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Where mergers go wrong | 1
may yield only two or three good Mergers achieving stated percentage of
precedents and only limited data on those; expected cost savings, percent N 92 36
accommodate the relatively narrow window Another company with substantial acquisi-
of opportunity between peaks in the tion experience left synergy estimation up to
lending season. the mergers and acquisitions department,
and paid the price. Based on accurate but
Forming effective deal teams high-level financial analysis (total cost per
Estimating synergies is difficult, but the customer served), they concluded that there
practice is critical and needs more was no value in integrating customer service
investment than it usually receives. operations. Line managers would probably
Companies we’ve studied have used a variety have discovered during due diligence that
of ways to improve their synergy estimates. the target’s smaller centers had much lower
labor productivity but compensated for this
Involve key line managers with an innovative Web servicing program.
Involving line managers in problem solving Consolidating operations could have both
and due diligence not only improves the improved labor productivity and brought
quality of estimates but also builds support the Web servicing program to the acquirer’s
for postmerger integration initiatives. larger service center. But they missed the
Synergy analysis also illuminates issues “unfreezing” time immediately following the
that will shape due diligence, deal structure, merger announcement, and the acquirer lost
and negotiations. the opportunity.
by a factor of three. The second went better that a well-designed post-merger integration
because executives leading the deal effort can sometimes even do better.7
understood that they needed to get the cost
(and deposit loss) estimates right. Instead of
simply applying the
One client had its head of loss data from the Companies with access to reliable data
first merger, which can develop sound benchmarks for
operations take the lead in
did not involve estimating realistic synergies. They can
estimating the savings from nearly as much also find insight into the sources and
geographic overlap patterns of error when estimating
rationalizing manufacturing
as the second, they them. MoF
capacity, distribution involved a line
manager who had Scott Christofferson (Scott_Christofferson
networks, and suppliers.
been part of a @McKinsey.com) is a consultant and Rob McNish
recent branch (Rob_McNish@McKinsey.com) is a principal in
closure program. By applying benchmarks McKinsey’s Washington, DC, office. Diane Sias
carefully and involving line management, the (Diane_Sias@McKinsey.com) is a principal in the New
bank avoided making the same estimation Jersey office. Copyright © 2004 McKinsey & Company.
error twice. All rights reserved.
What’s next?
Companies with access to reliable data can
1
See, for example, Hans Bieshaar, Jeremy Knight, and
Alexander van Wassenaer, “Deals that create value,” The
develop sound benchmarks for estimating McKinsey Quarterly, 2001 Number 1, pp. 64–73.
realizable synergies, insights into the sources 2
Richard H. Thaler, The Winner’s Curse: Paradoxes and
and patterns of error in estimating synergies, Anomalies in Economic Life, Princeton, New Jersey:
and tools to estimate deal synergies. Princeton University Press, 1992.
E X H IB I T 1
0 2 4 3 3 2 0 2 0 0 0 0 0 1 0
–200
Percentage 120 90 60 30 0 –30 –60 –90 –120 –150 –210 –240 –270 –280 –300 –330 –360
–400
of deviation
–600 from trend Negative deviation from trend
–800
1980 1984 1988 1992 1996 2000 20031
1
Through Q1 2003.
Source: McKinsey analysis
will likely need to reduce their risk exposure the appointment of a strong chief risk
or to raise costly additional capital as a officer who reports directly to the CEO or
cushion against that risk. the CFO and has enough stature to be seen
as a peer by business unit heads.
As with any strategy, a company’s risk
strategy should be “stress-tested” against Segregation of duties. Companies must
different scenarios. A life insurance separate employees who set risk policy and
company, for example, should examine how monitor compliance with it from those who
its returns would vary under different originate and manage risk. Salespeople, for
economic conditions and ensure that it felt instance, are transaction driven—not the
comfortable with the potential market and best choice for defining a company’s
credit losses (or with its ability to appetite for risk and determining which
restructure the portfolio quickly) in difficult customers should receive credit.
economic times. If it isn’t comfortable, the
strategy needs refining. Clear individual responsibilities. Risk-
management functions call for clear job
Creating a high-performing descriptions, such as setting, identifying, and
risk-management group controlling policy. Linkages and divisions of
The task of a risk organization is to responsibility also need to be defined,
identify, measure, and assess risk particularly between the corporate risk-
consistently in every business unit and then management function and the business units.
to provide an integrated, corporate-wide
view of these risks, ensuring that their sum Risk ownership. The existence of a
is a risk profile consistent with the corporate risk organization doesn’t absolve
company’s risk strategy. The structure of business units of the need to assume full
such organizations will vary according to ownership of, and accountability for, the
the type of company. In a complex and risks they assume. Business units understand
diverse conglomerate, such as GE, each their risks best and are a company’s first
business might need its own risk- line of defense against undue risk taking.
management function with specialized
knowledge. More integrated companies Encouraging a risk culture
might keep more of the function under the These elements will go a long way toward
corporate wing. Whatever the structure, improving risk management but are unlikely
certain principles are nonnegotiable. to prevent all excessive or recklessly
conservative risk taking. Companies might
Top-notch talent. Risk executives at both thus impose formal controls—for instance,
the corporate and the business-unit level trading limits. Indeed, the recently adopted
must have the intellectual power to advise Sarbanes-Oxley Act in the United States,
managers in a credible way and to insist makes certifying the adequacy of the formal
that they integrate risk-return considerations controls a legal requirement. Yet since
into their business decisions. Risk today’s businesses are so dynamic, it is
management should be seen as an upward impossible to create processes that cover
career move. A key ingredient of many every decision involving risk. Instead,
successful risk-management organizations is companies need to nurture a risk culture.
Running with risk | 11
The goal is not just to spot immediately the taking; risk-adjusted performance should be
managers who take big risks but also to assessed, too. Ultimately, people must be
ensure that managers instinctively look at held accountable for their behavior. Good
both risks and returns when making risk behavior should be acknowledged and
decisions. rewarded and clear penalties handed out to
anyone who violates risk policy and
To create a risk culture, companies need a processes.
formal, company-wide process to review
risk, with individual business units Finally, to convey the message that the
developing their own risk profiles, which potential downside of every decision must
are then aggregated by the corporate center. be considered as carefully as the potential
Such reviews help ensure that managers at rewards, CEOs should be heard talking
all levels understand the key risk issues and about risk as well as returns, in order to
know how to deal with them. Drawing up a emphasize the importance of risk/return
monthly heat map is one way of establishing trade-offs. The CEO’s open recognition of
a formal risk-review process. the importance of good risk management
will influence the entire company.
But more needs to be done. By focusing on
risk-adjusted performance, not just on
traditional accounting measures, business
Even world-class risk management won’t
managers will develop a better under-
eliminate unforeseen risks, but companies
standing of the risk implications of their
that successfully put the four best-practice
decisions. For businesses that require large
elements in place are likely to encounter
amounts of risk capital, suitable metrics
fewer and smaller unwelcome surprises.
include shareholder value analysis and risk-
Moreover, these companies will be better
adjusted returns on capital. A risk-adjusted
equipped to run the risks needed to
lens helped one credit card company
enhance the returns and growth of their
understand, contrary to expectations, that
businesses. MoF
returns from new customers and customers
about whom it had little information were
Kevin Buehler (Kevin_Buehler@McKinsey.com) is a
more volatile than returns from existing
principal and Gunnar Pritsch (Gunnar_Pritsch
customers, even if these groups had the same
@McKinsey.com) is an associate principal in
expected customer value. Now the approval
McKinsey’s New York office. Copyright © 2004
process also takes into account the higher
McKinsey & Company. All rights reserved.
risk that is associated with new customers.
Viewpoint
provide solid direction to boards and senior
The CFO’s central role management who are currently struggling to
understand risk.
In some organizations, such as financial Unique risk insights can permit a CFO to
institutions and commodity trading companies, drive more effective strategy and business
the risk-measurement team typically reports decisions, particularly in lining up the
directly to the CEO. For others, such as organization’s capital structure with its
processing companies or consumer-services strategy. This is a dynamic process that shifts
companies, the risk group reports to the CFO. with company strategies and external market
Whatever reporting structure is chosen, the changes. Obviously, an overly aggressive
crucial element is that the CFO and the chief balance sheet can lead to higher risk of
risk officer must be closely aligned. In this way downgrade and even bankruptcy. Conversely,
the CFO and the risk-measurement group can an overly conservative balance sheet can also
Viewpoint: The CFO’s central role | 13
EXHIBIT 1
Hello . . .
20
15
Date of index inclusion1
10
Abnormal returns, percent2
5
Median
0
Average
–5
–10
–15
–20
–20 –10 0 10 20 30 40 50 60
Number of days
1
For 103 US companies listed on S&P 500 index between December 1999 and March 2004.
2
Buy and hold abnormal returns (BHAR) vs. market model.
Source: Thomson Financial; Standard & Poor’s; McKinsey analysis
inclusion itself. This was clearly not the tracked index worldwide, we speculate that
case. Indeed, although abnormal returns in this holds for other major equity indexes,
the ten days prior to the effective date did such as the FTSE 100 and the Dow Jones
amount to a maximum average around Industrial Average, as well.
7 percent and a median around 5 percent,
they returned to zero within 45 days after We also looked at deletions from the S&P
the effective date (Exhibit 1). In terms of 500 index over the same period and found
statistically significant positive returns, the similar patterns of temporary price changes
effect disappears even sooner—after a mere around announcement (Exhibit 2). The price
20 days. pressure following exclusion from the S&P
500 faded after 40 to 50 days.
This result is consistent with the
phenomenon of liquidity pressure driving up Implications for executives
share prices initially as investors adjust their Since no lasting effect on a company’s share
portfolios and prices subsequently reverting price can be expected from the simple
to “normal” when portfolios are rebalanced. inclusion or exclusion effect alone,
In the end, there was no permanent price executives should not refrain from spin-offs
premium for new entrants to the S&P 500. and divestitures that would exclude a
This underlines the fact that the value of a corporation from a major index. Nor should
stock is ultimately determined by its cash they pursue major transactions solely
flow potential, unrelated to membership in a because these would gain them entry. Of
major equity index. As the S&P 500 is course, other factors behind such
probably the most widely and intensively transactions could well influence a
16 | McKinsey on Finance | Winter 2004
E XHIB IT 2
. . . and goodbye
20
15
Date of index inclusion1
10
Abnormal returns, percent2
5 Average
–5 Median
–10
–15
–20
–20 –10 0 10 20 30 40 50 60
Number of days
1
For 41 US companies delisted from S&P 500 index between December 1999 and March 2004.
2
Buy and hold abnormal returns (BHAR) vs. market model.
Source: Thomson Financial; Standard & Poor’s; McKinsey analysis
company’s share price and should be taken indexes and index funds,” Bank of England Quarterly
very seriously. Bulletin, 2000, Vol. 40, Number 1, pp. 61–8; R. Dash,
“Price changes associated with S&P 500 deletions,”
Standard & Poor’s, July 9, 2002.
On the other hand, extending our findings 2
A total of 116 stocks were added to the S&P 500 during
and recommendations to emerging-market this period including 1 due to a name change, 4 that were
subsequently acquired or delisted and 8 that we eliminated
stocks may be inappropriate, because their
as outliers because of their extremely negative returns after
inclusion in international equity indexes inclusion. (Excluding the outliers had no effect on our
could represent a form of “recognition” of conclusions; including them would have resulted in even
lower abnormal returns for the entire sample.)
quality, sparking analyst coverage and
3
See, for an exception, M. Beniesh and R. Whaley [2002],
investor interest in US or European markets.
“S&P 500 index replacements: a new game in town”,
There, the result could well be a permanent Journal of Portfolio Management, Vol. 29, Number 1,
increase in the company’s stock price as it pp.1–60. The authors conclude that there is a permanent
price impact from index inclusion when measuring excess
gains access to these equity markets. MoF
returns of added (or deleted) stocks versus the market
return. They acknowledge significant excess returns of
Marc Goedhart (Marc_Goedhart@McKinsey.com) is added stocks versus the market already long before index
inclusion, but they do not incorporate this in their analysis.
an associate principal in McKinsey’s Amsterdam office,
4
To account for the return patterns of new entrants prior to
where Regis Huc (Regis_Huc@McKinsey.com) is a
index inclusion, we first estimated a simple market model
consultant. Copyright © 2004 McKinsey & Company. for each of the included stocks over the 250 trading days
All rights reserved. preceding the start of the test period. From this we
estimated the abnormal buy and hold returns (BAHR)i for
included stocks around the effective date of inclusion
1
See also, for example, B. G. Malkiel and A. Radisich, “The following the method used by S. P. Kothari and J. B.
growth of index funds and the pricing of equity securities,” Warner [1997], “Measuring long-horizon security price
The Journal of Portfolio Management, 2001, Vol. 27, performance, Journal of Financial Economics, Vol. 43,
Number 2, pp. 9–21; R. A. Brealey, “Stock prices, stock Number 3, pp. 301–339.
Viewpoint: Why the biggest and best struggle to grow | 17
Why the biggest and best for shareholders—and may even be risky,
tempting executives to scale back value
compensation that ties bonuses to bottom- the five-year share price appreciation of the
line growth. In any case, management is S&P 500 may be one such bow to good
often tempted to respond as if the slowing reason. Ironically, relieving the CEO of
organic growth were merely temporary, the pressure to substantially outperform the
rejecting any downward adjustment to near- market may have given him the freedom he
term bottom-line growth. needs to focus on longer-term investments
in value-creating organic growth.
That may work in the short run, but as
individual businesses strip out controllable All growth is not created equal
costs, they soon begin to cut into the The right way for large companies to focus
muscle and bone behind whatever value-rich on growth, we believe, is to differentiate
organic growth potential remains—sales among entire classes of growth on the basis
and marketing, new product development, of what we call their value creation
new business development, R&D. At one intensity.2 The value creation intensity of a
industrial company we are familiar with, dollar of top-line growth directly depends
management proudly points to each savings on how much invested capital is required to
initiative that allows them to meet quarterly fuel that growth—the more invested capital,
earnings forecasts. the lower the value creation intensity.
Sorting growth initiatives this way requires
But the short-term focus on meeting understanding the timeframe in which
unrealistically high growth expectations can shareholder value can be created—as short
undermine long-term growth. Ultimately, as a matter of months for some acquisitions
the scramble to meet quarterly numbers will or more than a decade for some R&D
continue to intensify as cost cutting further investments. It also requires assessing the
decelerates organic growth. If the situation size of an opportunity by the amount of
gets more desperate, management may turn value it creates for shareholders, not merely
to acquisitions to keep bottom-line growth how much top-line revenues it adds. These
going. But acquisitions, on average, create are the particularly crucial factors for very
relatively little value compared to the large companies, where smaller investments
investment required, while adding enormous can get lost on the management agenda,
integration challenges and portfolio long-term investments fail to capture
complexity into the mix. Struggling under management’s imagination, and the
the workload, management can lose focus temptation is to invest in highly visible near-
on operations. In this downward spiral term projects with low value creation
management chases growth in ways that intensity.
create less and less value—and in the end
winds up effectively trading value for To illustrate, we dipped into M&A research
growth. to see how much value creation even top-
notch acquirers can reasonably expect. We
Some companies seem to have recognized have also modeled the value creation
the danger in constantly striving to exceed intensity of four different modes of
expectations. One company’s recent decision organic growth, by estimating results for
to vest half of its CEO’s stock award for prototypical organic growth opportunities
simply meeting (rather than handily beating) in the consumer packaged goods industry.
Viewpoint: Why the biggest and best struggle to grow | 19
While this specific hierarchy of value competition for share in order to maintain
creation intensity may not hold for every scale is typically intense, leading to lower
industry, it can serve as a useful example. margins. We estimate that increasing share
in a relatively mature market may destroy as
New product/market development tends to much as $0.25 or create as much as $0.40
have the highest value creation intensity. It of shareholder value for every dollar of new
provides top-line growth at attractive revenue. And for companies whose growth
margins, since competition is limited and is already stalling, growth in a stable market
the market is growing. We estimate that the merely postpones the inevitable.
prototypical new product in the consumer
goods industry can create between $1.75 Acquisitions. While they can drive a
and $2.00 in shareholder value for every material amount of top-line growth in
dollar of new revenue. Ironically, while this the relatively short order, it is now widely
type of growth creates the most value, it’s accepted that the average acquirer captures
particularly difficult for really large relatively little shareholder value from its
companies. Creating new demand for a deals.3 In fact, the numbers suggest that
product that did not previously exist requires even an acquirer who consistently enjoys a
outstanding innovation capabilities—and big top-quartile market reaction in each of its
companies that have tightened the screws on deals will create only about $0.20 in
operational performance are notorious for shareholder value for every $1 million
cutting away at research and development in revenues acquired.4
spending.
Obviously, the size and timing of growth
Expanding into adjacent markets typically opportunities are determined by business
requires incremental invested capital that fundamentals within each industry.
leads to lower, though still very attractive, Typically, though, they tend to come in
value creation intensity in the range of relatively small increments and mature over
$0.30 to $0.75 per dollar of new revenue. multiple years. In the packaged consumer
Facilitating adjacent market expansion goods industry, one study5 found that
requires outstanding execution skills and almost half of product launches had first
organizational flexibility. year sales of less than $25 million, and the
largest was only a little more than
Maintaining or growing share in a growing $200 million. The number of these sorts
market requires substantial incremental of top-line growth projects needed to move
investments to make the product and its the needle for the biggest companies is
value distinctive. But as long as the market daunting. When we stand back from this
is still growing, margins are not competed analysis, we can’t help but draw a very
away. As a result, we estimate value creation dispiriting observation for very large
in the range of $0.10 to $0.50 per dollar of companies: there are remarkably few
new revenue. growth opportunities that are large and
near-term and highly value creating all at
Growing share in a stable market does not the same time. Put another way, the amount
always create value. While incremental of top-line growth required to achieve a
investments are not always material, doubling in shareholder value varies
20 | McKinsey on Finance | Winter 2004
Some executives will no doubt find @McKinsey.com) is a principal in the Washington, DC,
uncomfortable the shift to a perspective that office. Copyright © 2004 McKinsey & Company. All
team analyzing an investment updated its low-return projects run a high risk of
cost of capital calculations but not its winding up destroying value, since they
growth and revenue calculations, its overall provide no margin for shareholders and
assessment of any given project would will always run some risk of encountering
inevitably overstate negative developments.
The fact is that in general the project’s value.
Theory aside, there are valid reasons for
projects that were
Another critical companies to set hurdle rates above—and in
unattractive in the past do point often some cases, even well above—the cost of
overlooked by capital. A better approach, we believe, is to
not magically become
companies is that base hurdle rates on a periodic assessment
attractive just because lower real interest of industry microeconomic fundamentals
rates on government to determine the likely range of returns for
interest rates drop.
bonds don’t always the industry over an appropriate cycle. This
lead to lower real approach ensures that project teams are
costs of equity. For example, with real pursuing only the best opportunities
government bond rates around 2 percent at available within a sector and not settling for
the time of this writing—after more than projects that may be easier to identify and
15 years of hovering around 3 percent— execute but that will yield lower returns.
many companies also reduced their estimates
of the cost of equity. Over the past year, we For example, companies in industries such
have seen nominal cost of equity estimates in as pharmaceuticals and branded consumer
the range of 7.5 to 8 percent.2 However, products frequently earn returns on capital
recent research by some of our colleagues3 exceeding 30 percent after-tax. For these
demonstrates that the nominal cost of equity companies, it is harder to find and develop
is probably closer to 9 percent, including a management talent than it is to get the
7 percent real cost of equity and a 2 percent necessary capital to pursue available
expected inflation rate.4 Indeed, the real cost opportunities. So it makes sense not to
of equity appears to be more stable than the invest in projects with returns at only
real risk-free rate, suggesting that while 10 percent—even though that may
interest rates may decline, investors’ technically be more than the company’s
demands for higher risk premiums likely cost of capital.
offset the effect of interest rate declines on
the nominal cost of equity. Oil companies provide a good example of
evaluating projects based on expected long-
Setting a better hurdle rate term industry fundamentals. While crude
Finance theory suggests that companies prices are relatively high today by historical
should invest in all projects that earn just standards, and constitute an equivalent to
slightly more than the cost of capital— low costs of capital, the volatility in crude
the rate at which investors will discount oil prices driven by short-term supply/
cash flows to estimate a company’s value. demand fluctuations through the past
Even when the analytics are correct, 30 years has taught petroleum companies
companies are often concerned that such to use a crude price based more on
Investing when interest rates are low | 23