure
hadn’t known that a second business unit was at to a rising Canadian dollar therefore came not just
the same time sourcing about $500 million from higher manufacturing costs but also from
of goods from Brazil, so instead of the company’s lower sales as Canadian customers rushed to buy
natural $200 million exposure, it ended up cheaper snowmobiles from competitors in the
with a net exposure of $500 million—a significant United States.
risk for this company.
In some cases, a company’s net economic
Elsewhere, the purchasing manager of a large exposure can be lower than its apparent nominal
chemical company used the financial markets to exposure. An oil refinery, for example, faces
hedge its direct natural-gas costs—which a large nominal exposure to crude-oil costs, which
amounted to more than $1 billion, or half of its input make up about 85 percent of the cost of its output,
costs for the year. However, the company’s sales such as gasoline and diesel. Yet the company’s
contracts were structured so that natural-gas prices true economic exposure is much lower, since the
were treated as a pass-through (for example, with refineries across the industry largely face
an index-based pricing mechanism). The company’s the same crude price exposure (with some minor
natural position had little exposure to gas price differences for configuration) and they typically
movements, since price fluctuations were adjusted, pass changes in crude oil prices through
or hedged, in its sales contracts. By adding a to customers. So in practice, each refinery’s true
financial hedge to its input costs, the company was economic exposure is a small fraction of
significantly increasing its exposure to natural- its nominal exposure because of the industry
gas prices—essentially locking in an input price for structure and competitive environment.
gas with a floating sales price. If the oversight
had gone unnoticed, a 20 percent decrease in gas To identify a company’s true economic exposure,
prices would have wiped out all of the company’s start by determining the natural offsets across
projected earnings. businesses to ensure that hedging activities don’t
actually increase it. Typically, the critical task
Keep in mind that net economic exposure includes of identifying and aggregating exposure to risk on
indirect risks, which in some cases account a company-wide basis involves compiling a
for the bulk of a company’s total risk exposure.2 global risk “book” (similar to those used by financial
34 McKinsey on Finance Number 36, Summer 2010

McKinsey on Finance #36


Hedging
Exhibit 1 of 2

Exhibit 1 Direct costs account for only a fraction


of the total cost of hedging.

Example: A gas producer hedged 3 years of its gas production


with a forward contract on a financial exchange

Estimated costs of hedging, % of total Description


value of revenues or costs hedged

Direct costs 0.1–0.4 • Bid–ask spread


• Marketing/origination fees

Opportunity cost • Opportunity cost of margin capital required to withstand significant


of margin capital 3.0–7.0 price moves (in this case, a two-sigma event—5% likelihood)
• Counterparty risk for in-the-money positions

Net asymmetric • The asymmetric exposure to varying gas prices makes the
upside lost 1.0–3.0
protected downside less than the lost upside

Total 4.1–10.4

and other trading institutions) to see the A natural-gas producer that hedges its entire
big picture—the different elements of risk—on a annual production output, valued at $3 billion in
consistent basis. sales, for example, would be required to hold
or post capital of around $1 billion, since gas prices
Calculate total costs and benefits can fluctuate up to 30 to 35 percent in a given
Many risk managers underestimate the true cost of year. At a 6 percent interest rate, the cost of holding
hedging, typically focusing only on the direct or posting margin capital translates to $60 mil-
transactional costs, such as bid–ask spreads and lion per year.
broker fees. These components are often only a
small portion of total hedge costs (Exhibit 1), Another indirect cost is lost upside. When the
leaving out indirect ones, which can be the largest probability that prices will move favorably (rise, for
portion of the total. As a result, the cost of example) is higher than the probability that
many hedging programs far exceeds their benefit. they’ll move unfavorably (fall, for example), hedging
to lock in current prices can cost more in forgone
Two kinds of indirect costs are worth discussing: upside than the value of the downside protection.
the opportunity cost of holding margin capital and This cost depends on an organization’s view of
lost upside. First, when a company enters into commodity price floors and ceilings. A large inde-
some financial-hedging arrangements, it often must pendent natural-gas producer, for example,
hold additional capital on its balance sheet was evaluating a hedge for its production during
against potential future obligations. This require- the coming two years. The price of natural
ment ties up significant capital that might have gas in the futures markets was $5.50 per million
been better applied to other projects, creating an British thermal units (BTUs). The company’s
opportunity cost that managers often overlook. fundamental perspective was that gas prices in the
The right way to hedge 35

next two years would stay within a range 75 percent of margin volatility. Large conglom-
of $5.00 to $8.00 per million BTUs. By hedging erates are particularly susceptible to this problem
production at $5.50 per million BTUs, the when individual business units hedge to
company protected itself from only a $0.50 decline protect their performance against risks that are
in prices and gave up a potential upside of $2.50 immaterial at a portfolio level. Hedging these
if prices rose to $8.00. smaller exposures affects a company’s risk profile
only marginally—and isn’t worth the manage-
Hedge only what matters ment time and focus they require.
Companies should hedge only exposures that
pose a material risk to their financial health or To determine whether exposure to a given risk
threaten their strategic plans. Yet too often is material, it is important to understand whether a
we find that companies (under pressure from the company’s cash flows are adequate for its cash
capital markets) or individual business units needs. Most managers base their assessments of
(under pressure from management to provide cash flows on scenarios without considering
earnings certainty) adopt hedging programs that how likely those scenarios are. This approach would
create little or no value for shareholders. An help managers evaluate a company’s financial
integrated aluminum company, for example, hedged resilience if those scenarios came to pass, but it
McKinsey
its oncrude
exposure to Finance
oil and#36
natural gas for doesn’t determine how material certain risks
<Article
years, evenslug>
though they had a very limited impact are to the financial health of the company or how
Exhibit
on < > margins.
its overall of < > Yet it did not hedge its susceptible it is to financial distress. That
exposure to aluminum, which drove more than assessment would require managers to develop a

Exhibit 2 Companies should develop a profile of probable cash flows—


a profile that reflects a company-wide calculation of risk exposures
and sources of cash.

Cash flow distribution and cash needs Probability of meeting cash Distribution of potential cash flows
obligations (eg, interest, dividends) to meet these cash obligations

High Avoid Provide Protect Keep


distress reliability investments/ strategic
growth flexibility

Probability

Low
Interest Dividend Maintenance Project R&D and Strategic
and capital capital marketing capital
principal expenditures expenditures expenditure
36 McKinsey on Finance Number 36, Summer 2010

profile of probable cash flows—a profile that reflects Look beyond financial hedges
a company-wide calculation of risk exposures An effective risk-management program often
and sources of cash. Managers should then compare includes a combination of financial hedges and
the company’s cash needs (starting with the nonfinancial levers to alleviate risk. Yet few
least discretionary and moving to the most discre- companies fully explore alternatives to financial
tionary) with the cash flow profile to quantify hedging, which include commercial or opera-
the likelihood of a cash shortfall. They should also tional tactics that can reduce risks more effectively
be sure to conduct this analysis at the portfolio and inexpensively. Among them: contracting
level to account for the diversification of risks across decisions that pass risk through to a counterparty;
different business lines (Exhibit 2). strategic moves, such as vertical integration;
and operational changes, such as revising product
A high probability of a cash shortfall given nondis- specifications, shutting down manufacturing
cretionary cash requirements, such as debt facilities when input costs peak, or holding addi-
obligations or maintenance capital expenditures, tional cash reserves. Companies should
indicates a high risk of financial distress. test the effectiveness of different risk mitigation
Companies in this position should take aggressive strategies by quantitatively comparing the
steps, including hedging, to mitigate risk. If, on total cost of each approach with the benefits.
the other hand, a company finds that it can finance
its strategic plans with a high degree of certainty
even without hedging, it should avoid (or unwind)
an expensive hedging program. The complexity of day-to-day hedging in commod-
ities can easily overwhelm its logic and value.
To avoid such problems, a broad strategic perspective
and a commonsense analysis are often good
places to start.

1 See Eric Lamarre and Martin Pergler, “Risk: Seeing around the

corners,” mckinseyquarterly.com, October 2009.


2 Indirect risks arise as a result of changes in competitors’ cost

structures, disruption in the supply chain, disruption


of distribution channels, and shifts in customer behavior.

Ankush Kumar (Ankush_Kumar@McKinsey.com) and Bryan Fisher (Bryan_Fisher@McKinsey.com) are partners in


McKinsey’s Houston office. Copyright © 2010 McKinsey & Company. All rights reserved.
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