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
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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
Timothy M. Koller, successful. Like any other business process,
and David Wessels they are not inherently good or bad, just as
marketing and R&D aren’t. Each deal must
have its own strategic logic. In our experience,
acquirers in the most successful deals have
specific, well-articulated value creation ideas
going in. For less successful deals, the stra-
tegic rationales—such as pursuing international
scale, filling portfolio gaps, or building a
third leg of the portfolio—tend to be vague.
Empirical analysis of specific acquisition stra-
tegies offers limited insight, largely because of the
wide variety of types and sizes of acquisitions
and the lack of an objective way to classify them by
strategy. What’s more, the stated strategy may
not even be the real one: companies typically talk
up all kinds of strategic benefits from acquisitions
that are really entirely about cost cutting. In the
absence of empirical research, our suggestions for
strategies that create value reflect our acqui-
sitions work with companies.
In our experience, the strategic rationale for an
acquisition that creates value typically conforms to
at least one of the following five archetypes:
improving the performance of the target company,
removing excess capacity from an industry,
creating market access for products, acquiring skills
or technologies more quickly or at lower cost
than they could be built in-house, and picking
winners early and helping them develop their
businesses. If an acquisition does not fit one or

more of these archetypes, it’s unlikely to create
value. Executives, of course, often justify
acquisitions by choosing from a much broader
menu of strategies, including roll-ups,
consolidating to improve competitive behavior,
transformational mergers, and buying cheap.
While these strategies can create value, we find
that they seldom do. Value-minded executives
should view them with a gimlet eye.
Five archetypes
An acquisition’s strategic rationale should be
a specific articulation of one of these archetypes,
not a vague concept like growth or strategic
positioning, which may be important but must
be translated into something more tangible.
Furthermore, even if your acquisition is based on
one of the archetypes below, it won’t create
value if you overpay.
Improve the target company’s performance
Improving the performance of the target company
is one of the most common value-creating acqui-
sition strategies. Put simply, you buy a company
and radically reduce costs to improve margins
and cash flows. In some cases, the acquirer may also
take steps to accelerate revenue growth.
Pursuing this strategy is what the best private-
equity firms do. Among successful private-equity
acquisitions in which a target company was
bought, improved, and sold, with no additional
acquisitions along the way, operating-profit
margins increased by an average of about 2.5 per-
centage points more than those at peer com-
panies during the same period.1 This means that
many of the transactions increased operating-
profit margins even more.
Keep in mind that it is easier to improve the
performance of a company with low margins and
low returns on invested capital (ROIC) than
3
that of a high-margin, high-ROIC company. Consider
a target company with a 6 percent operating-
profit margin. Reducing costs by three percentage
points, to 91 percent of revenues, from 94 per-
cent, increases the margin to 9 percent and could
lead to a 50 percent increase in the company’s
value. In contrast, if the operating-profit margin of
a company is 30 percent, increasing its value
by 50 percent requires increasing the margin to
45 percent. Costs would need to decline from
70 percent of revenues to 55 percent, a 21 percent
reduction in the cost base. That might not be
reasonable to expect.
Consolidate to remove excess capacity from
industry
As industries mature, they typically develop excess
capacity. In chemicals, for example, companies
are constantly looking for ways to get more produc-
tion out of their plants, while new competitors
continue to enter the industry. For example, Saudi
Basic Industries Corporation (SABIC), which
began production in the mid-1980s, grew from
6.3 million metric tons of value-added commodities—
such as chemicals, polymers, and fertilizers—
in 1985 to 56 million tons in 2008. Now one of the
world’s largest petrochemicals concerns, SABIC
expects continued growth, estimating its annual
production to reach 135 million tons by 2020.
The combination of higher production from
existing capacity and new capacity from recent
entrants often generates more supply than
demand. It is in no individual competitor’s interest
to shut a plant, however. Companies often find
it easier to shut plants across the larger combined
entity resulting from an acquisition than to
shut their least productive plants without one
and end up with a smaller company.
Reducing excess in an industry can also extend to
less tangible forms of capacity. Consolidation in
4 McKinsey on Finance Number 36, Summer 2010
the pharmaceutical industry, for example, has
significantly reduced the capacity of the
sales force as the product portfolios of merged
companies change and they rethink how to
interact with doctors. Pharmaceutical companies
have also significantly reduced their R&D
capacity as they found more productive ways to
conduct research and pruned their portfolios
of development projects.
While there is substantial value to be created
from removing excess capacity, as in most
M&A activity the bulk of the value often accrues
to the seller’s shareholders, not the buyer’s.
Accelerate market access for the target’s (or
buyer’s) products
Often, relatively small companies with innovative
products have difficulty reaching the entire
potential market for their products. Small pharma-
ceutical companies, for example, typically
lack the large sales forces required to cultivate
relationships with the many doctors they need
to promote their products. Bigger pharmaceutical
companies sometimes purchase these smaller
companies and use their own large-scale sales
forces to accelerate the sales of the smaller
companies’ products.
IBM, for instance, has pursued this strategy
in its software business. From 2002 to 2009, it
acquired 70 companies for about $14 billion.
By pushing their products through a global sales
force, IBM estimates it increased their revenues
by almost 50 percent in the first two years after
each acquisition and an average of more than
10 percent in the next three years.2
In some cases, the target can also help accelerate
the acquirer’s revenue growth. In Procter &
Gamble’s acquisition of Gillette, the combined
company benefited because P&G had stronger
sales in some emerging markets, Gillette in
others. Working together, they introduced their
products into new markets much more quickly.
Get skills or technologies faster or at lower cost
than they can be built
Cisco Systems has used acquisitions to close gaps
in its technologies, allowing it to assemble a
broad line of networking products and to grow very
quickly from a company with a single product
line into the key player in Internet equipment. From
1993 to 2001, Cisco acquired 71 companies,
at an average price of approximately $350 million.
Cisco’s sales increased from $650 million in
1993 to $22 billion in 2001, with nearly 40 percent
of its 2001 revenue coming directly from these
acquisitions. By 2009, Cisco had more than $36 bil-
lion in revenues and a market cap of approx-
imately $150 billion.
Pick winners early and help them develop their
businesses
The final winning strategy involves making
acquisitions early in the life cycle of a new industry
or product line, long before most others recognize
that it will grow significantly. Johnson & Johnson
pursued this strategy in its early acquisitions
of medical-device businesses. When J&J bought
device manufacturer Cordis, in 1996, Cordis
had $500 million in revenues. By 2007, its revenues
had increased to $3.8 billion, reflecting a 20 per-
cent annual growth rate. J&J purchased orthopedic-
device manufacturer DePuy in 1998, when
DePuy had $900 million in revenues. By 2007, they
had grown to $4.6 billion, also at an annual
growth rate of 20 percent.
This acquisition strategy requires a disciplined
approach by management in three dimensions.
First, you must be willing to make investments early,
long before your competitors and the market see
the industry’s or company’s potential. Second, you
The five types of successful acquisitions
need to make multiple bets and to expect that
some will fail. Third, you need the skills
and patience to nurture the acquired businesses.
Harder strategies
Beyond the five main acquisition strategies
we’ve explored, a handful of others can create
value, though in our experience they do so
relatively rarely.
Roll-up strategy
Roll-up strategies consolidate highly fragmented
markets where the current competitors are too
small to achieve scale economies. Beginning in the
1960s, Service Corporation International,
for instance, grew from a single funeral home in
Houston to more than 1,400 funeral homes
and cemeteries in 2008. Similarly, Clear Channel
Communications rolled up the US market for
radio stations, eventually owning more than 900.
This strategy works when businesses as a group
can realize substantial cost savings or achieve
5
higher revenues than individual businesses can.
Service Corporation’s funeral homes in a given city
can share vehicles, purchasing, and back-office
operations, for example. They can also coordinate
advertising across a city to reduce costs and
raise revenues.
Size per se is not what creates a successful roll-up;
what matters is the right kind of size. For Service
Corporation, multiple locations in individual cities
have been more important than many branches
spread over many cities, because the cost savings
(such as sharing vehicles) can be realized
only if the branches are near one another. Roll-up
strategies are hard to disguise, so they invite
copycats. As others tried to imitate Service Corpo-
ration’s strategy, prices for some funeral
homes were eventually bid up to levels that made
additional acquisitions uneconomic.
Consolidate to improve competitive behavior
Many executives in highly competitive industries
hope consolidation will lead competitors to
6 McKinsey on Finance Number 36, Summer 2010
focus less on price competition, thereby
improving the ROIC of the industry. The evidence
shows, however, that unless it consolidates to
just three or four companies and can keep out new
entrants, pricing behavior doesn’t change:
smaller businesses or new entrants often have an
incentive to gain share through lower prices.
So in an industry with, say, ten companies, a lot
of deals must be done before the basis of com-
petition changes.
Enter into a transformational merger
A commonly mentioned reason for an acquisition
or merger is the desire to transform one or
both companies. Transformational mergers are
rare, however, because the circumstances
have to be just right, and the management team
needs to execute the strategy well.
Transformational mergers can best be described by
example. One of the world’s leading pharma-
ceutical companies, Switzerland’s Novartis, was
formed in 1996 by the $30 billion merger of
Ciba-Geigy and Sandoz. But this merger was much
more than a simple combination of businesses:
under the leadership of the new CEO, Daniel
Vasella, Ciba-Geigy and Sandoz were transformed
into an entirely new company. Using the merger
as a catalyst for change, Vasella and his manage-
ment team not only captured $1.4 billion in
cost synergies but also redefined the company’s
mission, strategy, portfolio, and organization,
as well as all key processes, from research to sales.
In every area, there was no automatic choice for
either the Ciba or the Sandoz way of doing things;
instead, the organization made a systematic
effort to find the best way.
Novartis shifted its strategic focus to innovation
in its life sciences business (pharmaceuticals,
nutrition, and products for agriculture) and spun
off the $7 billion Ciba Specialty Chemicals
business in 1997. Organizational changes included
structuring R&D worldwide by therapeutic
rather than geographic area, enabling Novartis to
build a world-leading oncology franchise.
Across all departments and management layers,
Novartis created a strong performance-oriented
culture supported by shifting from a seniority-
to a performance-based compensation system for
managers.
Buy cheap
The final way to create value from an acquisition
is to buy cheap—in other words, at a price below a
company’s intrinsic value. In our experience,
however, such opportunities are rare and relatively
small. Nonetheless, though market values revert
to intrinsic values over longer periods, there can be
brief moments when the two fall out of alignment.
Markets, for example, sometimes overreact to
negative news, such as a criminal investigation of
an executive or the failure of a single product
in a portfolio with many strong ones.
Such moments are less rare in cyclical industries,
where assets are often undervalued at the bottom of
a cycle. Comparing actual market valuations
with intrinsic values based on a “perfect foresight”
model, we found that companies in cyclical
industries could more than double their shareholder
returns (relative to actual returns) if they acquired
assets at the bottom of a cycle and sold at the top.3
While markets do throw up occasional opportu-
nities for companies to buy targets at levels below
their intrinsic value, we haven’t seen many cases.
To gain control of a target, acquirers must pay its
shareholders a premium over the current
market value. Although premiums can vary widely,
the average ones for corporate control have
The five types of successful acquisitions 7

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

governance and value creation: Evidence from private

the possibility that markets may be overvaluing
a potential acquisition. Consider the stock market
bubble during the late 1990s. Companies that
merged with or acquired technology, media, or
telecommunications businesses saw their
equity,” Social Science Research Network working paper,
February 19, 2010.
2 IBM investor briefing, May 12, 2010 (www.ibm.com/investor/
events/investor0510/presentation/pres3.pdf).
3 Marco de Heer and Timothy M. Koller, “Valuing cyclical
companies,” mckinseyquarterly.com, May 2000.
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
and Werner Rehm absolute and relative standards, large corpo-
rations across many sectors have the financial and
operating firepower to launch bids, and the
deleveraging trend now under way has left several
of the more conspicuous private-equity players
licking their wounds after years of overindulgence.
In these circumstances, something more than
just another turn in the acquisition cycle may lie
ahead. The basics are in place for a period when
mergers and acquisitions reassert their fundamental
purpose: enabling strong corporate performers
to match their acquisitions to their long-term stra-
tegic goals and to drive out weak, inefficient
managers. Such a period not only would be ripe
with opportunity but also could hugely benefit
the economy, the reputation of business, and
shareholders.
First, the market value of many companies is closer
to their estimated intrinsic value than it has
been at any time in the past two decades. Right
now, for instance, the aggregated market value
of the S&P 500 is roughly $11 trillion. We estimate
that this figure is comfortably justified by
expected cash flows—the best barometer of value—
given a return to historical average levels of
earnings growth and returns on equity. Market
values rarely fall below intrinsic value or
even come as close to it as they have over the past
18 months. Assets may not be as cheap as
they were 18 months ago, but corporate buyers

in today’s environment need to find only enough
synergies to justify the purchase premium,
rather than also having to recoup the cost of buying
in an overvalued market.
Second, these synergies exist. Strong corporate
performers that can exploit strategic and operational
synergies should be able to outbid rational
private-equity players that rely only on operational
improvements and more costly leverage. Across
all sectors of the economy, the median operating
margins of companies with more than $5 bil-
lion in market capitalization are 5 to 20 percent
higher than the operating margins of small
ones, with only a few exceptions, such as basic
materials and energy. In some sectors,
including IT hardware, health care products, and
trucking, this gap in operating margins is
expected to widen over the next two years. We
have found that a mere 1 percent increase in
the operating margins of an acquired business can
create as much as 10 percent more value.
Third, large corporations have the currency,
in both cash and shares, to pursue acquisitions.
Outside of the financial, food, pharma, semi-
conductor, and telecommunications sectors, the
return to shareholders of a median large-cap
company in the S&P 500 was 5 to 10 percent higher
than that of its small-cap equivalents from
January 2007 to this April. Large companies
therefore have relative currency for deals.
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.
9
Furthermore, we estimate that about half of the
S&P 500’s $1 trillion in cash holdings lies outside
the United States. Clearly, the better choice
for value creation is investing this cash in global
growth acquisitions rather than taking a tax
hit when repatriating the earnings to buy back
US-held shares.
Private equity, which holds about $500 billion in
investible assets, will no doubt reassert itself
where it can show that it adds value. But its impact
on M&A pricing should remain subdued for a
while as tight credit compresses leverage ratios for
buyouts. The deals that emerge in an environ-
ment without cheap credit will mark a return to
the fundamental purpose of M&A: seizing
opportunities when a combination of assets can
create value for shareholders by driving out
real inefficiencies and benefiting from scale or
scope. This wave of acquisitions therefore
will favor corporate buyers with good strategies
and great deal execution.
The trick will be to act quickly and decisively:
during any M&A wave, asset prices will go up and
returns to acquirers will go down. As compet-
itors start to pick up attractive targets, large com-
panies will have to act or they won’t be able
to take advantage of this unique opportunity, when
market values and fundamental performance
support good returns on M&A. At some point, the
market may overheat again, but for now the
landscape for strategic acquirers hasn’t looked this
promising in decades.
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 Carlyle Group, one of the world’s premiere
private-equity firms, has built a career on assessing
companies across industries and around the
globe. In the latest installment of our interview series
McKinsey conversations with global leaders,
Rubenstein shares his insights on how to manage
a diverse and decentralized organization, how
to identify the markets of greatest potential in a
changing world economy, and how to attract
leaders who are both intelligent and “have their
ego in check.” He also discusses the new eco-
system he sees developing for the private-equity
industry as pressures build for some of its
largest players go public. Richard Elder, a director
in McKinsey’s Washington, DC, office, conducted
the interview.
The big picture: Global rebalancing
McKinsey on Finance: People would say we’re
at a fledgling recovery. You travel the world;
you have investors around the world. What are your
perspectives on how you see the recovery
playing out?
David Rubenstein: Very few people predicted
how serious the recession would be or exactly
its timing or its length. And therefore, any prediction
about how great the recovery will be or how it
will occur probably should be taken with a grain of
salt. Nobody really knows, is the point.
My perception, though, is that the recovery is
under way in different ways around the world. The

United States is recovering nicely but not
as great as we would like. We’ll probably grow at
2 to 3 percent this year. I believe that we will
have very serious problems, though, with our debt.
We still have $14 trillion of debt coming out
of this recession. We have an annual deficit of
$1.6 trillion. We have unemployment that
is stated to be 9.7 percent but that is actually
about 16.5 percent, if you count people who
are looking for full-time jobs who have part-time
jobs. And we have a serious problem with
our currency.
In Europe, I think growth is probably going to
be even less than it is in the United States.
The northern European countries by and large,
with the exception of England and Ireland,
perhaps, are growing quite nicely. I’m not sure
there’s going to be any real growth in the
southern European countries; and as a result,
the growth overall on year will probably be
2 to 3 percent at best case. Maybe 1 to 2 per-
cent overall.
Asia and the other emerging markets that have
become very important of late are probably
going to grow anywhere from 5 to 10 percent a
year. And as a result, that’s where many of the
investors around the world really want to put a lot
of their money. So China, India, Brazil, Turkey,
Saudi Arabia, South Korea, and Taiwan
are all great emerging markets, and I think
they’re all likely to go pretty well.
We find the greatest single emerging market in
the world in China. There’s nothing close to it
because of its size and entrepreneurial spirit, the
encouragement of private equity, the great
growth opportunities we see all throughout the
economy in China. We have 45 full-time
Chinese natives working for us now in China doing
deals through various funds that we have. We
11
have three regular funds, a buyout fund, a growth
fund, a real-estate fund, and now two renminbi
funds—so I don’t think you can deploy too much
money in China.
I don’t really want my competitors to come there
and realize that, but right now it is a little bit
more competitive than it has been in the past. And
the competition is not just from global private-
equity firms or American private-equity firms
investing there. Indigenous Chinese firms
are probably now our biggest competitor in China.
McKinsey on Finance: Given all the changes
that have happened—especially outside the United
States—and what regulation might or might not
come, has Carlyle rethought how it assesses risk?
David Rubenstein: Political risk is something
that’s on your mind all the time when you’re
investing overseas. To be honest, the greatest
political risk that I see is the United States.
In other countries around the world, sometimes
you have a better sense of what they’re going
to do and they’re more consistent than the United
States. But sure, you do have political risks in
all countries. You never know what a government
might do at a change of power in a country.
We have people around the world who help us
assess risk, and we actually have a lot of
people who are specializing in government and
understanding government and who help
our investment teams assess whether or not the
investment makes sense.
McKinsey on Finance: How do you then think
about some of the developing markets?
David Rubenstein: Well, in the year 2014 the
emerging markets will surpass the developed
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
longer. If China, by the year 2035, is the biggest
economy in the world, how much longer can
you call it an emerging market?
India will probably be the second biggest economy
in the world at that time. How much longer
can we call that an emerging market? The emerging-
market concept is a little dated, and I think we
really have to bifurcate emerging-market countries
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.
Right now, we think that the greatest emerging
markets are China, India, Brazil, Turkey, Taiwan,
South Korea, Saudi Arabia. Countries in Africa
have great appeal to people like us. I don’t think
you can deploy that much capital there in sub-
Saharan Africa or in South Africa, but we do think
that the opportunities will be considerable
as those countries begin to develop further their
natural resources.
McKinsey on Finance: One country you
haven’t mentioned is Russia. How do you think
about Russia?
David Rubenstein: We opened in Russia twice
and we closed in Russia twice. I don’t think
that the opportunities are as great there for Western
private-equity capital as for other countries.
And one of the reasons is, there is a fair amount of
excess capital in Russia, certainly held by the
oligarchs, and they don’t really need our capital
to develop deals.
I would say that countries like China don’t really
need our capital either. At this point, I think
what China really wants is expertise, contacts,
management skills. What they would like to do
is to have the private-equity skills and techniques
and contacts of Western firms come to China,
teach the Chinese how these things are done in the
West, and then when those skills are imparted,
probably the Chinese will be able to do some of the
same things we’ve done in the West. So they
don’t really need our capital so much, but they toler-
ate our capital in order to get the other things
that I think they would like.
In the industry: Private equity
McKinsey on Finance: As the private-equity
industry continues to evolve, are you seeing that
there will be fewer larger firms such as Carlyle,
Blackstone, and KKR and that the middle tier might
get squeezed out? Or are you seeing a proliferation
of funds—and therefore companies—going forward?
David Rubenstein: I think it’s very difficult to
get a new fund or firm off the ground today.
On the other hand, I don’t think a lot of the funds
or firms that went into business years ago
are going to implode or go out of business. Some
may. Some may have track records that are
so damaged as a result of the recession they can’t
raise a new fund.
I think what you will begin to see is some of these
smaller firms in certain niche areas be acquired
by larger firms, and I do think that some firms will
probably not be as dominant in their area as
they once were because their track record isn’t as
good or they can’t raise as much money as
they once did.
On the other hand, I do think that the large private-
equity firms, the largest ones—KKR, Blackstone,
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group
“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
larger percentage of capital that’s available,
because their brand names, I think, give investors
some comfort. These firms all survived the
recession in reasonably good shape and are going
to become what I’ll call “alternative investment-
fund managers.” They won’t just be private-equity
firms. They’re now going to expand their offer-
ings so they have not only private-equity funds
but also real-estate funds, infrastructure funds,
distressed debt funds, and credit funds, and just
all kinds of different funds—hedge funds, hedge
fund of funds, private-equity fund of funds. So they
can use their brand name and help sell those funds
around the world but also acquire very talented
people who could manage these funds. I think
virtually all of these funds and firms will probably
be public entities within five years or so.
McKinsey on Finance: When you say a public
entity, how much of it do you think will be
public? Is there a certain amount that you would
say is probably always going to be retained
within a small group of founders?
David Rubenstein: Well, I think that the
large, global private-equity firms—most, again,
of which are American—will go public in part
because having currency to make acquisitions of
the kind of firms I think they can acquire to
expand their offering base will be possible with
the currency of a public stock.
13
Second, the currency will enable you to retain and
recruit employees and, particularly if
your competitors have those currencies to offer, you
need to do that. And third, the monetization of
the founders is an important factor that shouldn’t
be ignored. Most of the founders of these global
private-equity firms are probably between 55 and
65. And at some point, they want to monetize
what they have built, and I think the IPO helps
monetize it. It also helps to reduce the share
the founders have and probably spreads the wealth
within the firm, and maybe that’s a healthy thing.
So I think for all these reasons, we’ll probably see
these firms go public in the not-too-distant future.
McKinsey on Finance: Do you find that when
you talk to a lot of other private-equity firms,
and certainly the banking industry, that Asia is
the next big run?
David Rubenstein: All of the large, global
private-equity firms are more or less American.
I don’t know if that can continue forever,
because at some point other parts of the world will
say, “We should have global dominant private-
equity firms here.”
The United States, right after World War II, was
48 percent of the world’s GDP. We’re now about
22 percent. So the world may say, “Why is it, with
just 22 percent of the world’s GDP, that all the
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
Born in 1949,
in Baltimore, Maryland
Married, with 3 children
Education
Graduated with a bachelor
of arts and science in
1970 from Duke University
Earned a law degree in
1973 from the University of
Chicago Law School
Career highlights Fast facts
The Carlyle Group Chairman of the
Cofounder and managing John F. Kennedy Center
director (1987–present) for the Performing
Arts, president of the
Shaw, Pittman, Potts Economic Club of
& Trowbridge (now
Washington, and regent
Pillsbury, Winthrop,
of the Smithsonian
Shaw, Pittman)
Institution
Lawyer (1981–87)
Member of the board
Deputy assistant
of directors or trustee
to the president
of Duke University,
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
out just investing inside the United States.
Now we invest more money outside of the United
States than inside the United States; we
have more people outside the United States than
we have inside the United States investing.
David Rubenstein: All of us who are doing
this are kind of making it up a bit on the fly.
Obviously we’re looking at other global firms and
what they’ve done. In our case, what we
tend to do is control all the investment decisions
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
McKinsey on Finance: Over time, Carlyle
has gotten bigger and bigger and therefore more
geographic, with more people, more systems,
et cetera. How do you manage a company that
started with just a few of you and now is a
very, very diverse, very decentralized global firm?
all the deals have to be approved centrally and
by experienced people who are serving on
those committees. Second, we do have extensive
training programs to give people a sense of
what we are about, how we regard ethics as an
important part of our business, and to make
sure there’s a common culture in the firm.
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group
We call it One Carlyle. Everybody is part of
one firm. No matter what part of the firm you’re at,
you’re part of Carlyle. It’s One Carlyle. We also
try to make sure that the people in the firm
get together on a regular basis at conferences or at
training sessions and retreats to make sure they
understand who they’re working with. And we also
incent people. Those people who cooperate with
other people in the firm, no matter what part of the
firm they’re with, we take note of it and we reward
people in bonuses and other types of compensation.
So, through many different ways, we try to incul-
cate and manage a common culture. We do manage
things centrally a bit by the investment approval
process, and the hiring process is largely central
as well.
McKinsey on Finance: Carlyle has always
had the famous “DBD” [David Rubenstein,
Bill Conway, Dan Daniella]. You’ve been very
vocal that you don’t necessarily socialize
outside of the firm but that you actually work
extremely well together inside.
David Rubenstein: There are three people
who really have been running Carlyle for most of its
history, and we do get along quite well, in part
because we have different areas of responsibility.
Bill Conway tends to oversee most of the invest-
ment activity. Dan Daniella oversees a lot of the
operational activities, as well as our real-estate
energy businesses. And I tend to oversee fund-raising
and probably recruiting a bit and somewhat
the strategic vision of the firm. I have been more or
less the face of the firm because I’ve been willing
to do interviews and make speeches. But all of us
are equal partners and all of us consult regu-
larly on all matters, even though one person may
be taking the lead.
If you’re a public company, it’s difficult to say that
you have three CEOs. And we recognize that.
15
Without conceding that we’re going to go public or
even saying that we will, if we were to go public I
suspect we might have to change our model a bit and
have either a CEO or designate one of us to be the
CEO—or find someone else within the firm to do it.
There’s no doubt that, as long as the three founders
are there, it’d be difficult for somebody else to
completely be the CEO, but we recognize that we
might have to step back a bit if somebody else
were the CEO. We just haven’t decided that yet, in
part because we haven’t yet decided if we’re
going to go public.
McKinsey on Finance: What have you learned
from the different management styles and the
different types of companies you all have owned,
and how has that changed over time?
David Rubenstein: First, you don’t really know
how good a company is going to be when you buy it.
Ninety-five percent or more of the projections of
what you’re going to earn are wrong. We’re just not
right on how good companies are going to be
or how bad they might be. Second, when you don’t
have a good manager at the outset, you need to
get one. And if somebody is not a very good manager
in the first year or so, he or she is probably not
going to get much better, so you probably should
make a change.
You should be very careful about the assumptions,
in terms of the economy, that you get in your
projections. Some people often assume the econ-
omies are going to go very well all the time,
and that’s probably a mistake. Buying companies
that really have a good culture is extremely
important. Making certain that the people in your
firm know how to add value—that’s also very
important. Making certain that the numbers you
see when you do the due diligence are accurate,
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
generally there are many different mistakes we’ve
made, and I think we’ve probably made every
mistake you can make, but actually we’ve generally
done pretty well.
We’ve averaged about 30 percent gross internal
rate of return on all the money we’ve invested—
almost $60 billion of equity over the 23 years or so
of the firm. So we’ve been right more than we’ve
been wrong. And I like to focus a bit more on our
mistakes, because I like to look at what we did
wrong—and the deals we should have done that we
didn’t do, or the deals we shouldn’t have done
that we did do. And I tend to focus on that. But
obviously, the deals we’ve done that have
worked out have been much greater than deals
that we’ve had that didn’t work out.
McKinsey on Finance: How do you actually
get that level of insight into what really makes a
company tick before you commit the capital?
David Rubenstein: The gestation period from
the beginning of looking at a deal to the closing
of a deal is probably about six months. Now if you
had a year or two to look at a company, you’d
probably know even more, but six months is an
average gestation period. So during that
period of time, we are retaining consultants. It
might be an accounting firm, it might be a law
firm—specialized insurance analysts, and all kinds
of different experts who can give us some sense
of what the firm is like.
Obviously we spend a lot of time with management
as well. We talk to competitors. We talk to
customers. There’s no foolproof way, and obviously
some people do make mistakes. But more often
than not, buyout deals, private-equity deals, will
work out; and that’s in part because of the extensive
amount of due diligence.
One of the reasons private-equity deals tend to
work out to a higher extent than venture-
capital deals do is you have a long amount of time
to do the due diligence. You’re looking at predict-
able cash flows, existing management structures.
Venture capital, typically, is much less
developed in terms of the management structure,
and the idea may not actually work out, and
the cash flow may not really be there.
So that’s why venture capital deals tend not to
do as well, in terms of numbers. Eight out of every
ten may not work in venture capital. Two may
work. Whereas in buyouts, I suspect nine out of
every ten probably work.
McKinsey on Finance: One of the hot topics
right now for most businesses is organic
growth. How do you proactively think about
the innovation that is required within
these companies to create that organic growth?
David Rubenstein: Well, when you’re looking
at an emerging company—a growth company
or an emerging growth company or something like
that—you are looking at whether they are
going to be innovative enough to actually grow a
business from a relatively modest business
to a real earnings business.
And at those kinds of companies, you are looking
at innovation—whether they have one or two
ideas that are really going to take this to the next
level. In more mature buyouts, you tend not
to be looking as much for innovation as for more
efficiency. You want to make the company
operate more effectively. Maybe they could reduce
their costs in some ways. Maybe they can do a
bolt-on acquisition. You tend not to focus as much
on innovation in some of the larger companies,
and maybe to some extent we’re doing that now.
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group
But I think you see the innovation much more in
these emerging companies where you have
$10 million to $40 million of revenue, maybe very
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
tend to do is spend a lot of time in the due-
diligence process assessing whether these inno-
vations they have on the drawing boards are
likely to happen.
McKinsey on Finance: When you think about
all the different companies you own, especially
around the world—obviously a lot of different
local cultures, a lot of different practices, et cetera—
how do you balance between the local autonomy
for the deal team there, even though the ultimate
approval is done centrally here, and all those
different nuances and everything else that require
you to make the right decisions?
David Rubenstein: The deal teams tend
to generate their own ideas. You can’t completely
control everything centrally, because the more
and more you control centrally and squeeze your
local people, they will not be happy. If you have
a very, very dedicated, talented team of people and
they’re very good at negotiating deals, they are
people who want some freedom.
And if you get people who just don’t want any
freedom and who will do whatever you tell them
centrally, they’re not the kind of people you
want representing you, because, presumably, in
negotiating deals with the people they’re
trying to buy things from they’ll be as weak as
they might be in dealing with you.
So you want strong people. You want people who
are willing to argue with you and debate with
you, because if they’re not willing to debate with
17
people on the centralized investment committees,
they presumably won’t debate with their own
CEOs, and that’s not a good thing.
Business in society: Redefining
public service
McKinsey on Finance: As you think about the
private-equity industry, how do you think
about the societal or environmental implications
of the investments that you are making?
David Rubenstein: Well, there’s no doubt that
many private-equity investors focused for
many years on getting good rates of return and
just telling their investors about those good
rates of return, and then getting more money from
those same investors. I think increasingly we’ve
recognized that if you only focus on internal rates
of return, you’re probably going to do a dis-
service to yourself. Because in the end, other
people who are stakeholders in what you do
are not going to be happy.
We need to make a better case that we are
paying taxes, we are sensitive to environmental
concerns, we are sensitive to socially respon-
sible investment principles. I think the private-
equity industry may be a little late to that
game, but it’s now catching up, and I think we’re
doing a much better job. In our own case at
Carlyle, we’ve been very careful to invest in certain
areas and not invest in other areas. We have,
for example, not invested in tobacco. We haven’t
invested in alcohol. We haven’t invested in
gambling. We haven’t invested in hand-guns,
things like that. We’ve been careful about
investing in certain areas that we just are not
happy about and don’t want to be associated with.
18 McKinsey on Finance Number 36, Summer 2010
Generally, we try to invest in companies we
think are going to add some productivity to the
economy that’s relevant, and add jobs. We’re
not interested in buying companies where we’re
only going to make our money by destroying
jobs, or taking them offshore.
McKinsey on Finance: Can you describe what
social responsibility means to you personally?
David Rubenstein: When I turned 54, I read
that a person my age probably would live, on
average, another 27 years, and therefore I realized
I had lived two-thirds of my life, and I didn’t
want to spend the other third of my life just acquiring
more money and waiting for my heirs to give
it away.
So I concluded I would try to give away as
much as I could while I was alive. And therefore,
I decided to get deeply involved in a lot of
philanthropic areas, particularly ones that were
helpful to me: schools that were helpful to
me, causes that were helpful to me, things that
were important to my community.
I’m deeply involved in education, deeply
involved in performing arts, deeply involved in
medical research, and deeply involved in a
number of other areas that I think are important
to our country. I think at a younger age, people
still are very interested in going into public
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
program is designed to encourage people to go into
business at some point in their career and to go
into public service. And it’s designed to show that
you can mix these two types of careers.
I do encourage people to go into public service.
I think it’s easier to do it early in life—when
you can have more responsibility, probably, in the
government than you would in the private
sector—and then come out and make money, if you
can, and then perhaps later in life you can do
things in public service.
But the important thing from the time that I
went into government to now is this: when I went
into government in the 1970s, if you wanted to
serve your country, typically you did it in govern-
ment. You might be in the military, the Peace
Corps, or in federal-government service. Now there
are many NGOs—nongovernmental organiza-
tions—that are providing extensive public services
to our country, that you can serve in these
NGOs and do a very good job, or create your own
NGO. And so, I think many people who want to
go into public service today don’t feel they have
to go into government. And I encourage them to
not necessarily go into government if they want to do
something in public service.
Everybody has a social responsibility to make
the earth a little bit better than when you came
into it. And so, when I die, I hope people will
say that I did something to make the world a little
bit better in one or two areas. And I hope my
children will take the same kind of responsibility
in whatever wealth they may get and use it in
the same kind of useful ways.
On leadership: Mending the
public–private divide
McKinsey on Finance: What are your
thoughts on leaders and leadership, in terms of
today’s business context?
McKinsey conversations with global leaders: David Rubenstein of The Carlyle Group
David Rubenstein: Well, clearly there are
fewer individuals around the country to look up to
as leaders in the business community, for
example, than may have been the case years ago.
We did, in the 1970s and ’80s, begin to make
rock stars of our CEOs. But I don’t think that today
there are as many leaders in the financial-
services community as I wish there were, because
so many of them had problems in the recession.
I do feel, unfortunately, that we’ve demonized
business leaders to some extent. I think the
government of the United States, to some extent,
has in effect implied that if you make too
much money, if you’re too highly compensated by
the government’s standards, you must have
done something wrong. And as a result of that,
very few business leaders are as willing to be
engaged with government as they were in the past.
One of the strengths of the US government system
has been that people who have private-sector
experience can go freely in and can go freely out. I
think our government has benefited by having
people with extensive private-sector experience.
And I think our private sector has benefited
from people with government experience going
into the private sector. Now, at the senior
levels of government, people who are willing to go
in from the private sector are fewer and fewer.
The most talented people in the business world
that I know today wouldn’t consider going
into government. It’s unfortunate.
McKinsey on Finance: How were you shaped
by your time in public service?
David Rubenstein: Well, I was very fortunate.
I was a young man. I became, at the age of 27,
deputy domestic policy adviser to the president of
the United States—a job that I probably wasn’t
19
qualified for. But it gave me a great thrill working
in the White House, advising the president
of the United States. And I did learn much more
about public policy and about the world than
I would have if I’d been practicing law at that time,
which was probably the alternative.
As I look at myself now as a man of 60 years old, I
think that experience was very good in shaping
my perspectives and making me understand how
government works, how our country relates
to other countries. And I wouldn’t have traded those
four years in the White House for anything else,
no matter what else I might have had in terms of
financial opportunities at the time. I’m very
glad that I did it. On the other hand, I don’t lust
to go back into government.
McKinsey on Finance: When you go through
the talent and hiring process, do you look
for people who have actually had some kind of
public-service background?
David Rubenstein: Private-equity firms have
gotten a little bit into a rut of hiring people
who have gone to very good colleges, spent two
years in an investment-banking firm, then
gotten an MBA, and then spent either a year or two
in private equity, and then come to them.
And I think we are now increasingly looking
for people that have operational skills, as well as
finance skills. And because government is
increasingly an important part of our lives, we’re
probably going to have people with more
government skills. Right now, I spend more time
dealing with governments around the world
than I did 10 or 15 years ago, because governments
are increasingly looking at what private-equity
and investment firms are doing.
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.

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,
Conor Kehoe, Asia emerged from the global downturn a winner,
and Badrinath with its economies continuing to post higher
Ramanathan
growth rates and its banks suffering far less damage
from the credit crisis. But if Asia’s financial
institutions thought that the region’s good fortunes
were sufficient to provide a competitive edge,
they ought to think again. When it comes to M&A,
for example, acquisitions by the region’s banks
have significantly underperformed those
by what we call principal investors—a group that
includes private-equity firms and sovereign-
wealth funds—even in a rapidly growing market.
That is among the findings of a recent McKinsey
analysis of financial-sector M&A in Asia.1
21
The study found that acquisitions by principal
investors generate a median annual internal rate
of return (IRR) of 22 percent, compared with
–7 percent for strategic investors. This finding holds
true for deals of similar sizes, across time and
across Asian countries—before, during, and after
the global financial crisis.
Why such a gap? For one thing, principal
investors have been sharper at picking the right
geographies. For another, Asian banks appear
not to capitalize as much as they could on their
industry expertise; principal investors get
more mileage from an active approach to ownership.
Finally, they seem to be better at parlaying
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
selecting the right geographies. Despite the higher
risk profile associated with opportunities
in emerging markets, these investors completed
more deals in the Asian ones, such as China,
India, and Indonesia. The deals generated signifi-
cantly higher returns than did those in more
developed markets, such as Japan and Taiwan.
In contrast, strategic investors—the financial
institutions—completed more deals in the low-
return developed markets. While principal
investors outperformed strategic investors every-
where, this difference in geographic focus
played a significant role in creating the perfor-
mance gap.
• Once deals are complete, strategic players
appear to gain less advantage from their
deep industry expertise than principal investors
do from an active approach to ownership.
In developed Asia, as much as 46 percent of the
value in acquisitions by principal investors
comes from improving the earnings of the com-
panies they invest in. In contrast, the earnings
performance of the strategic players declined,
cutting their IRR in developed Asia by 31 per-
cent. Among deals in Asia’s emerging markets,
both types of players earned comparable
returns from earnings enhancement.
 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.

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
Olivia Nottebohm, recovery is taking hold around the world, but the
and Andy West
cost cutting so prevalent during the recent
recession looks to remain a strategic priority for
some time. Indeed, the number of executives
reporting steps to reduce operating costs in the
next 12 months increased significantly from
February to April, even as confidence in the
economy grew.1 Yet any successes companies have
at cutting costs during the downturn will
erode with time. Many executives expect some
proportion of the costs cut during the recent
recession to return within 12 to 18 months2—and
prior research found that only 10 percent of
cost reduction programs show sustained results
three years later.3
25
On either schedule, any programs initiated in the
early months of the downturn are already beginning
to fail—just as savings would be most useful to
finance growth. Sales, general, and administrative
(SG&A) costs prove to be particularly intransigent.
While manufacturing efficiencies have enabled
an average S&P 500 company to reduce the cost of
goods sold (COGS) by about 250 basis points
over the past decade, SG&A costs have remained
at about the same level (Exhibit 1).
Why is it so difficult to make cost cuts stick? In most
cases, it’s because reduction programs don’t
address the true drivers of costs or are simply too
difficult to maintain over time. Sometimes,
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
operations to set useful cost reduction targets.
In the midst of a crisis, they look for easily available
benchmarks, such as what similar companies
have accomplished, rather than taking the time to
conduct a bottom-up examination of which costs
can—and should—be cut. In other cases, individual
business unit heads try to meet targets with
draconian measures that are unrealistic over the
long term, such as across-the-board cuts that
don’t differentiate between those that add value or
destroy it. In still others, managers use inaccurate
or incomplete data to track costs, thus missing
important opportunities and confounding efforts
to ensure accountability.
While there’s no single silver bullet to ensure that
cost-management programs will stick, large,
multibusiness unit organizations can better their
chances by improving accountability, focusing
on how they cut costs, drawing an explicit
connection to strategy, and treating cost reductions
as an ongoing exercise.
Assign accountability at the right level
Few would dispute that the support of top exec-
utives is necessary for cost-management efforts to
succeed. Involved CEOs and CFOs, in particular,
can help mediate the inherently political nature of
such exercises and provide critical energy and
motivation. Yet in our experience, the involvement
of top managers is not by itself sufficient—
especially in a period of growth, when they
naturally turn their attention to other initiatives.
Instead, most cost innovation happens at a very
small and practical level. Breaking costs out in this
way helps managers to find the specific groups or
individuals responsible for them and to identify and
deal swiftly with pockets of expense mismanage-
Five ways CFOs can make cost cuts stick
ment. Take, for example, the cost-cutting program
at one multinational high-tech company. Initially,
the CFO had little actionable information on who
was responsible for which costs. Profit-and-loss
(P&L) statements were reported only for product-
based business units, even though geographic
sales units had higher costs. This lack of detail made
it very difficult to assign responsibility for
overall cost reductions. For instance, if freight costs
for a business unit increased from year to year,
it was difficult to determine whether this happened
because of shipping behavior by factories or
costs incurred by the sales organization in deliver-
ing third-party parts to customers.
To resolve these issues, the company redefined the
way it collected and reported information, to ensure
that costs were broken out for each of 100 orga-
nizational units. That helped managers quickly
identify two headquarters units and a sales
organization that were responsible for large cost
increases. Together, the managers came up with a
plan to control future costs. Among other
things, the plan assigned cost accountability to
the company’s more than 60 separate organi-
zational units. This approach ensured that the
people managing costs were those closest to
the decisions, who could ensure that cost manage-
ment was not hurting the business.
Importantly, the process planners who run such
programs as Six Sigma improvement efforts
are generally the wrong choice to manage cost-
cutting programs. They typically lack both
the content expertise and authority to make difficult
trade-offs in areas that often require more
detailed knowledge of where costs occur and the
ability to make keen subjective judgments about
which costs to cut. Only someone at the level of, say,
a sales manager has the detailed knowledge
and authority to decide whether it’s really necessary
27
to travel to one client meeting in person, while
conducting another by videoconference. Such
informed cuts are more likely to endure because
the people responsible for them can be held
accountable through appropriate incentives, such
as performance evaluations, that consider both
costs and business performance.
Focus on how to cut, not just how much
Cost reduction programs often lose effectiveness
over time because top management kicks off
the effort with broad cost reduction targets (“How
much do we want to save?”) but then leaves
decisions on how to meet those targets to individual
line managers. The presumption is that they
have a more detailed understanding of their partic-
ular area of the business and will take the right
actions to control costs. While this is true in
some instances, we have seen too many cases where
managing to a number has resulted in flawed
decisions, such as delaying critical investments,
shifting costs from one accounting category to
another, or even cutting costs in a way that directly
undermines revenue generation. Clearly, the
benefits of such cost cuts are likely to be illusory,
short lived, and at times damaging to long-
term value creation.
A more enduring approach includes changing
the way people think about costs by, for example,
setting new policies and procedures and then
modeling the desired behavior. If a company
announces, say, a new travel policy, senior managers
need to set the tone with their own actions—for
example, by aggressively using videoconferences
instead of travel or eliminating catering for
in-person meetings. Even something as simple as
no longer providing sandwiches for lunch
meetings can be part of a pattern of behavior that
signals real and enduring change. And since
backpedaling on this kind of behavior when the
28 McKinsey on Finance Number 36, Summer 2010
economy picks up again would send the reverse
message, managers should model only cost cuts
they intend to stick with. If they know they’ll
eventually restore catering for in-person meetings,
it could well be better not to cut it in the first place.
Benchmarks matter. External ones on some
measures may be difficult to get, but where they
are available—for example, on travel expenses—
they can enable managers to compare performance
across different units and identify real differences,
as well as trade-offs that may not be in line
with the organization’s overall strategy. Internal
benchmarks are easier to access and provide
great insights, especially because managers are
more likely to understand and adjust for
differences among their company’s organizational
units than among different companies repre-
sented by external benchmarks.
One multinational capital goods manufacturer
combined the two perspectives, analyzing
the major categories of expenditure and developing
targets based on both internal and external
benchmarks. Using external ones for travel spending,
managers found that the company’s travel
costs were higher than those of any peer—both per
employee and as a percentage of revenue
(Exhibit 2). They then set an aggressive target to
reduce travel expenses—and, to make the
effort stick, instituted new travel policies on booking
hotels and airfares. By examining internal
benchmarks across suborganizations (such as
departments, business units, or locations),
managers also identified which executives needed
to do a better job of educating their organizations
on travel policy. In addition, they increased
accountability by tracking each unit’s performance
on a monthly basis to measure compliance and
encouraged underperforming divisions to manage
their travel costs more aggressively. The effort
changed travel behavior across the entire
organization as subunits shared best practices.
Don’t let P&L accounting data get in the
way of cost reduction
CFOs often manage cost reduction efforts by
tracking accounting data in their companies’ P&L
statements. These can be a useful starting point
in a crisis, if other data are unavailable. But over
the long term, P&L categories, such as overall
SG&A costs, don’t give the kind of per-unit insights
that help focus cuts in, say, travel expenses
on the units that can best afford to cut them.
Unfortunately, few companies have the kinds of
systems they need to track costs at a fine-grained
level—and they face a number of challenges
in establishing them. Multiple data systems may
make it difficult to aggregate and compare data
from different geographies. Inconsistent accounting
practices between businesses or time periods
may lead to significant distortions. Changes in
organizational structure (as a result of acqui-
sitions, divestitures, or even changes in the
allocation of overhead costs) may similarly distort
tracking. Finally, onetime expenses in either
the baseline or the tracking period may become
excuses for deviations from the plan. As a
result, business or functional managers often
use data issues to divert attention from their
lack of progress.
Indeed, one medical-product company experienced
all these issues simultaneously in the initial stages
of its cost transformation program. Business unit
heads objected that tracking numbers from the
central financial database were flawed because of a
range of factors.4 As a result, the company couldn’t
reduce costs during the first several months of its
program, and discussions focused on the integrity
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
a dramatic reduction in several cost categories
bucketed under “other costs.” By getting the
data right and moving quickly beyond questions
about data integrity, the organization signifi-
cantly simplified the effort of cost reporting, making
it much easier to maintain the cost program
over time.
Clearly articulate the link between cost
management and strategy
Strategy must lead cost-cutting efforts, not vice
versa. The goal cannot be merely to meet a bottom-
line target. Indeed, among participants in a
November 2009 survey, those who worked for
companies that took an across-the-board
approach to cost cutting in the recent downturn
doubt that the cuts are sustainable. Those who
predicted that the cuts could be sustained over the
next 18 months were more likely to say that their
companies chose a targeted approach.5
Yet in our observation, many companies do not
explicitly link cost reduction initiatives to broader
strategic plans. As a result, reduction targets
are set so that each business unit does “its
fair share”—which starves high-performing units
of the resources needed for valuable growth
investments while generating only meager improve-
ments at poorly performing units. Moreover,
initiatives in one area of a business often have
unintended negative consequences for the
company as a whole. For example, a global low-
tech medical-device company’s initiatives to
reduce manufacturing and product costs were led
at the plant level, without input or customer
insights from sales and marketing teams. The
leaders of the cost-cutting effort in manufac-
turing nearly rendered several products defective
because they did not know how customers used
the products. Consequently, the effort led to the
loss of accounts and market share.
To create value through cost cutting, managers
need to understand the best ways to allocate
operating expenses, such as selling costs and R&D.
To do so, they must understand, at the most
detailed possible level, the return on invested
capital (ROIC) and the growth of the markets
in which a company plays. Mapping costs against
business units and geographies will reveal
both opportunities for cost reductions and areas
in which the business should increase its invest-
ments to take advantage of growth opportunities
or to “double down” in high-ROIC businesses.
At a high-tech company, for example, the granular
mapping of R&D spending by product families
identified some that despite their aging techno-
logical and growth profiles were still receiving
R&D and marketing investments. Clearly, these
low-ROIC businesses did not warrant a high
level of new resources. Management could redirect
them to growth units because it was able to map
costs at a very granular level.
With such insights, managers will also be able
to deliver a consistent message on how cost
reductions would make a company stronger—a
message reducing short-term resistance and
even inspiring the organization to support the
effort. Moreover, once these practices are baked
into the company’s standard operating practices,
cost reductions will become a more enduring part
of its strategy for long-term health.
Treat cost management as an
ongoing exercise
Most companies treat cost management as a one-
off exercise driven by the need to manage short-
term profit targets—and some of these exercises do
Five ways CFOs can make cost cuts stick
succeed in the short term because of constant
pressure from the CEO or CFO. Yet such hasty cost-
cutting activity typically goes into reverse once
the pressure is removed and rarely results in
sustainable changes in cost structure. In our expe-
rience, the reason is that one-off exercises don’t
require internal capability building.
A better approach is to use the initial cost
reduction program as an opportunity to build a
competency in cost management rather than
in mere cost reduction. Cost-management programs
need to be scoped as two- to three-year initiatives
rather than as immediate-term efforts with one-year
horizons. Also, effective cost-management
programs, by their very nature, include plans for
dealing with changing business conditions—
for instance, by adjusting for activity-level changes,
competitive drivers, or both.
In the case of the multinational manufacturing
company, many of the processes introduced
as part of the cost reduction initiative became the
basis for ongoing cost management. The finance
and accounting group created a system for
monitoring costs at a detailed and accurate level,
where none had existed before. Managers
encouraged greater communication between finance
and accounting, the business units, and func-
tional groups such as IT. Better communication
uncovered inconsistencies in accounting
practices. Changes in performance-management
systems and incentives further promoted the
cost-management approach. Purchasing managers
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.
31
ably removed from the cost base. Toward the end
of the third fiscal quarter of the effort, detailed
plans for building upon and sustaining the initiative
through the next fiscal year were developed
and vetted. These plans and practices enabled the
company to manage costs in the long term.
Companies must improve their processes and
capabilities if they hope to reduce or contain costs
in a sustainable manner. Rethinking common
practices in cost management should help to realize
this goal. In particular, achieving a more fine-
grained perspective on where costs occur should
be a centerpiece of any successful cost-
management program.
1 F ifty-four percent of the executives surveyed in April
indicated that they would take steps to reduce operating costs
in the next 12 months, compared with 47 percent in
February. In April, two-thirds of the respondents rated
economic conditions in their countries as better than
they had been six months previously, and another two-thirds
expected further improvement by the end of the first half of 2010.
See “Economic Conditions Snapshot, April 2010: McKinsey
Global Survey results,” mckinseyquarterly.com, April 2010. The
online survey (in the field April 5–9, 2010) received
responses from 2,059 executives representing the full range of
industries, regions, functional specialties, and tenures.
2 See “What worked in cost cutting—and what’s next: McKinsey
Global Survey results,” mckinseyquarterly.com, January 2010.
3 Suzanne P. Nimocks, Robert L. Rosiello, and Oliver Wright,
“Managing overhead costs,” mckinseyquarterly.com, May 2005.
4 These included changed accounting practices that shifted
costs from one P&L category to another, the transfer of a shared
cost center from one business unit to another, changes
in allocations of corporate overhead, and special onetime
initiatives, such as product launches.
5 See
 “What worked in cost cutting—and what’s next: McKinsey
Global Survey results,” mckinseyquarterly.com, January 2010.
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
Ankush Kumar dynamics and global financial turmoil have created
unprecedented volatility in commodity prices in
recent years. Meanwhile, executives at companies
that buy, sell, or produce commodities have
faced equally dramatic swings in profitability.
Many have stepped up their use of hedging
to attempt to manage this volatility and, in some
instances, to avoid situations that could put a
company’s survival in jeopardy.
When done well, the financial, strategic, and oper-
ational benefits of hedging can go beyond
merely avoiding financial distress by opening up
options to preserve and create value as well.
But done poorly, hedging in commodities often
overwhelms the logic behind it and can actually
destroy more value than was originally at risk.
Perhaps individual business units hedge opposite
sides of the same risk, or managers expend too
much effort hedging risks that are immaterial to a
company’s health. Managers can also under-
estimate the full costs of hedging or overlook natural
hedges in deference to costly financial ones. No
question, hedging can entail complex calculations
and difficult trade-offs. But in our experience,
keeping in mind a few simple pointers can help
nip problems early and make hedging strategies
more effective.
Hedge net economic exposure
Too many hedging programs target the nominal
risks of “siloed” businesses rather than a
company’s net economic exposure—aggregated

risk across the broad enterprise that also includes
the indirect risks.1 This siloed approach is a
problem, especially in large multibusiness organi-
zations: managers of business units or divisions
focus on their own risks without considering risks
and hedging activities elsewhere in the company.
At a large international industrial company, for
example, one business unit decided to hedge
its foreign-exchange exposure from the sale of
$700 million in goods to Brazil, inadvertently
increasing the company’s net exposure to fluctu-
ations in foreign currency. The unit’s managers
hadn’t known that a second business unit was at
the same time sourcing about $500 million
of goods from Brazil, so instead of the company’s
natural $200 million exposure, it ended up
with a net exposure of $500 million—a significant
risk for this company.
Elsewhere, the purchasing manager of a large
chemical company used the financial markets to
hedge its direct natural-gas costs—which
amounted to more than $1 billion, or half of its input
costs for the year. However, the company’s sales
contracts were structured so that natural-gas prices
were treated as a pass-through (for example, with
an index-based pricing mechanism). The company’s
natural position had little exposure to gas price
movements, since price fluctuations were adjusted,
or hedged, in its sales contracts. By adding a
financial hedge to its input costs, the company was
significantly increasing its exposure to natural-
gas prices—essentially locking in an input price for
gas with a floating sales price. If the oversight
had gone unnoticed, a 20 percent decrease in gas
prices would have wiped out all of the company’s
projected earnings.
Keep in mind that net economic exposure includes
indirect risks, which in some cases account
for the bulk of a company’s total risk exposure.2
33
Companies can be exposed to indirect risks
through both business practices (such as
contracting terms with customers) and market
factors (for instance, changes in the com-
petitive environment). When a snowmobile manu-
facturer in Canada hedged the foreign-exchange
exposure of its supply costs, denominated in
Canadian dollars, for example, the hedge success-
fully protected it from cost increases when
the Canadian dollar rose against the US dollar.
However, the costs for the company’s US
competitors were in depreciating US dollars. The
snowmobile maker’s net economic exposure
to a rising Canadian dollar therefore came not just
from higher manufacturing costs but also from
lower sales as Canadian customers rushed to buy
cheaper snowmobiles from competitors in the
United States.
In some cases, a company’s net economic
exposure can be lower than its apparent nominal
exposure. An oil refinery, for example, faces
a large nominal exposure to crude-oil costs, which
make up about 85 percent of the cost of its output,
such as gasoline and diesel. Yet the company’s
true economic exposure is much lower, since the
refineries across the industry largely face
the same crude price exposure (with some minor
differences for configuration) and they typically
pass changes in crude oil prices through
to customers. So in practice, each refinery’s true
economic exposure is a small fraction of
its nominal exposure because of the industry
structure and competitive environment.
To identify a company’s true economic exposure,
start by determining the natural offsets across
businesses to ensure that hedging activities don’t
actually increase it. Typically, the critical task
of identifying and aggregating exposure to risk on
a company-wide basis involves compiling a
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
value of revenues or costs hedged
Direct costs 0.1–0.4
Opportunity cost
of margin capital 3.0–7.0
Net asymmetric
upside lost 1.0–3.0
Total 4.1–10.4
and other trading institutions) to see the
big picture—the different elements of risk—on a
consistent basis.
Calculate total costs and benefits
Many risk managers underestimate the true cost of
hedging, typically focusing only on the direct
transactional costs, such as bid–ask spreads and
broker fees. These components are often only a
small portion of total hedge costs (Exhibit 1),
leaving out indirect ones, which can be the largest
portion of the total. As a result, the cost of
many hedging programs far exceeds their benefit.
Two kinds of indirect costs are worth discussing:
the opportunity cost of holding margin capital and
lost upside. First, when a company enters into
some financial-hedging arrangements, it often must
hold additional capital on its balance sheet
against potential future obligations. This require-
ment ties up significant capital that might have
been better applied to other projects, creating an
opportunity cost that managers often overlook.
Description
• Bid–ask spread
• Marketing/origination fees
• Opportunity cost of margin capital required to withstand significant
price moves (in this case, a two-sigma event—5% likelihood)
• Counterparty risk for in-the-money positions
• The asymmetric exposure to varying gas prices makes the
protected downside less than the lost upside
A natural-gas producer that hedges its entire
annual production output, valued at $3 billion in
sales, for example, would be required to hold
or post capital of around $1 billion, since gas prices
can fluctuate up to 30 to 35 percent in a given
year. At a 6 percent interest rate, the cost of holding
or posting margin capital translates to $60 mil-
lion per year.
Another indirect cost is lost upside. When the
probability that prices will move favorably (rise, for
example) is higher than the probability that
they’ll move unfavorably (fall, for example), hedging
to lock in current prices can cost more in forgone
upside than the value of the downside protection.
This cost depends on an organization’s view of
commodity price floors and ceilings. A large inde-
pendent natural-gas producer, for example,
was evaluating a hedge for its production during
the coming two years. The price of natural
gas in the futures markets was $5.50 per million
British thermal units (BTUs). The company’s
fundamental perspective was that gas prices in the
 The right way to hedge 35

next two years would stay within a range
of $5.00 to $8.00 per million BTUs. By hedging
production at $5.50 per million BTUs, the
company protected itself from only a $0.50 decline
in prices and gave up a potential upside of $2.50
if prices rose to $8.00.
Hedge only what matters
Companies should hedge only exposures that
pose a material risk to their financial health or
threaten their strategic plans. Yet too often
we find that companies (under pressure from the
capital markets) or individual business units
(under pressure from management to provide
earnings certainty) adopt hedging programs that
create little or no value for shareholders. An
integrated aluminum company, for example, hedged
McKinsey
its oncrude
exposure to Finance
oil and#36
natural gas for
<Article
years, evenslug>
though they had a very limited impact
Exhibit
on < > margins.
its overall of < > Yet it did not hedge its
exposure to aluminum, which drove more than
75 percent of margin volatility. Large conglom-
erates are particularly susceptible to this problem
when individual business units hedge to
protect their performance against risks that are
immaterial at a portfolio level. Hedging these
smaller exposures affects a company’s risk profile
only marginally—and isn’t worth the manage-
ment time and focus they require.
To determine whether exposure to a given risk
is material, it is important to understand whether a
company’s cash flows are adequate for its cash
needs. Most managers base their assessments of
cash flows on scenarios without considering
how likely those scenarios are. This approach would
help managers evaluate a company’s financial
resilience if those scenarios came to pass, but it
doesn’t determine how material certain risks
are to the financial health of the company or how
susceptible it is to financial distress. That
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
a company-wide calculation of risk exposures
and sources of cash. Managers should then compare
the company’s cash needs (starting with the
least discretionary and moving to the most discre-
tionary) with the cash flow profile to quantify
the likelihood of a cash shortfall. They should also
be sure to conduct this analysis at the portfolio
level to account for the diversification of risks across
different business lines (Exhibit 2).
A high probability of a cash shortfall given nondis-
cretionary cash requirements, such as debt
obligations or maintenance capital expenditures,
indicates a high risk of financial distress.
Companies in this position should take aggressive
steps, including hedging, to mitigate risk. If, on
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.
Look beyond financial hedges
An effective risk-management program often
includes a combination of financial hedges and
nonfinancial levers to alleviate risk. Yet few
companies fully explore alternatives to financial
hedging, which include commercial or opera-
tional tactics that can reduce risks more effectively
and inexpensively. Among them: contracting
decisions that pass risk through to a counterparty;
strategic moves, such as vertical integration;
and operational changes, such as revising product
specifications, shutting down manufacturing
facilities when input costs peak, or holding addi-
tional cash reserves. Companies should
test the effectiveness of different risk mitigation
strategies by quantitatively comparing the
total cost of each approach with the benefits.
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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