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Andreas Beroutsos, The more successful private equity becomes, the more scrutiny it attracts. In November
Andrew Freeman, and 2006, the United Kingdom’s Financial Services Authority warned of the growing risk
Conor F. Kehoe to the industry as private equity firms set their sights on ever bigger targets, in the process
taking on ever higher debt. Elsewhere, the high fees and dividends that some firms
are extracting within months of closing deals suggest that the clubby industry may have
entered a period of excess. Some firms may well find that they have bitten off more
than they can chew. But it would be wrong to assume that the challenge private equity
firms pose to the public equity model is about to ease.
True, McKinsey research shows that three- market prices for similar assets. Markets
quarters of private equity firms perform are reasonably efficient, and most important
no better than the stock market over time. assets sold to private equity firms undergo
Even so, the top 25 percent of private equity a relatively wide auction. Indeed, if anything,
firms do outperform the relevant stock the risk is that private equity firms over-
market indexes. Moreover, they do so by a pay for their assets as they compete against
considerable margin—and persistently. strategic public buyers. Nor do private
equity firms obtain the bulk of their returns
More important still is the source of their by profiting from a rising market or an
success. Top performance does not, as even more quickly rising sector within the
many imagine, come from unusual financial market. Their real—and often overlooked—
acumen. In our observation of private- source of success is the governance model
sector deals worth more than $100 million, they apply to the companies they own.
very few of the successes came about This is an advantage that public companies
because firms paid less than prevailing find hard to emulate.
McKinsey on Finance Winter 2007
Active ownership in private equity with their own. But in addition they not
To find out what the private equity only commit their own time to make the
advantage entails, we examined the data board more effective but also conduct
behind 60 deals completed by 12 top- research to develop personal views about
half private equity firms and interviewed the direction a company should take,
individual deal partners (the firm represen- using their block vote to speed up decision
tatives in each company in our portfolio). making. Among the 60 deals we reviewed
We asked these partners how much time they in depth, active private equity partners
spent on their respective companies, what devoted half of their time to the company
resources they had, and to what end—and (usually at its premises) during the first
corroborated their input by interviewing three months after the deal. Less active and
CEOs. We then correlated the reported less successful deal partners spent only
behavior with the amount of value created about 15 percent of their time in this way.
in excess of what an equivalent investment
in similar quoted equities would generate. Similarly, active deal partners had teams
Our analysis was skewed toward the better of analysts working with them; less active
deals by the better firms. It suggests some partners worked alone. Active partners
lessons for public-company executives who build up their own viewpoint about how a
might wish to emulate their performance. company could create value, verifying or
modifying hypotheses they had developed
We found that private equity firms at the during the due-diligence phase of the deal.
top of their game exert ownership control Less active partners typically reviewed and
over management and in this way create commented on plans drawn up by man-
levels of sustainable above-average agement. Active partners became familiar
performance that set them apart from public with management, sometimes long in
companies, as well as from their rivals in advance of a deal, and made any replace-
the private equity industry itself. All these ments quickly. Less active partners
firms conduct deep research into their target made replacements too, but usually much
companies prior to acquisition. Once an later. Finally, active partners measured
acquisition is completed, the contrast performance using operational indicators
in governance style between the good and (usually linked to the value creation plan),
the great can be striking. It’s even more whereas less active partners tended to rely
striking when measured against the prac- on standard financial measures.
tices of traditional public companies,
which typically diffuse shareholder bases, In our view, this active assertion of owner-
powerful CEOs, and nonexecutive directors ship is the crucial difference between
(who have no research staff, no budgets to the best private equity firms’ concept of good
hire external support, and access only to governance and the one put into practice
data that management supplies). by public companies and less successful
private equity firms. Intriguingly, private
Top private equity firms seem more com- equity firms have longer time horizons—a
mitted to effective oversight of their five-year holding pattern is the norm—
investments. True, they use high levels of than the quarterly earnings treadmill of
compensation to align managers’ interests public markets.
What public companies can learn from private equity
Public companies can and should under- this participation in the upside, the high
take similar intensive and externally leverage of private equity deals imposes its
focused assessments. However, since these own discipline and motives to perform.
assessments are time consuming and Incentives at private equity–owned companies
expensive, and because market outlooks and often are significantly better than
opportunities do not change very quickly those at publicly listed ones, especially in
for public companies, they need not under- mature industries; management, with its
take the more intensive process annually. own wealth invested, bears greater risk.
In our experience, an assessment is neces- This incentive structure is also better
sary only following a major deal in the designed to align the interests of the owners
sector, a change in the industry structure, and the managers. While the incentives
or major changes in input costs, such as that publicly listed companies can offer are
raw-materials prices. Otherwise, every sometimes constrained (for example,
three to four years should be adequate. In by executives’ fear of being labeled as “fat
off years, the normal strategic-planning cats”), many of them actually can offer
process ought to suffice—and could involve greater incentives that are better aligned
no more than a cursory update of a few with the shareholders’ interests.
key assumptions.
Finally, performance-management con-
Tough but realistic targets linked to versations in private equity–owned
significant incentives companies are frequent, fact based, and
For private equity players, the first element hard edged. When their performance
of performance management is to forge a suffers, private equity players are quick to
close link between the KPIs used to evaluate act, spending more time with management,
management and the value creation plan replacing underperforming teams, and
developed during due diligence and the hiring external experts. While many publicly
100-day phase. Private equity firms expend held companies have similar conversations,
a lot of effort to design KPIs that are focused few are as rigorously implemented and as
and comprehensive and to ensure that focused on value creation as those at private
they cascade down the organization. In this equity firms. In this vein, public companies
respect, private equity players resemble should review these conversations to ensure
good performance managers in public com- that the performance challenge is robust,
panies; the difference is the way private fact based, and transparently linked to value
equity firms create incentives, based on the creation initiatives.
KPIs, and use them to manage acquisitions.
Evaluation of key managers and an ongoing
At companies governed by private equity search for talent
firms, managers have significant incentives One of the most important yet challenging
in the form of equity stakes, coinvestment aspects of conducting a private equity–style
opportunities, and bonus payouts for program in a public company is forming
meeting key objectives. In the private equity a management team that is fully ready for
deals we reviewed, top managers typically radical change. In the case of multibusiness
owned 5 to 19 percent of the equity and had companies, corporate senior executives
invested a substantial amount of their must stand 100 percent behind the business-
own net worth to obtain it. In addition to unit-management teams they are backing
McKinsey on Finance Winter 2007
and be ready to make changes to meet their The challenge for public companies is not
goals. The senior executives must there- so much securing the skills to undertake the
fore get to know the team’s strengths and tasks described here but rather developing
weaknesses, identify who must be replaced the will to undertake these tasks without the
and which new roles must be filled, and incentives, powerful and well-supported
have enough knowledge to supplement the board members, and an exit time frame that
team with external support that plugs any the private equity system provides. Public
remaining gaps. To do all this, they need companies also face the challenge of finding
to spend enough time on site; the private the time for senior management and
equity best practice is 50 percent of a the board to undertake these value-creating
partner’s time for the first three months. tasks while dealing with the growing
Finally, they should assess whether demands of compliance. The alternative,
the management team is a credible agent of of course, is to go private.
change: a team that has been happy with
the status quo for a long time may find
that it cannot generate the “followership”
needed for a radical program, no matter Private equity, as a governance system,
how strong its desire to do so. In these cir- will no doubt suffer its own ups and downs,
cumstances, the solution is to rotate in new particularly if the industry’s performance
teams to manage the business unit. falters. However, if private equity continues
to offer superior governance in a range
of circumstances, we believe that it could
rival the public market system in size.
That scenario presents a clear challenge to
public companies and their boards: they
simply must raise their governance game.
MoF
The authors would like to thank Braam Verster for his contributions to this article.
Richard Dobbs, With announced merger activity approaching $4 trillion globally in the first 11 months1
Marc Goedhart, and of 2006, the year had already surpassed the record levels set in 2000 (Exhibit 1). That
Hannu Suonio earlier boom was known not only for the number of deals completed but also for a lack
of discipline and the number of deals that destroyed value for the shareholders of the
acquiring companies; in fact, earlier McKinsey research shows that as many as two-thirds
of all transactions failed to create value for the acquirers.2 Are shareholders doing any
better this time around?
1 As of December 11, 2006.
2 Tom Copeland, Tim Koller, and Jack Murrin,
Valuation: Measuring and Managing the They appear to be. But there is still room From our analysis of announcement effects,
Value of Companies, first edition, Hoboken
NJ: John Wiley & Sons, 1990, pp. 318–21. for improvement. we compiled two indexes of M&A value
3 Paul Healy, Krishna Palepu, and Richard
creation. The first, deal value added (DVA),
Ruback, “Do mergers improve corporate
performance?” Journal of Financial We reviewed nearly 1,000 global mergers tracks the financial markets’ assessment
Economics, 1992, Volume 31, pp. 135–75;
and Todd Hazelkorn, Marc Zenner, and
and acquisitions from 1997 to 2006, of how much total value a deal will create,
Anil Shivdasani, “Creating value with mergers comparing share prices two days before and irrespective of whether the buyer or seller
and acquisitions,” Journal of Applied
Corporate Finance, 2004, Volume 16, Issue two days after each deal was announced in captures it. DVA measures the aggregate
2–3, p. 84.
4 Announcement effects are useful to assess
order to assess the financial markets’ initial value change at the time of announcement
the impact of M&A on its own, as they reaction to the deals. Academic research across both companies as a percentage
strip out many of the other factors that drive has found a positive correlation between of a transaction’s value (adjusted for market
share price movements beyond just the M&A
announcememt. But because the market’s these so-called announcement effects movements). The second index, proportion
initial response to deals can be either wrong or
and long-run value creation,3 so in the aggre- of companies overpaying (POP), examines
affected by factors other than the value of the
deal (such as bid speculation before the deal, gate, announcement effects are useful in the success of acquirers in capturing value
signaling, and tax and market liquidity issues),
announcement effects cannot be used to assess
assessing trends in the ability of M&A to from deals, by measuring the proportion of
the value that any individual deal creates. create value.4 all transactions in which the initial share
MoF 22
M&A index
McKinsey on Finance Winter 2007
Exhibit 1 of 5
Glance: Global M&A activity in 2006 surpassed the peak level reached in 2000.
Exhibit title: A new boom in M&A activity
Exhibit 1
A new boom in M&A activity Volume of announced M&A deals,1 $ trillion
Private equity
Global M&A activity in 2006 surpassed the peak Corporate
level reached in 2000.
4.0 3.8
0.5
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
1 Includes announced deals (not withdrawn) >$25 million in value; 2006 data as of December 11.
Source: Dealogic; McKinsey analysis
MoF 22
M&A index
Exhibit 2 of 5
Glance: Both cash and stock deals are doing better in the current boom than during the one that
ended in 2000.
Exhibit title: Creating more value
Exhibit 2
Creating more value Average deal value added (DVA),1 %
Both cash and stock deals are doing better Previous M&A boom Current M&A boom Average,
in the current boom than during the one that 20 1997–2006
ended in 2000.
15 Pure cash deals 14%
10 Total DVA 4%
5
0 Pure stock deals –3%
–5
–10
–15
–20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Number
90 126 139 133 89 39 49 78 93 108
of deals
1 ForM&A deals involving publicly traded companies; DVA defined as combined (acquirer and target) change in market capitalization,
adjusted for market movements, from 2 days prior to 2 days after announcement, as % of transaction value; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis
Are companies getting better at M&A?
price reaction for the acquirer was negative, average DVA of +13.7 percent, compared
indicating that the acquirer overpaid with –3.3 percent for pure-stock deals.
(adjusted for market movements). In other
words, POP represents the proportion of This greater share of cash deals during
acquirers that the market perceives to have the present boom partially explains
transferred to the sellers more than 100 per- the market’s more favorable reactions. Yet
cent of the value created in their deal. even when we compared those reactions
on a like-for-like basis, both cash and stock
Our analysis of these measures indicates deals did better in the current boom. Both
that deals in the boom beginning in 2003 kinds of deals have also created more value
are creating proportionally more value— as it has progressed; in contrast, during
and that acquiring companies are keeping the previous boom, both types of deals
more of it for their shareholders.5 created progressively less value (Exhibit 2).
deals by private equity and other privately transaction value. During the current boom, companies appear to be keeping more
owned companies, since to measure the share however, the average DVA has been 6.1 per- of that value, as measured by the lower
price impact on both the acquirer and the
target company both must be publicly listed. cent, with the annual numbers trending proportion of acquirers that the market
We established other criteria for inclusion upward to +10.6 percent, from +2.1 percent. believes to be overpaying for deals (our POP
as well: (1) The absolute size of the deal had
to exceed $500 million, to ensure the liquidity Today, in fact, the DVA index is at a ten- index). In the current boom, the proportion
of the target and materiality; (2) The target year record high. Those numbers stand in overpaying has averaged 57 percent,
had to be at least 5 percent of the acquirer’s
size (measured by market capitalization), stark contrast to the previous boom’s, decreasing annually from 63 percent in 2003
so that the resulting impact on share prices
would adequately reflect the transaction
when the DVA averaged only 1.6 percent for to 56 percent in 2006. In contrast, from
and not other events or noise in the share price; the whole period—and trended downward 1997 to 2000 the overall average was
(3) Transactions had to involve a full change
of ownership (defined as the acquirer going from from +8.6 percent in 1997 to –5.9 percent6 65 percent, with the level of overpayment
0 to 100 percent ownership) to ensure that in 2000. increasing significantly, from 54 percent
the premium paid reflected a full change of
control and that the combined company in 1997 to 73 percent in 2000. Today’s POP
would be fully capable of capturing the intended The financial structure of the deals index stands near a ten-year low, despite
value from the combination.
6 The DVA is negative when the stock market’s announced during these two periods of greater competition from private equity firms,
reaction to a deal announcement is so
intense M&A activity differs as well. which conduct more than 20 percent of
unfavorable (possibly because of the loss of
creditability for the management team) that the This time around, cash deals represent a all global merger activity. Both the DVA and
decline in the acquirer’s market capitalization
more than offsets the increase in the acquired
much greater percentage of the public-to- POP indexes, which were moving in the
company’s share price. public transactions making up our data- wrong direction during the last M&A boom,
7 Gregor Andrade, Mark Mitchell, and Erik
Stafford, “New evidence and perspectives on base—nearly half, compared with the 1999 are now moving in the right one (Exhibit 3).
mergers,” Journal of Economic Perspectives, to 2000 range of 20 to 30 percent. Like
2001, Volume 15, Number 2, pp. 103–20.
8 One way to understand this difference is to some academic researchers,7 we also found While today’s lower POP could reflect many
think of a cash deal as a stock deal with a share that cash deals in our sample received a factors, one explanation is lower deal
buyback, with all its corresponding positive
effects. See Richard Dobbs and Werner Rehm, more favorable market reaction than stock premiums (Exhibit 4). In contrast to the
“The value of share buybacks,” McKinsey deals, possibly because of trading and 1990s, when the typical price premium
on Finance, Number 16, Summer 2005,
pp. 16–20. signaling effects.8 Cash deals generated an hovered around 30 percent, acquirers now
MoF 22
10 M&A index
McKinsey on Finance Winter 2007
Exhibit 3 of 5
Glance: Both deal value added and proportion overpaying, which headed in the wrong direction
during the last M&A boom, are now heading in the right one.
Exhibit title: Dramatically different trends
Exhibit 3
Dramatically different Trends in deal value added (DVA) and proportion overpaying (POP) during 2 most recent M&A booms1
trends DVA,1 % POP,1 %
Previous M&A boom Current M&A boom Previous M&A boom Current M&A boom
Both deal value added and proportion 15 80
overpaying, which headed in the wrong
direction during the last M&A boom, 10 70
are now heading in the right one.
5 60
0 50
–5 40
–10 30
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
1 For M&A deals involving publicly traded companies; DVA defined as combined (acquirer and target) change in market capitalization,
adjusted for market movements, from 2 days prior to 2 days after announcement, as % of transaction value; POP defined as proportion
of transactions where share price reaction, adjusted for market movements, from 2 days prior to 2 days after deal, was negative for
acquirer; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis
MoF 22
M&A index
Exhibit 4 of 5
Glance: Average deal premiums were around 30% in late 1990s but nearer 20% now,
helping to reduce the proportion of overpayers.
Exhibit title: Paying lower premiums
Exhibit 4
Paying lower premiums Median 1-week premium,1 %
Average deal premiums were around 30 percent Previous M&A boom Current M&A boom
in the late 1990s but nearer 20 percent now, 80
helping to reduce the proportion of overpayers. 70
60
Proportion of
50 overpayers
40
30
20 Average deal
10 premiums
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
1 For
M&A deals involving publicly traded companies; 1-week premium = price offered per share vs target company’s share price 1 week
before announcement; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis
MoF 22
M&A index
Are companies 11
Exhibit 5 of 5 getting better at M&A?
Glance: The POP index is also lower for cash versus stock deals, but currently both deal types
receive a more positive initial market reaction.
Exhibit title: Cash deals are better received
Exhibit 5
Cash deals are better Proportion overpaying (POP),1 %
received
Previous M&A boom Current M&A boom Average,
90 1997–2006
The POP index is also lower for cash versus
stock deals, but currently both deal types 80
receive a more positive initial market reaction POP for pure 69%
70 stock deals
than during previous boom.
60
Total POP 62%
50 POP for pure 49%
40 cash deals
30
20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
1 ForM&A deals involving publicly traded companies; POP defined as proportion of transactions where share price reaction,
adjusted for market movements, from 2 days prior to 2 days after deal, was negative for acquirer; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis
pay just slightly more than 20 percent (Exhibit 5). The overall POP index has
to win their target acquisitions, suggesting improved considerably, thanks to the grow-
that boards and management teams may ing proportion of cash deals. Even when
be more cautious about overpaying. Not that we consider cash deals and stock deals
prices are low—indeed, acquirers are separately, however, the POP index is consid-
paying very high multiples. But on average, erably lower today than it was in 2000.
price premiums are lower than they were
before, and especially lower than they were
at the last boom’s peak, in 2000.
Mergers can and often do create value
Another explanation for the lower propor- in the eyes of investors. The improvements
tion of deals that are deemed value reflected in our M&A indexes are encour-
destroying to the acquirer is the market’s aging: despite the recent intense volume
reaction to cash deals versus stock deals of M&A , it appears that acquirers have
at the time of announcement. In pure cash been disciplined about creating value.
deals an average of around 49 percent Nonetheless, plenty of room remains for
of acquirers overpay, compared with 69 per- acquirers to improve their M&A performance
cent for pure stock deals—a difference by focusing on the scope to create value
that has remained fairly constant over time and to ensure that they don’t overpay.
MoF
The authors wish to thank Himanshu Wardhan and Silvio Wenzel for their contributions to this article.
Bin Jiang and What’s in a name? In the vernacular of equity markets, the words “growth” and “value”
Timothy Koller convey the specific characteristics of stock categories that are deeply embedded in the
investment strategies of investors and fund managers. Leading US market indexes, such
as the S&P 500, the Russell 1000, and the the Dow Jones Wilshire 2500, all divide
themselves into growth- and value-style indexes. Academics also use these categories as
shorthand, arguing at length over which investment approach creates more value—a
value strategy or a growth strategy. These names explicitly convey the expectation that
growth stocks will have higher revenue growth prospects than value stocks.1 And
investors, even large institutional ones, often make investment decisions based largely
on those expectations.2
1 Although there is no universal definition of
It’s not illogical that executives would in deference to presumed shareholder
growth and value stocks, most investors agree
on the broad characteristics of companies often draw from this reality an assumption expectations of growth.
in each category: growth stocks tend to have
that having the label growth or value
higher price-to-earnings ratios or market-
to-book ratios, while value stocks have low P/Es attached to a company’s shares can actually The trouble is that such thinking is wrong
and M/Bs and may have high dividend yields.
2 Sophisticated investors do sometimes defy drive prices up or push them lower. In our in both cases. Evidence comes from
the growth and value stereotypes. Legg experience, many executives have expended a recent McKinsey analysis of the S&P/
Mason Value Trust, one of the most successful
mutual funds over the past 20 years and considerable effort plotting to attract Barra indexes of S&P 500 companies.3
widely considered to rank among the leading more growth investors, believing that an Although growth stocks are indeed valued
value investors, includes in its top ten
investments some companies that would defi- influx of growth investors leads to higher at a higher level than value stocks on
nitely be classed as growth companies. As valuations of a stock. Some executives average, as measured by market-to-book
of October 2006, Legg Mason Value Trust
holds more than 9 percent of its total even turn this assumption into a rationale ratios (M/Bs),4 their revenue growth rates
assets (worth $1.9 billion) in Amazon.com and
for using a high share price to defend are virtually indistinguishable from those
Google, both clearly growth rather than
value companies. risky acquisition programs—for example, of value stocks (Exhibit 1). The growth
MoF 22
Growth stocks
The truth1about 13
Exhibit of 2 growth and value stocks
Glance: Companies that show up on growth indexes actually don’t grow appreciably faster than
those that show up on value indexes.
Exhibit title: No advantage in growth
Exhibit 1
No advantage in growth
Median value = 8.7% Median growth = 10.1%
Companies that show up on growth indexes 14
6
4
2
0
–3 –1 1 3 5 7 9 11 13 15 17 19 21 23 25 >25
Growth rate, 3-year average, 2002–05,2 %
1 S&P 500/Barra Growth Index and S&P 500/Barra Value Index as of Dec 2005.
2 Excluding goodwill; does not include financial-sector stocks; 3-year average adjusts for annual volatility.
index’s 10.1 percent median compounded stocks; it is that the concepts of growth
revenue growth rate for 2002 to 2005 versus value are just not meaningful.
is not statistically different from the 8.7 per- Companies can have high price-to-earnings
cent median of the value index. Thus, the ratios (P/E s) and M/B s because they have
probability that a company designated as a high growth and moderate ROIC s, low
growth stock will deliver a given growth growth and high ROIC s, or high growth
rate is virtually indistinguishable from the and high ROICs. Branded consumer
probability that a value company will do so. products companies, for example, have high
ROIC s but modest growth, while hot
What does distinguish companies on retail companies have high growth and
growth indexes from those on value indexes modest ROIC s. This point may seem
is return on invested capital. For the value counterintuitive, but it is actually consistent
3 Barra (which in 2004 merged with Morgan index, the median ROIC , averaged over with the conceptual drivers of value. Both
Stanley Capital International to form MSCI
three years, and excluding goodwill, is a company’s ability to grow and its ability
Barra) offers financial models and analytics
intended to provide insight into the risks only 15 percent, compared with 35 percent to earn returns greater than its cost
behind investment decisions. S&P and Barra
collaborated from 1992 to 2005 to produce
for the growth index (Exhibit 2). In other of capital generate higher cash flows—and
the official S&P 500/Barra Value and the S&P words, the average growth stock is likely to hence higher valuations.5 Therefore, a
500/Barra Growth indexes. Constituents for
the S&P 500/Barra Value and Growth indexes deliver twice the average value stock’s book high M/B or P/E for a company that is not
studied in this article are as of the end of 2005.
4 The median M/B for growth stocks was 4.8 at
return on capital. In fact, the correlation growing fast is hardly surprising. At such
the end of 2005, while the median M/B for of M/Bs with ROIC in 2005 was 20 percent, companies, higher returns simply make up
value stocks was 2.2. The medians are the same versus 1 percent for growth rates. for slower growth.
with or without financial-sector stocks.
5 See Bing Cao, Bin Jiang, and Timothy Koller,
Exhibit 2
Instead, better returns
on capital Median value = 15% Median growth = 35%
35
Growth stocks have much better returns on
30
0
–5 0 5 10 15 20 25 30 35 40 45 50 >50
ROIC, 3-year average, 2002–05,2 %
1 S&P 500/Barra Growth Index and S&P 500/Barra Value Index as of Dec 2005; ROIC = return on invested capital.
2 Excluding goodwill; does not include financial-sector stocks; 3-year average adjusts for annual volatility.
companies to generate the same growth companies whose stocks have been newly
in future cash flows, the higher- ROIC designated as growth stocks clearly shows
company needs to invest less capital back that growth investors don’t precipitate
into its business than the lower-ROIC a change in valuation levels. Rather, they
company. The excess cash at the higher- respond to it, moving into a stock only after
ROIC company can then be plowed into the share price has already moved to a
higher-return projects or given back higher M/B or P/E . And while the number of
to shareholders.6 Naturally, a company with growth investors does sometimes increase up
a higher ROIC is valued at a higher level. to three months before a sustained increase
In fact, any growth index includes many in the M/B , it often takes them as long
familiar names that enjoy high ROICs but as 12 months after an increase in valuation.
actually have delivered limited growth
relative to their industries from 2002 to Stocks downgraded from growth to value
2005. Examples include Boeing (0.5 per- show a more striking pattern: when
cent), Heinz (1.6 percent), Anheuser-Busch these stocks changed to value status, their
6 This comparison can be reduced to a simple
Bin Jiang (Bin_Jiang@McKinsey.com) is a consultant in McKinsey’s New York office, where Tim Koller
(Tim_Koller@McKinsey.com) is a partner. Copyright © 2007 McKinsey & Company. All rights reserved.
16 McKinsey on Finance Winter 2007
Dominic Barton As a banker at Goldman Sachs in the 1980s and 1990s, John Thornton made his mark
and Richard He Huang blazing new financial trails with clients in Europe and Asia—trails that eventually led him
to the presidency of that prestigious investment bank. Three years ago, Thornton set out
on a radically different path: he retired from Goldman to start up a leadership program at
Beijing’s elite Tsinghua University.
That path has taken Thornton deep Bank of China (ICBC), which completed a
into the heart of the world’s most intriguing $21.9 billion initial public offering
business environment. He spends five in October 2006. Thornton also serves as
months of the year in China, where his a director of Ford Motor, Intel, and
teaching duties put him in contact with top News Corporation, giving him a unique
students, government officials, and China’s vantage point on the workings of Chinese
emerging business elite. Yet this activity boardrooms and how they compare with
is just a part of Thornton’s diverse efforts their Western counterparts.
to assist China’s bold but challenging
march toward economic development and Upon joining China Netcom’s board,
reform; he also advises government officials Thornton initiated an effort to establish a
and business leaders in China, Europe, corporate-governance committee—the
and the United States. Thornton is one of first of its kind for a major Chinese
the few Westerners to serve as a director state-owned enterprise. The committee’s
on the boards of several major players in establishment has since led to a broader
China’s economy, including telecom giant effort to redefine how the company relates
China Network Communications (China to its stakeholders, including the Chinese
Netcom) and the Industrial and Commercial government. Today Netcom stands at the
Governing China’s boards: An interview with John Thornton 17
vanguard of a fledgling movement among complexity and scale in the history of any
China’s state-controlled companies to nation—that need to be better understood
understand Western governance standards and appreciated by the outside world. The
and tailor them to the country’s unique Chinese government is trying to maintain a
circumstances. Thornton recently sat down degree of social stability that is the essential
in his New York office with Dominic foundation for the country to achieve
Barton, a director in McKinsey’s Shanghai anything, while at the same time growing
office, and Richard Huang, an associate and transitioning what was, until not long
principal in the Beijing office, to discuss ago, still essentially a command economy.
China’s corporate-governance landscape and And the government is doing all of this in
the country’s reform challenges in general. the context of an incredible rate of change.
Pick an issue: the health care system,
McKinsey on Finance: Let’s start with environmental degradation, energy needs,
some context: how should outside investors mass urbanization, or poverty in the rural
and executives think about corporate population. Any one of these challenges
governance in China? would be a formidable task for a country
and its leaders. China has dozens of
John Thornton: China today faces a set problems of this magnitude. Clearly, a key
of challenges—many unprecedented in factor in raising the odds that the broad
carefully as it moves forward. The chairman more disparate and less clear. Any one
of Netcom likes to say that he does not party secretary in a small city can have a
see a contradiction between party influence huge impact.
and the protection of minority shareholders
because the goals of the two are the same— McKinsey on Finance: What’s
namely, Netcom’s success as a business. the operating style of Chinese company
No one wants Netcom and all the other boards?
state-owned enterprises to succeed more
than the Chinese government and Commu- John Thornton: In the case of ICBC —
nist Party do, because the success of China’s largest commercial bank—a board
these businesses will better allow the party meeting can feel almost more like an
and government to tackle the myriad internal operating meeting than a Western
problems the country faces, which I men- board of directors meeting. So the topics
tioned before. of conversation, the level of detail, and the
honest interchange are quite impressive.
McKinsey on Finance: What do changes There’s very little formality, and if directors
at Netcom mean for other Chinese state- have disagreements they argue it out right
owned enterprises? in front of you.
John Thornton: Netcom is without a There is, of course, always room for
doubt a pioneer of the governance improvement. The other day I was asked to
transformation. As a key player in the be on a board committee call at 9:00 PM
telecom industry and a pillar of the Chinese here in New York—9:00 AM Beijing time.
economy, its governance reforms will The call ended at 10:30. Then I was told,
have a significant impact on other large “By the way, we’re going to call you back at
state-owned enterprises. Perhaps more than 5:00 AM your time to have a board meeting
anything else, Netcom illustrates that to discuss with the whole board what we
practical and balanced solutions acceptable just discussed.” So at times, basic operating
to both the investing community and the practices need to be improved: notification
Chinese government are achievable. The of meetings, timely provision of succinct and
reforms there can also change the attitude useful information, a good chair to run
of Chinese authorities toward corporate the meeting and ensure that members have
governance, from one of complying with their say.
minimum legal requirements to aiming
for best practices to advance the business McKinsey on Finance: How do Chinese
interests of all the shareholders. company executives regard Western
governance standards?
McKinsey on Finance: What of the
broader swath of companies? John Thornton: One of the trends
I’ve seen recently is a reluctance on the part
John Thornton: When you get to the of Chinese companies to list in the United
second category of state-owned enterprises— States because of the very high standards
that is, below the 163 largest—I think being imposed by Sarbanes-Oxley and other
almost by definition the story becomes both rules that they feel they can’t or don’t
Governing China’s boards: An interview with John Thornton 21
want to meet. Instead they’re listing in John Thornton: Improving what might
Hong Kong and perhaps London, where the be called the national human-resources
standards are very high but the way system is one key. You find an outstanding
those standards are posed relates more to person, he’s put in to be the chief executive
the spirit of the rules rather than the of the XYZ Chinese state-owned enterprise.
statute-based, legal-based system that exists He’s there for three to five years, does
in the US . a good job, and is then snatched away to be
the party secretary in XYZ province, the
mayor of a city, or the chief executive of
‘Foreign directors, however, can bring a fresh and a competing firm. From the standpoint, as
different perspective that is often extremely valuable’ it were, of the ultimate shareholder—the
to Chinese companies government—these are all human resources
to be deployed in whatever way they
McKinsey on Finance: Does the West need to be deployed. This clearly needs to
send the wrong signal to China on this kind be changed.
of issue?
McKinsey on Finance: How can
John Thornton: I tend to think that a foreign director be most helpful on a
high-level conceptual advice actually isn’t Chinese board?
all that valuable. Senior Chinese leaders
have all heard the expression “corporate John Thornton: First, ask thoughtful
governance.” They’ve all heard the questions and be willing to challenge
expression “transparency.” What they really management in a constructive way. As I
need is people who can actually make mentioned earlier, it is not that Chinese
these things happen in a way that is effective directors don’t do this. They do. Foreign
and that works in the Chinese system. directors, however, can bring a fresh and
That goes to the question of internal train- different perspective that is often extremely
ing programs at companies, to the question valuable. Second, they can leverage their
of university education in China, to the experience and personal networks and serve
kinds of real experiences that Westerners as a window to the Western business
have inside China, and to the question world. Finally, having gained an understand-
of not just taking a conceptual framework ing of China-unique issues and com-
that works somewhere else and trying pany culture, it’s important for them to
to impose it. I’m very sympathetic to the be a catalyst for real change.
Chinese desire to build a system that
works for them, because I think we have to McKinsey on Finance: Do you have any
acknowledge from experience, especially tips on the dos and don’ts of being a
over the past few years, that there’s no one foreign director on the board of a Chinese
system that’s perfect. company and how to be effective?
The authors wish to thank Simon Wong for his contributions to this interview.
Timothy Koller The US Financial Accounting Standards Board (FASB) recently adopted new rules to
and Werner Rehm require that companies reflect the value of their pension funds on the balance sheet. Critics
almost immediately began complaining that the change would cause investors to rethink
the value estimates of a wide swath of companies. Those with significant pension liabilities,
the critics argued, would face lower valuations as they moved off-balance-sheet assets
and liabilities onto the balance sheet.
Yet we are certain that knowledgeable already heard executives pondering plans
investors won’t pay much mind. After all, to change capital structure policies,
they’ve seen such rule changes before. dividend payouts, or buyback programs
Remember the rules that govern accounting to accommodate greater volatility
for M&A and for expensing stock options? in shareholder equity as expenses and
In both of those high-profile cases, none of liabilities appear on balance sheets.
the changes made the slightest bit of
difference to the valuation that knowledge- With few exceptions,1 these managers would
able investors placed on stocks. be ill advised to use financial-accounting
changes to guide strategic decisions.
The greater risk, however, is that the new Investors already know the level of pension
accounting rules could lead managers to liabilities from the ample disclosures in
1 In some states, for instance, companies may make strategic mistakes that might actually the footnotes to financial statements.
not pay dividends if the level of book destroy value. The new accounting With no new information, they will value
equity falls below the par value of the shares.
rules merely move data from one page of businesses just as they did before. In short,
Basing legislation on accounting rules, as in
this case, also is ill advised. an annual report to another. Yet we’ve managers should not change their behavior
24 McKinsey on Finance Winter 2007
merely because accounting rules have The real value destruction came from
changed—and they must learn to ignore managers, who prior to the rule change
the pundits and to focus on investing jumped through hoops—and spent
in projects with a positive net present value substantial sums on accountants—in an
(NPV), even if next quarter’s accounting effort to make the pooling of interest
earnings drop. possible for deals that were straightforward
takeovers. Take, for example, AT&T’s
Remembrances of things past acquisition of NCR , in 1991. To get NCR
Before managers make strategic mistakes, to agree to pooling accounting, AT&T
they would do well to recall some earlier incurred costs on the order of $500 million,
episodes of controversy over changed according to outside-in estimates.4 That
accounting rules. In 2001 intense lobbying, money was wasted because investors don’t
news coverage, legislative reviews, care about the accounting treatment of
and general bluster accompanied proposed a deal. Similarly, executives still often use
new accounting rules for mergers and accounting rationales such as earnings
acquisitions. Before then, companies could, per share (EPS) accretion to drive M&A
in certain well-defined circumstances, decisions. Finance theory and practice make
carry over the book value of an acquired it crystal clear that using changes in EPS
company with no goodwill, 2 using an as a proxy for value creation is misleading
accounting approach known as pooling at best and completely wrong at worst.5
of interest. After the rule changed,
all transactions automatically generated Another accounting tempest erupted in 2004,
goodwill, which is recorded as an asset when FASB began requiring companies to
and must be tested periodically for a loss in account for employee stock option expenses
value. If the test indicates such a loss, the on their income statements—more than ten
company must write down the difference years after the first attempt to change the
and charge it against earnings. Either rules. Coalitions of companies, politicians,
method results in identical cash flows, and and business publications joined hands to
therefore value, since any write-down of argue that the change would ruin busi-
goodwill is a noncash charge.3 nesses, especially in the high-tech industry,
by limiting their freedom to issue employee
Back in 2001, though, managers, lobbyists, stock options.
and banks alike feared that the elimination
of pooling accounting would make Of course, all the information necessary to
acquisitions more difficult, thus stifling put a value on issued and outstanding
2 Goodwill is the amount paid for a target above
worth.6 One sell-side analyst we talked with with no new information: the rule simply
summarized his feelings succinctly: “I don’t means that financial information about
care as long as the information is there.” the fair value of the under- or overfunding
and about the annual financial performance
Rationally, the expensing of stock options of all postemployment plans must move
should have been a nonevent. But managers, from the footnotes to the balance sheet and
partially driven by politics and punditry, the statement of comprehensive income.
started to base their compensation policies The data from the footnotes will replace the
on accounting rules rather than the value current amounts on the balance sheet,
employees added. Many well-known which were in essence obsolete estimates and
companies changed the way they compensate often not even close to the market value
employees, moving away from options of the funded status.
and toward other means, such as restricted
stock options and straightforward cash This new standard, which is similar (but
bonuses. In itself, this could be a neutral not equal) to the requirements of
move. It’s the accounting-based rationale international accounting rules,9 could result
that indicates the wrong priorities of in a drop in shareholder equity on the
executives. Worse, about 900 companies order of $200 billion, or 5 percent, for the
from many industries decided to vest their S&P 500.10 Yet absent some new infor-
options early,7 most likely to avoid option mation that investors previously didn’t have,
expenses in the first year that the new rule they probably won’t care. Nor will they
went into effect. This move had a negative care about the increased equity volatility
NPV: employees who previously had that might come with the implementation
to work for several years to gain access to of the new rule. The changes might require
options suddenly had the immediate right amendments to some tightly written
(though not the obligation) to exercise them. debt covenants, but we doubt they will force
Since any increase in flexibility increases renegotiations. Savvy lenders understand
the value of options to employees, this early the difference between accounting and cash
vesting inevitably drained value away from flow: for example, credit-rating agencies
shareholders. Again, in some of these cases, have long incorporated in their ratings the
6 Fraud, of course, is new information. the decisions may well have been based debt from pension liabilities and other
If investors learn that a company wrongly on a business rationale. Still, we doubt that off-balance-sheet items (for example, leases).
reported data on anything, they will
react to the news. But the discovery of fraud it was a good one if the force behind
is far different from the reporting of data
the decisions was accounting rather than Pension regulations in general are of course
in the income statement rather than in the
footnotes. the creation of shareholder value. important. The US Pension Protection Act
7 According to data from Bear Stearns.
8 “A corporation will recognize in its statement of 2006 aims to improve the funding of
of financial position an asset for a plan’s Pension accounting rules: More corporate pension plans by imposing tighter
overfunded status (or a liability for a plan’s
underfunded status) and recognize changes in of the same funding requirements, which influence
the funded status in the year in which FASB Statement 158,8 which went into cash flows to equity and therefore equity
the changes occur through the statement
of comprehensive income.” effect on December 15, 2006, changes how value. Similarly, scholars and practitioners
9 For instance, International Accounting
corporations account for the funding alike rightfully debate whether the
Standards (IAS) rules also require
recognition of gains and losses in the P&L, status of their pension and other postemploy- discount rates used in estimating pension
not the statement of comprehensive income.
10 “Market impact of pension accounting ment benefit plans. Beyond the headlines, liabilities are correct, given macroeco-
reform,” Merrill Lynch, October 2006. this change once again provides investors nomic developments. But this is a good
26 McKinsey on Finance Winter 2007
debate about the NPV of liabilities—and In our experience, when managers plan
very different from moving data from one to change capital funding or payout regimes,
page to another. pensions, compensation, or other financial
plans solely as a result of revised accounting
Watch out for what’s important rules, value is typically destroyed. Share-
Given these changes in accounting rules— holder value depends on cash flows and the
and the certainty that more will come— cost of capital, not on the method of
value-minded managers, boards, and accounting for them. MoF
advisers must be disciplined about keeping
their focus on fundamentals. Too much
time is wasted debating the impact of
accounting rules that simply do not matter.
Tim Koller (Tim_Koller@McKinsey.com) is a partner in McKinsey’s New York office, where Werner Rehm
(Werner_Rehm@McKinsey.com) is a consultant. Copyright © 2007 McKinsey & Company. All rights reserved.
Running head 27
28 McKinsey on Finance Winter 2007
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