McKinsey on Finance - McKinsey & Company

Number 41, Autumn 2011

Perspectives on Corporate Finance and Strategy

McKinsey on Finance

A bias against investment?

18

Governance since the economic crisis: McKinsey Global Survey results

22

Google’s CFO on growth, capital structure, and leadership

7

Finding the courage to shrink

2

The savvy executive’s guide to buying back shares

14

McKinsey on Finance is a quarterly

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corporate finance practice. This

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This and archived issues of McKinsey

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1

2Finding the courage

to shrink

Spinning off businesses

can have real advantages

in creating value—if

executives understand how.

7Google’s CFO

on growth, capital

structure,

and leadership

Patrick Pichette describes

the attitudes and

behavior that Google

hopes will keep it

growing like a start-up.

14The savvy executive’s

guide to buying

back shares

Timing share repurchases

is tricky. The most

shareholder-friendly

approach: don’t try.

22Governance since the

economic crisis:

McKinsey Global Survey

results

Corporate directors

know what they should be

doing. But they haven’t

raised their game since

2008 and must strengthen

their capabilities

and spend more time on

board work.

18A bias against

investment?

Companies should be

investing to improve their

performance and set the

stage for growth. They’re

not. A survey of executives

suggests behavioral bias

is a culprit.

McKinsey on Finance

Number 41, Autumn 2011

2

It takes courage to break up a company. CEOs

and boards of directors often fear that investors will

view asset divestitures as admissions of failed

strategy—that having certain businesses under the

same corporate umbrella never made sense.

Many worry that shedding assets will cost a com-

pany the benefits of scale, cut into the advantages

of analyst coverage, or even damage employee

morale. Spin-offs in particular draw scrutiny because

they shrink the size of the parent company but,

unlike sales, don’t generate cash to reinvest.

We don’t believe these arguments hold up. What’s

more, they may lead executives to pass up value-

creating opportunities. A fundamental principle of

Bill Huyett and

Tim Koller


corporate finance holds that a business creates

the most value for shareholders and the economy

as a whole when it is owned by the best—or, at least,

a better—owner.1 So it makes sense that com-

panies should continually reallocate their resources

as circumstances change. Moreover, the benefits

of being part of a large company come at a cost; in

fact, many spun-off companies can make sub-

stantial cuts in overhead costs once they are inde-

pendent. Investors typically don’t care about a

company being too small once it reaches a threshold

of about $500 million in market capitalization.2

And in our experience, executives and employees

of spun-off companies often feel liberated and

quite happy to be on their own.

Spinning off businesses can have real advantages in creating value—if executives

understand how.

3

So it’s a good sign that there’s been something of a

revival in spin-off activity this year. According

to Bloomberg, as of August 25, 174 companies had

announced spin-offs of all sizes—quickly

approaching the previous global record of 230, in

2006. Among the notable deals: Kraft Foods’s

spin-off of its North American grocery unit and

ConocoPhillips’s spin-offs of its downstream

businesses.

The trick to executing a spin-off strategy—and

to overcoming predictable objections to it—is to

understand where the value is created. Markets

typically respond favorably to spin-offs, but savvy

managers understand that such deals create

value not from some mechanical market reaction

but from the sharpened strategic vision that

comes with restructuring or the tax advantages

relative to a sale.

Spin-offs: A brief history

Company breakups through spin-offs date back at

least a hundred years. Many of the earliest and

best-known ones were mandated by courts to split

up monopolies, including the 1911 breakup of

Standard Oil into 34 separate companies, as well

as the 1984 breakup of AT&T into 8 companies.

After the AT&T breakup, spin-offs became a

more common way for companies to change their

strategic direction. American Express, for

example, spun off Lehman Brothers in 1994, ending

its strategy of becoming a financial supermarket.

In 1993, as the historical links between chemical

and pharmaceutical businesses became less

relevant, the British chemical company Imperial

Chemical Industries3 (ICI) spun off its pharma-

ceutical business as Zeneca.4 Recent spin-offs have

reflected similar shifts. In 2008, when the

integration of the production and delivery of media

content didn’t lead to the anticipated benefits,

Time Warner announced that it would spin off its

cable television business.

Some of the major conglomerates built in the

1960s and ’70s used spin-offs to break themselves

up. ITT, one of the best-known conglomerates

of that era, used a double spin-off in 1995 to split

itself into three companies, ITT Sheraton

(now part of Starwood Hotels and Resorts), Hartford

Financial Services, and the remaining industrial

businesses, which kept the ITT name. In January

2011, ITT announced that it was further

splitting up into three companies: ITT Corporation

(industrial process and flow control), Zylem

(water and waste water), and ITT Exelis (defense).

In an even more extreme example, the com-

pany that was Dun & Bradstreet in 1995 has spun

out businesses four times (1996, 1998, 1999, and

2000) and now exists as seven different companies.

Understanding the benefits

One common misperception about spin-offs is that

they are quick fixes for low valuations. Managers

see the typically favorable response that markets

have to a spin-off announcement as confir-

mation that a spin-off itself mechanically illuminates

value that investors previously overlooked. But

that belief is misleading.

Such assumptions rest errantly on a “sum

of the parts” calculation. For each of a company’s

businesses, analysts add up an assumed

earnings multiple based on the multiples of industry

peers. If they find that the sum of the parts

is greater than the market value of the company

as currently traded, they assume the market

hasn’t valued the business properly.

4 McKinsey on Finance Number 41, Autumn 2011

Unfortunately, these analyses often are flawed—

usually because the selected peers are not

actually comparable in industry, performance,

or both. Once truly comparable businesses

are identified, the undervaluation typically dis-

appears (exhibit).

The real reason spin-offs are so valuable is tied to

expected performance: increased valuations

reflect the market’s expectation that performance

will improve at both the parent company and

the spun-off business once each has the freedom

to change its strategies, people, and organi-

zation. Indeed, of the 85 spin-offs associated with

a major restructuring5 of a company globally

since 1992, spun-off businesses nearly doubled their

growth rates and increased their operating profit

margins by a median of 1.6 percent over five years.

Among parent companies, profit margins

increased 11 percent in the first year after the spin-

off and an additional 3.5 percent by the fifth

year.6 Also, one academic study concluded that

spin-offs improve the allocation of capital,

because researchers observed changes in strategy

among spun-off businesses.7 They found that

higher-profit businesses tended to increase

their investment spending, while lower-profit ones

tended to cut it.

This ability to change strategic direction is

the biggest source of performance improvements.

Consider, for example, Bristol-Myers Squibb,

which spun off its Zimmer orthopedic-devices

business in 2001 with an initial market value

Exhibit

Disguised example of large company with multiple business units

Unit A

Unit B

Enterprise value

Debt

Equity

Current market value

In the first analysis, Unit C’s multiple was based on a diverse set of peers.

Unit C

13×

11×

20×

12×

10×

10×

36

10

10

33

9

5

9

11

100

56

(10)

46

47

(10)

37

$39 billon

19

–

24

Assumed earnings multiplier

Assumed estimate of value, $ billion

Revised estimate of value, $ billion

Difference, %Revised earnings multiplier

A ‘sum of the parts’ valuation can lead to misleading conclusions if not carefully conducted.

MoF 2011Spin-offsExhibit

Deeper analysis narrowed the sample to include only companies with comparable performance in growth and returns on capital.

5Finding the courage to shrink

of $5.4 billion. Under Bristol-Myers Squibb, Zimmer

relied on pricing to drive revenue growth. The

separation allowed Zimmer to invest in developing

new technologies, launch new products, and

grow in new geographies. The company also more

aggressively reduced costs by, for example,

improving the efficiency of its manufacturing plants.

Another source of improvement is eliminating

conflicts and potential conflicts between the parent

and the spun-off company. The pharmaceutical

company Merck, for example, spun off Medco, its

pharmacy benefits manager, in 2003, with an

initial market value of $6.6 billion. Because the

parent company was an important supplier to

Medco, there were long-standing questions about

whether Medco gave preference to Merck drugs

over those of other pharmaceutical companies. The

separation eliminated that concern in Medco’s

negotiations with customers and helped Medco

accelerate its growth by shifting clients

to generic drugs and a mail-order pharmacy.

Spun-off companies may also attract more desirable

management talent. In 2007, Tyco International

split itself into three companies: Covidien, Tyco

Electronics, and the original Tyco International.

Shortly after the spin-off, then-CFO Chris Coughlin

described the advantages, reporting that the

health care business, Covidien, had made significant

strides in attracting new talent that would

probably not have been attracted to the old Tyco.8

In a health care company with a clearly defined

strategy, employees and prospective employees

could see themselves advancing professionally

while remaining in health care and playing a sig-

nificant role in the business.

Sell or spin?

When executives decide to dispose of a business

unit because their company is no longer a

better owner of it, their first inclination is usually

to sell it outright. Yet spinning off these units

may have tax advantages over selling them. In fact,

most early spin-offs were completed by UK- or

US-based companies partly because the tax laws

of those two countries treated most spin-offs as

tax-free transactions. Several continental-European

countries changed their tax laws, beginning in

the late 1990s, to facilitate spin-offs. Since the

1998 breakup of Dutch telecommunications

company KPN and TNT Post, more continental-

European businesses have used spin-offs to

break up their companies.

Tax benefits can make a spin-off preferable even

if a potential buyer is willing to pay a sizable

premium. In the United States today, for example,

a company must pay income tax of 35 percent

on any gain from the sale of a business, but a spin-off

can be structured as a tax-free transaction.

Consider a hypothetical example. ParentCo has

decided to divest one of its business units,

which—if spun off—would have a market capitali-

zation of $1 billion. It also has a $1.3 billion

offer from another company to buy the unit outright,

reflecting a typical acquisition premium. Since

ParentCo’s book value for the unit is $300 million,

the outright sale would carry a tax liability

of $350 million on a $1 billion gain on the sale,

reducing after-tax proceeds to $950 million,

less than the unit’s expected market capitalization.

From a shareholder value perspective, taxes

alone should make ParentCo seriously consider a

spin-off rather than a sale.

Three factors determine the breakeven point:

the tax rate, the premium from the sale, and the

tax book value of the business relative to the

sale price. Because of the tax dynamics, companies

are more likely to spin off highly profitable


businesses and sell less profitable ones. The ratio

of the tax book value to the selling price is a

good proxy for how profitable a business is. A highly

profitable business may have a tax basis that is

only 10 percent of the selling price. To break even

between selling and spinning off, the company

would need to receive a 46 percent premium on the

sale. On the other hand, a low-profit business

with a tax book value of 80 percent of the

selling price would need to receive only an 8 per-

cent premium to break even.9

In many cases, understanding the shareholder

benefits that spinning off assets can have should

provide executives with the dose of courage

they may need to overcome resistance to this type

of value-creating divestiture.

The authors wish to acknowledge the contributions of Katherine Boas and Mauricio Jaramillo.

Bill Huyett ([email protected]) is a partner in McKinsey’s Boston office, and Tim Koller (Tim_Koller@

McKinsey.com) is a partner in the New York office. Copyright © 2011 McKinsey & Company. All rights reserved.

1 See Richard Dobbs, Bill Huyett, and Tim Koller, “Are you still the best owner of your assets?” mckinseyquarterly.com, November 2009.

2 See Robert S. McNish and Michael W. Palys, “Does scale matter to capital markets?” mckinseyquarterly.com, August 2005.

3 ICI was subsequently acquired in 2008 by Dutch chemicals conglomerate AkzoNobel.

4 Zeneca later merged with Astra in 1999 to form AstraZeneca.5 All told, we identified 919 spin-offs of all sizes since 1992.

For 85 of these deals, the spun-off business was worth more than 20 percent of the combined companies’ value and had a market capitalization of at least $1 billion.

6 For 59 large spin-offs between 1990 and 2010, where the per-formance of the companies could be measured five years later.

7 Robert H. Gertner, Eric A. Powers, and David S. Scharfstein, “Learning about internal capital markets from corporate spinoffs,” The Journal of Finance, 2002, Volume 57, Number 6, pp. 2479–506.

8 See Laura Corb and Tim Koller, “When to break up a conglomerate: An interview with Tyco International’s CFO,” mckinseyquarterly.com, October 2007.

9 Investors don’t pay taxes on the value of the shares they receive in a spin-off until they sell those shares. But they may be immediately liable to taxes on any dividends they receive if a company distributes them from the proceeds of a sale.

7

When it comes to playing the classic role of the

no-nonsense chief financial officer, Patrick Pichette

has his own personal interpretation. As Google’s

CFO, he may oversee $36 billion in cash reserves

at one of the world’s most recognized companies,

but he still flies coach class, rides a beat-up bicycle

to work, and responds directly to e-mails from

fellow “Googlers” every day. “It takes a little more

time,” he says. “But it crushes the idea of

bureaucracy—and that’s the way it should be.”

An alumnus of Bell Canada and McKinsey and a

Rhodes Scholar with a master’s degree in philosophy,

politics, and economics from Oxford University,

Pichette is no less direct about the business side of

things. He calls acquisitions an “accelerator”

for growth and scoffs at the idea of business units

James Manyika


because they force people into “ownership” positions

that hinder creative flexibility. Pichette is also a

passionate advocate of sustaining Google’s start-up

culture—even as the company now generates

$30 billion a year in revenue.

Clad in a rugby shirt and jeans in his office at

Google’s Mountain View, California, headquarters,

he recently sat down with McKinsey’s James

Manyika to lay out some of his thinking on growth,

strategy, and the financial side of Google’s business.

McKinsey on Finance: How do you think

about growth?

Patrick Pichette: As [Google executive

chairman Eric Schmidt] once said, “If we’re not

Patrick Pichette describes the attitudes and behavior that Google hopes will keep it

growing like a start-up.


building a product that at least a billion people

will use, we’re wasting our time. How can you be a

company that wants to change the world if you

don’t have at least a billion people using your stuff?”

The corollary of that is if you have a product

that a billion people want, he’ll also say, “Give me

a billion users, I’ll show you how to monetize.”

And, by the way, computer science is the key linchpin

to actually delivering that. Once you understand

those three things, Google’s initiatives completely

make sense: Android, Chrome, Chrome OS,

Google Wallet, and of course search.1

The challenge is in the planning. How do I feed the

winners and hold back on the ones who aren’t

performing the way they should? They shift a lot.

McKinsey on Finance: How do you do that?

Patrick Pichette: We have a quarterly review

process that examines every core product area

and every core engineering area against three

beacons. First, what did it do in the last 90

days and what will it do in the next 90 days? Because

in those 180 days, there’s a lot to deliver—for

example, in the amount of code that has to ship out

and the number of users and whether it’s going

viral or not. We track these things continuously,

but it’s worth taking a look at—in some cases

weekly, in some cases monthly, but at least every

90 days, given where we are.

The second beacon is what’s your trajectory? Do

the financial models and operating metrics

for a couple of years out suggest a trajectory that is

gaining or losing momentum? In some cases,

are you going to need more capital expenditures

because you’ll need more data? If you have a

fantastic success, then you need more capacity—

Google Instant, for example, sometimes generates

answers to user queries before they’ve finished

typing. That requires a lot of computing power.

Then the third beacon is what’s your strategic

positioning in the context of a fast-changing land-

scape? If a competitor buys another company,

what does that mean? Or if we ourselves decide to

move on something this quarter, what does

that mean for everything else that we have?

These beacons are very tactical and short

term, with financial and operational metrics always

running, and always viewed in the context of

a shifting strategic landscape. For example, if we

9

thought product growth would be X but now

it’s three-quarters of X, we retune our resources

accordingly. So if we had planned to hire a

sales force of 200 in the expectation that a product

would be ready to ship, we might delay hiring

them for an additional 90 days to give engineering

time to run through all the testing. And we

have those kinds of conversations in most areas

of the company every quarter. It takes about

a week, a week and a half—and if we need to, we

shift resources.

McKinsey on Finance: In many companies,

those allocation decisions are pretty sticky,

and reallocating that quickly is hard to do. What

makes it happen here?

Patrick Pichette: We don’t have business units.

Once a company has business units, managers

tend to take ownership of these units’ resources.

Managers have a plan, and the natural instinct

is to say, “Those resources are mine and I have to

fight to keep them.”

At Google, we’re more relaxed. We trust each

other. When we sit down to do these allocation

reviews, we’re all one team with our Google

hats on, and the question is what’s winning. In that

context, it’s so much easier. People will say,

“The guys next door are really on fire. They should

get the next 15 engineers.”

That kind of mind-set gives people the confidence

that when they’re on fire and things are going

great for them, they’ll get the capital and engineers

they need too. In a fast-moving environment,

that’s the way it should be.

McKinsey on Finance: Coming back to your

perspectives on growth, how does M&A fit in?

Patrick Pichette: The best way to portray M&A

is as an accelerator. The reason we purchased

On2 Technologies,2 for example, was to get a video

codec to enable more innovation from developers

straight into HTML5 for Chrome. A video codec

makes it possible to open-source applications

from any developer because it gives developers

another standard to develop on. Codecs matter

because enabling the ecosystem around products

like Android, for example, gives users and

developers an incentive to push related innovations.

So for M&A, the mind-set is to comb the world

constantly, given our agenda of development.

If we find a piece that fits what we’re going to do in

8 to 12 months—for example, we have a team

of 6 and we know we need a team of 15—then M&A

is an accelerator because it fits into a very clear

plan of what we’re trying to achieve.

You’ll find that the vast majority of the acquisitions

that we do are in fact those types of acquisitions.

Yes, on occasion we will do small investments in

really innovative spaces, but they’re really

small. That’s not where I spend my time. There’s

no need for me to spend my time on projects

that are really experimental, like cars that drive

themselves.

McKinsey on Finance: So how do you think

about projects in their early stages, before the

business model is clear—how do you prepare for

these large, hopefully growing markets?

Patrick Pichette: In a way, though, we do know

these business models—and what we know is

independent of how that knowledge is monetized.

Take Android, for example. What we know

is that anyone with a smartphone searches a ton

more than somebody without a smartphone.



Career highlights

Google (2008–present)

Senior vice president

and CFO

Bell Canada

Enterprises (2001–08)

President of operations,

Bell Canada (2004–08)

Executive vice president

(2003–04)

CFO (2002–03)

Executive vice president of

planning and performance

management (2001–02)

Call-Net Enterprises

(1994–96)

Vice president and CFO

McKinsey & Company

(1989–94, 1996–2000)

Principal (1996–2000)

Associate (1989–94)

When they search, they also get ads on which we

make money. I don’t even need a sales force.

I just need people to adopt the Android standard.

Now I’ve got this multiplication of devices out

there in the world, and the minute that users are

accustomed to getting directions, they use

Google Maps. They do searches; they get an answer,

and they just press click to call. Search and

search advertising, which are the bread and butter

of the company, allow us to bring forward what

would have been a glacial pace of adoption for many

services, with just a few hundred engineers—

not 10,000—and no capital, because these

services are running on the capital base. Just on

that basis, we already have a home run.

The great thing about Google is that it’s not a

capital-intensive business. We don’t have to make

a bet of $19 billion that is plunked somewhere

and then wait and see what happens. That’s the

beauty of innovation; you can do trial and error

so many times or launch and iterate or release in

beta. If something sticks, then you keep it going.

Patrick Pichette

Education

Graduated with a BA in

business administration in

1987 from Université

du Québec à Montréal

(UQAM)

Earned an MA in

philosophy, politics, and

economics in 1989 from

Oxford University

Fast facts

Board member, director,

chairman of audit

committee, and member

of leadership development

and compensation

committee at Amyris

Biotechnologies since

2010

Director and member of

audit committee at

Alaska Communications

Systems Holdings

since 2004

Advisory board member

of Engineers Without

Borders (Canada)

11Google’s CFO on growth, capital structure, and leadership

McKinsey on Finance: On that point, to what

extent do considerations about capital structure

factor into your thinking?

Patrick Pichette: Capital structure matters

a lot, and degrees of freedom matter immensely.

The debate that I hear a lot is do you have too

much cash? Do you not have enough cash? My

answer is always the same: look at how much

change has occurred in the digital space in just the

last 48 months—48 months ago, who knew

about Netflix or Facebook? Look at the degrees of

freedom needed to continue to lead in this space.

Yes, there are rumors of bubbles, but setting those

aside, there’s a company that we all know very

well that bought another company that we know

very well for $8.5 billion a few days ago. Not

$150 million, but $8.5 billion. Make the case, for

one minute, that it would have been strategic

for us to make that acquisition instead. We would

have needed more than $8.5 billion because

that’s what the acquirer was willing to pay. If the

acquisition had been really strategic for

us, we would have needed to be able to pounce.

If we could predict the strategic flexibility we’ll

need in such an uncertain environment, we could

optimize the balance sheet perfectly. But consider

the constraints: leverage, dividends, and so

on. Then call me the next day and say, “Hey, I need

something. I’m inventing X.” But I can’t help—

I don’t have the flexibility—and end up giving up

what could be the most important asset the

company needs in order to change over the next

ten years. We believe there’s an opportunity

cost of not having that flexibility.

Now, if we were in some other industry we’d

probably have a completely different conversation.

Your industry is really what drives your degrees

of freedom, and because those degrees of freedom

are so wide in the digital space, the cost of

not having flexibility can be absolutely crucial.

McKinsey on Finance: So how does that factor

into the way you think about investor

relations? What’s your philosophy about what

and how to communicate with investors?

Patrick Pichette: One of the most important

documents in the history of Google is the

original founders’ letter. It’s a seminal document

because [Google cofounders Larry Page and Sergey

Brin] and Eric are still here—and the funda-

“Your industry is really what drives your degrees of freedom, and because those degrees of freedom are so wide in the digital space, the cost of not having flexibility can be absolutely crucial.”


mental premise that actually led the company to

success has not changed. These are visionary

and incredibly smart men. They see the future in a

way that you and I have a tough time seeing.

They see the world with their own time frames,

and they are willing to invest at that pace.

Think of Android. Android was a very small project

five years ago. Larry and Sergey said, “Yes,

that’s going to work.” But read the press articles

four years ago; everyone was asking, “What

is that? Another distraction from Google.” Yet

look at the resounding success.

It’s really about finding the right audience and

the right investors. It’s important to have investors

match your risk profile and your company

philosophy. So a short-term hedge fund manager

using a formula that says, “If trigger X happens,

then I do Y”—that’s probably not a good match for

us. But thoughtful, long-term investors who

are actually patient because they believe the digital

economy is going to change? Those investors

have already been served very well, and it’s a

good match.

McKinsey on Finance: Is the right investor in

this case somebody who buys into growth or

a particular kind of growth? You could argue that

many other growth profiles don’t look like yours.

So unless your investors focus on growth driven by

disruptions and innovations, they probably

should go elsewhere.

Patrick Pichette: Absolutely, but there is already

a proven foundation. Many people argue that

search and search monetization are yesterday’s

story. But if you talk to Google engineers, our

view of the world is that search is completely nascent.

Think about where we’ve been: five years ago,

to do a search you typed one word; you hardly dared

type two. Then you looked at the results, and

maybe typed another word. Today, you type in

whole sentences, like “How do I get from this place

to that place in 40 minutes?” And if you don’t

get a good answer, you wonder what’s going on

with Google today. People have that much

faith in Google to get it right.

Today, every day, 15 percent of the queries we get

at Google are completely new—we’ve never

seen them before. Imagine that we could give the

perfect answer for each one. How much would

a person pay for the perfect answer? These are the

degrees of freedom available to Google to

continue to innovate—and we haven’t even talked

about local searches that people do on

their phones.

As an investor with us, you already have all the

growth opportunities of what has been a

proven model with a ton of upside because there’s

still so much innovation to come. Then you

have all the potential of our other investment areas,

like cloud computing. You’re buying two stories

in one, but it’s definitely a growth story.

McKinsey on Finance: Let’s shift gears a little

bit. Given everything you’ve just described,

how do you think about the people you hire in

finance—their capabilities, their profiles,

their backgrounds?

Patrick Pichette: I think there are two

elements to the answer. The first one is that Google

continues to attract and retain immensely high-

caliber talent. They’re the top 1 percent of the top

1 percent of the top 1 percent. The bar continues

to be incredibly high.

In consequence of that, their expectation is that

they’re going to have a job that’s immensely

interesting. We naturally attract people who want

Patrick Pichette: The tone at the top matters.

I spend a lot of time with Googlers—and I get

tons of questions. People write me directly, and

they know I’m going to answer back directly.

This is not a finance issue—all 25,000 of them are

like, “Hi, I’m Sam. I’m in the sales office in

Dublin and I’ve got a question for you.” That’s the

way the company should be. That’s what makes

Google special. It takes a little more time on my side,

but it crushes the concept of bureaucracy.

When I fly in North America, I fly economy, like

everybody. I bike to work—and my bike is

sufficiently beat-up that I don’t even have a lock

for it. Nobody is going to steal my bike. That’s

what a start-up would do. That’s what we do. If you

live these examples at the top, you don’t have

to feel like the police. People just know.

their financial forecasts to work—and they’re going

to work like mad to make sure that this only

takes one day of their week. Then they’re going to

spend the other four days of the week rein-

venting the business, doing crazy analyses that

are going to be deeply fact based, in order to

find key insights.

We naturally attract these people, and because

we have them I can close the books in three

days. I’m not spending 19 days closing the books.

All of my team is saying, “All right, we’re done.

Let’s go back to the cool stuff.”

McKinsey on Finance: You mentioned offline

earlier that part of your role is to serve as a

custodian of the culture. Part of that, of course,

is the talent you are bringing in. How else is

finance the custodian of the culture?

13Google’s CFO on growth, capital structure, and leadership

James Manyika ([email protected]) is a director of the McKinsey Global Institute and a partner in

McKinsey’s San Francisco office. Copyright © 2011 McKinsey & Company. All rights reserved.

1 In addition to the company’s well-known search function, Google initiatives include the Android smartphone software, the Chrome Web browser, the Chrome OS (operating system), and the Google Wallet online-payments system.

2 Google acquired On2 Technologies, a video compression technology company, in February 2010.

14

Managers, like investors, often gauge the

performance of share repurchases against that old

investment adage: buy low, sell high. If they

could consistently time repurchases to periods

when shares were undervalued, as some try

to do, they could reward loyal shareholders at the

expense of those who sell out.

Of course managers, like investors, can’t always do

what old adages suggest. Markets are volatile

and unpredictable, and what seem to be longer-

term trends can quickly reverse course. Over-

confidence can lead executives to buy back shares

even at the peak share price—and a bias for

caution can restrain them from buying shares

when prices are lowest. The result is that

Bin Jiang

and Tim Koller

The savvy executive’s guide to buying back shares

companies seldom consistently pick the right

time to buy back their shares at advantageous

prices.1 Indeed, for the years 2004 through

2010, our analysis finds that a majority of com-

panies repurchased shares when they and the

market were both doing well—and were reluctant

to repurchase shares when prices were low

relative to their intrinsic valuations. Few stopped

repurchases even as the market peaked in

2007. And when the market bottomed in 2009,

few companies were buying back shares.

One global technology company is a typical case

(Exhibit 1). After a large repurchase of shares

in 2004, the company accelerated its purchases as

profits and share prices increased. Just as prices

Timing share repurchases is tricky. The most shareholder-friendly approach: don’t try.

15

peaked, in 2007, it bought back the most shares

ever—more than five times as much as it had

in 2004. As the financial crisis developed in 2008,

managers reduced the level of the company’s

repurchases. It didn’t buy back any shares in 2009

or 2010, despite continued strong profits and

a bargain on share prices, which had dropped by

around 50 percent. In hindsight, it’s easy to

understand why the company stopped the buybacks

in 2009 and 2010, amid deep market uncertainty.

Nonetheless, the best time to buy is generally

when everyone is scared.

That buyback pattern is not unique. We looked at

the S&P 500 companies between 2004 and

2011, a period for which we have quarterly share

buyback data. It turns out that companies

don’t just tend to buy back more shares when the

underlying earnings are strong—they also

seem more willing to do so when their share prices

Exhibit 1

Amount of shares repurchased, $ billion

By end of fiscal year

Net income, $ billion

Closing price at end of quarter, $

Repurchase price (weighted average for quarter), $

$

Average share price, 2004–10 = $55.6

$ billion

One global technology company repurchased more shares at their peak price than at any other time.

MoF 2011Share repurchaseExhibit 1 of 2

Source: Standard & Poor’s; McKinsey analysis

2004

0.9

1.8

1.5

2.2

2.5

2.8

5.2

3.4

1.9

3.9

3.03.1

2005 2006 2007 2008 2009 2010

70

80

60

50

40

30

20

10

0

5.5

6.0

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

0.5

1.0

90


are high. The result is a cyclical pattern: companies

pay out disproportionately large amounts at

the top of a cycle and withhold repurchases at the

bottom.

Over longer-term periods, such as the up-and-down

market cycle from 1998 to 2005 or 2006 to

2010, share repurchases came at the expense of

long-term loyal shareholders by delivering

lower returns than they might otherwise have

received. We compared the actual repurchases

of S&P 500 companies from 2004 to 2010

with a modeled strategy of buying the same dollar

amount of shares each quarter, much as an

investor might regularly purchase shares as part of

an income-averaging approach or as a company

might think of a share repurchase as akin to a

regular dividend. We found that the latter strategy

significantly outperformed what actually

happened.2 For companies that repurchased 5 to

Exhibit 2

We modeled total returns to shareholders (TRS) for a strategy of buying the same dollar amount of shares each quarter and compared this model with companies’ actual TRS from share repurchases.

TRS for actual shares repurchased1 relative to model, %

Only 23% of companies achieved TRS above that of the model.

77% of companies earned less.

Number of companies,2 2004–10

Median TRS for actual share repurchases = –3.0%

Companies would have earned more if they had purchased an equal dollar amount of shares each quarter.

MoF 2011Share repurchaseExhibit 2 of 2

1 Where total shares were >25% of beginning shares outstanding. Based on S&P 500 members’ quarterly repurchases from 2004–10. Sample size of 135 excludes 5 companies with unusual circumstances.

2Grouped in weighted 3-year-average TRS cohorts based on compound annual growth rate for TRS for up to 3 years immediately after purchase.

12.5 and above 1

10.0 to 12.4 0

7.5 to 9.9 1

5.0 to 7.4 2

2.5 to 4.9 2

0 to 2.4 25

0 to –2.4 29

–2.5 to –4.9 26

–5.0 to –7.4 9

–7.5 to –9.9 12

–10.0 to –12.4 12

–12.5 and below 16

17The savvy executive’s guide to buying back shares

25 percent of their outstanding shares, the

median return of actual buybacks lagged behind

that of the modeled strategy by 4.5 percent.

For companies that bought back more than 25 per-

cent of their shares, the median return of

actual buybacks lags behind that of the alternative

approach by 3 percent. Only 31 percent of the

companies earned a positive return from buying

back shares—less than you would expect from

a random throw of the dice (Exhibit 2).

These findings suggest an easy fix: companies

should give up trying to time the market.

Long-term shareholders will be better off if

management would simply forecast total

excess cash and evenly distribute it each calendar

quarter as “dividends” in the form of share

repurchases. CFOs can approach such regular

buybacks in two ways. First, they can repurchase

shares as excess cash becomes available. This

is the easiest approach and the one least likely to

send adverse signals to investors around the

potential for excess cash or cash shortfalls. It is

probably right for most companies, even if it

generates lower returns.

Second, companies can evenly distribute

similarly sized repurchases over time. For those

willing to stand by their forecasts of future

cash flows, this dividend-like approach will probably

generate higher returns for shareholders.

Investors will, however, inevitably try to determine

exactly what management is thinking, given

the level of repurchases it sets. And it’s worth

bearing in mind that as with dividends,

investors may react negatively if repurchases

eventually decline, viewing this as a signal

of management’s pessimism.

Bin Jiang ([email protected]) is a consultant in McKinsey’s New York office, where Tim Koller (Tim_Koller@

McKinsey.com) is a partner. Copyright © 2011 McKinsey & Company. All rights reserved.

1 Some academic studies have concluded that companies do, in fact, time their share repurchases well. Those findings, however, are driven primarily by smaller companies that make a one-time decision to repurchase shares. Once smaller companies are excluded, the smart-timing effect disappears. Furthermore, most of those studies were done before large companies began to repurchase shares regularly as a substitute for dividends.

2 To test whether companies timed the repurchase of shares to the advantage of shareholders who didn’t sell, we first calculated the three-year return after each repurchase date. We compared a weighted average of these returns, using the dollar amount of each repurchase as weights to a weighted average return, as if companies had repurchased the same dollar amount of shares each quarter. The results were similar no matter which measure of returns we used.


One of the puzzles of the sluggish global economy

today is why companies aren’t investing more.

They certainly seem to have good reasons to: cor-

porate coffers are full, interest rates are low,

and a slack economy inevitably offers bargains. Yet

many companies seem to be holding back.

A number of factors are doubtless involved, ranging

from market volatility to fears of a double-dip

recession to uncertainty about economic policy.

One factor that might go unnoticed, however,

is the surprisingly strong role of decision biases in

the investment decision-making process—a

role that revealed itself in a recent McKinsey Global

Survey. Most executives, the survey found,

believe that their companies are too stingy, especially

for investments expensed immediately through

the income statement and not capitalized over the

longer term. Indeed, about two-thirds of the

respondents said that their companies underinvest

in product development, and more than half

that they underinvest in sales and marketing and

in financing start-ups for new products or new

markets (Exhibit 1). Bypassed opportunities aren’t

just a missed opportunity for individual

companies: the investment dearth hurts whole

economies and job creation efforts as well.

Such biases, left unchecked, amplify this conser-

vatism, the survey suggests. Executives who

believe that their companies are underinvesting

are also much more likely to have observed a

number of common decision biases in those com-

panies’ investment decision making. These

Tim Koller,

Dan Lovallo, and

Zane Williams


Companies should be investing to improve their performance and set the stage

for growth. They’re not. A survey of executives suggests behavioral bias is a culprit.

19

executives also display a remarkable degree of

loss aversion—they weight potential losses

significantly more than equivalent gains. The clear

implication is that even amid market volatility

and uncertainty, managers are right now probably

foregoing worthy opportunities, many of which

are in-house.

The survey respondents1 held a wide range

of positions in both public and private companies.

All had exposure to investment decision making

in their organizations. Nearly two-thirds of them

reported that their companies generated annual

revenues above $1 billion, and the findings are con-

sistent across industries, geographies, and

corporate roles.

More bias means less investment

The survey results were also consistent with earlier

findings that biases are common within the

investment decision-making process.2 More than

four-fifths of respondents reported that their

organizations suffer from at least one well-known

bias. More than two-fifths reported observing

three or more.

Generally, the most common biases that affect

decisions could be traced to the past experiences of

those who make or support a proposal. The

confirmation bias, for example, was the most

common one—decision makers focus their

analyses of opportunities on reasons to support a

proposal, not to reject it. Depending on the

Exhibit 1 Executives believe their companies should be investing more.

MoF 2011Decision biases Exhibit 1 of 3

Source: Feb 2011 McKinsey survey of >1,500 executives from 90 countries

Would your company maximize value creation by spending more or less than it currently does on each of the categories below?

% of respondents who answered “by spending more” or “much more,” n = 1,586

Spend much more Spend more

Product development 40 24

Acquisitions 26 17

21 11Non-IT-related capitalexpenditures

IT-related capital expenditures

36 23

Sales, marketing, and advertising

34 23

Costs to finance start-ups for new products or in new markets

30 23


proposal, this bias can result in decisions to under-

invest or not to invest at all just as easily as in

decisions to overinvest. Another common bias was

a tendency to use inappropriate analogies based

on experiences that aren’t applicable to the decision

at hand. A third was the “champion” bias—

managers defer more than is warranted to the person

making or supporting an investment proposal

than to merits of the proposal itself.

The presence of behavioral bias seems to have a

substantial effect on the performance of corporate

investments. Respondents who had reported

observing the fewest biases were also much more

likely to report that their companies’ major

investments since the global financial crisis began

had performed better than expected. By contrast,

those who reported observing the most biases were

more likely to report that their companies’

investments had performed worse than expected

(Exhibit 2).

The biases reported by respondents correlate

with the performance of investments—and appear

to constrain their overall level, as well. Indeed,

respondents reporting fewer biases were significantly

less likely than those reporting more to state

that their companies had forgone beneficial invest-

ments (Exhibit 3).

Wary executives

Executives also reported a high degree of

loss aversion in the investment decisions they’d

observed. They exhibited the same tendency

themselves, even when the value they expected

from an investment appeared strongly positive.

Exhibit 2 The more biases reported, the lower the perceived returns on a company’s investments.

MoF 2011Decision biases Exhibit 2 of 3

How would you characterize the returns on your company’s major investments since the global financial crisis started?

% of respondents

Number of biases observed by respondents within their companies

Higher than forecast

About the same as forecast

Lower than forecast

1 Figures do not sum to 100%, because of rounding.


0

18

54

211n =

28

11

25

50

202

24

2

25

47

397

28

3+

39

37

640

24

21

When asked to assess a hypothetical investment

scenario with a possible loss of $100 million and a

possible gain of $400 million, for example, most

respondents were willing to accept a risk of loss

only between 1 and 20 percent, although the

net present value would be positive up to a 75 per-

cent risk of loss. Such excessive loss aversion

probably explains why many companies fail to

pursue profitable investment opportunities.3

This degree of loss aversion is all the more surprising

because it apparently extends to much smaller

deals: respondents were just as averse to loss when

the size of an investment was $10 million and the

potential gain $40 million. Even if it made sense to

be so loss averse for larger deals, it still wouldn’t

make sense to be as averse to loss for smaller ones,

especially considering how much more frequently

smaller opportunities occur.

Executives may be limiting the investments of their

companies because of economic fundamentals

and policy uncertainties. But their decision making

is also tainted by biases and loss aversion that

harm performance and cause companies to miss

potentially value-creating opportunities.

Exhibit 3 Companies exhibiting a greater number of biases are more likely to pass up worthwhile investments.

MoF 2011Decision Biases Exhibit 3 of 3

Have you forgone investments that, in retrospect, would have helped?

% of respondents who answered yes, n = 1,586


Number of biases observed by respondents within their companies

0 1 2 3+

4451 52

58

Tim Koller ([email protected]) is a partner in McKinsey’s New York office, where Zane Williams

([email protected]) is a consultant; Dan Lovallo is a professor at the University of Sydney Business

School and an adviser to McKinsey. Copyright © 2011 McKinsey & Company. All rights reserved.

1 Including more than 1,500 executives, from 90 countries, who completed our February 2011 survey.

2 See Dan Lovallo and Olivier Sibony, “The case for behavioral strategy,” mckinseyquarterly.com, March 2010.

3 Loss aversion, a decision maker’s preference for avoiding losses over acquiring gains, is a central part of what’s commonly called risk aversion.



Corporate boards are under pressure to take

more responsibility for developing strategy and

overseeing business risk after the financial

crisis exposed many cases of inadequate gover-

nance.1 Yet according to the latest McKinsey

Quarterly survey on governance,2 directors report

that their boards have not increased the time

spent on company strategy since our previous survey,

conducted in February 2008—seven months

before the collapse of Lehman Brothers. Moreover,

44 percent of respondents say their boards simply

review and approve management’s proposed

strategies. Just one-quarter characterize their

boards’ overall performance as excellent or

very good; even so, the share of boards that formally

evaluate their directors has dropped over the

past three years.

In this survey, we asked directors how much time

their boards spend on different activities, how

well they understand the issues their companies

face, and what factors they think would be

most effective in improving board performance.

The picture that emerges is that boards have

taken to heart the new and higher demands placed

on them. But some directors say they feel ill

equipped to live up to these expectations because

of inadequate expertise about the business and

the lack of time they can commit to their board duties,

which they say is less than ideal for them to

cover all board-related topics in proper depth.

The most effective remedies, respondents say,

would be to spend more time overall on board work,

improve the mix of skills or backgrounds on the

Corporate directors know what they should be doing. But they haven’t raised

their game since 2008 and must strengthen their capabilities and spend more time

on board work.


23

board, and have tougher and more constructive

boardroom discussions.

Developing strategy

In our 2008 survey, more respondents wanted

to increase the amount of time their boards

spent on strategy development and talent manage-

ment than on core governance and compliance,

execution, or performance management. Interest-

ingly, in this year’s survey, directors say their

boards are now spending roughly the same amount

of time on strategy (23 percent of board time,

versus 24 percent in 2008) and talent (10 percent,

versus 11 percent) that they were three years ago.

With the lack of progress, it’s not surprising that two

out of every three directors still say they want

to focus more on these two areas, with a slightly

lower share saying they would like to spend more

time on business risk management (Exhibit 1).

The amount of time spent on these areas differs

by overall board performance, and directors at

underperforming boards see a greater need

than others to do better: 78 percent of them want

to spend more time on strategy, compared

with 65 percent of directors who view their boards’

performance as excellent or very good and say

the same.

Understanding the company

It stands to reason that corporate directors need

to know their companies and their industries

very well if they are to challenge management on

strategic issues, yet that knowledge is often

Exhibit 1

Increase No change Reduce

% of respondents

1 Respondents who answered “other” are not shown.2Respondents who answered “don’t know” or “not applicable” are not shown.3For example, prioritizing key initiatives against strategy, approval of M&A transactions.

% of time board currently spends on issue1

Survey 2011Board governanceExhibit 1 of 6Exhibit title: Shifts in strategy and talent

How would you shift the amount of board time spent on each activity over the next 2–3 years based on the activity’s relative value to the company?2

Strategy, n = 1,535

23 70 25 4

22Execution,3

n = 1,52342 36 20

18Performance management,n = 1,509

47 35 17

14Core governance and compliance,n = 1,491

32 42 23

14Business risk management,n = 1,500

64 28 6

10Talent management,n = 1,469

67 24 6

Shifts in strategy and talent


lacking. The results indicate a need to better educate

boards on industry dynamics and how their

companies create value, among other core issues

where respondents say their boards’ knowledge

is incomplete (Exhibit 2). Only 21 percent of direc-

tors surveyed claim a complete understanding

of their companies’ current strategy.

Respondents on boards in the financial sector,

where many boards failed to prevent manage-

ment forays into risk-laden subprime mortgages

before the 2008 crisis, indicate that directors’

knowledge is below average on industry dynamics

(just 6 percent claim to have complete under-

standing) but slightly above average on company

risk (17 percent).

Half of all directors say the information they get is

too short-term. These responses resonate with

calls from governance oversight bodies for boards

to take a greater role in developing long-term

strategy. Directors who describe their boards’

overall performance as excellent or very good are

happier about the time frame of the information

they receive—though a third of those respondents

still say it is too short-term.

Improving board performance

Insufficient time spent on key issues (strategy,

risk, and talent) and inadequate knowledge (about

their companies and industries) are probably

two important reasons why just 26 percent of res-

pondents characterize their boards’ overall

performance as excellent or very good (Exhibit 3).

Directors at publicly owned companies—the

category that has been the most frequent target of

criticism and regulated governance reforms—

are more positive about their boards’ performance

than their peers at private-equity firms and

family-owned businesses. This is notable, since

companies in the latter two categories have

been widely perceived to enjoy superior governance

due to stronger owners and more active boards.

Exhibit 2% of respondents,1 n = 1,597

1 Respondents who answered “don’t know” are not shown; figures may not sum to 100%, because of rounding.

Board’s understanding of given issues

Survey 2011Board governanceExhibit 3 of 6Exhibit title: Knowledge is lacking

Your company’s financial position 36 50 14

Your company’s current strategy 21 58 22

How value is created in your company 16 58 26

Risks your company faces 14 54 32

Dynamics of your company’s industries 10 55 34

Complete understanding

Good understanding

Limited or no understanding

Knowledge is lacking

25

How can boards of all categories raise their

game? Among the survey’s options for improving

performance, the one selected by the most

respondents was to spend more time on company

matters, both at formal meetings and through

informal contact (Exhibit 4). Directors3 say that

on the whole, they are putting in 28 days’ worth of

work and should ideally spend 38 days to discharge

their responsibilities effectively; chairs put in

36 days and should ideally spend 47 days. More time

overall would presumably help directors cope

with core governance and compliance duties and

still be able to deal with strategy, risk, and

talent issues more thoroughly than before. It’s also

a logical expectation on the part of directors

that if they spend more time on company issues,

they will receive more compensation in return:

respondents report that they are being compensated

for roughly 25 days of work per year, or 11 percent

less time than they are actually spending.

Many directors also call for better people dynamics

that enable tough and constructive boardroom

discussions. This factor is the one where there is

the biggest difference between boards that

respondents say need to improve or improve signifi-

cantly (44 percent prioritize it) and boards

rated by their directors as excellent or very good

(26 percent highlight this need).

More effective director training was cited about

half as frequently by respondents as a factor

that could improve performance, but training and

director assessments are key parts of new codes

designed to professionalize boards, such as the UK

Corporate Governance Code.4 Indeed, other

results indicate considerable room for improvement

at most companies. One-third of boards never

evaluate individual directors, for example, and

among those that do, 42 percent of board members

view those evaluations as ineffective. Similarly,

Exhibit 3% of respondents,1 by company ownership

1 Respondents who answered “don’t know” are not shown; figures may not sum to 100%, because of rounding.

Quality of board’s overall performance

Survey 2011Board governanceExhibit 4 of 6Exhibit title: Room for improvement

Total, n = 1,597

Public shareholders, n = 330

Private-equity firm, n = 334

Family owned, n = 545

Excellent Very good

Good Needs significant improvement

Needs improvement

22 39 28 8

256 39 27

23 39 28 6

24 43 27 4

3

3

2

3

Room for improvement



more than half of respondents report a need for

improvement in the training of new board members.

On the whole, board chairs report a slightly

rosier view. They tend to be more positive than

nonchairs on the effectiveness of training

programs, the frequency of director evaluations,

the effectiveness of information provided to

their boards, the extent of their boards’ role in

developing strategy, and overall performance.

Given the differences, these results emphasize that

many chairs may need to take a more honest

look at how their boards are performing and

what they need in order to perform at a much

higher level.

Looking ahead

• Most boards say they want to spend more time

on strategy development, risk, and talent

management, which may require meeting more

days per year and companies compensating

directors for their extra time spent. Boards could

also shift time in each category toward high-

impact areas—in strategy, for example,

Exhibit 4% of respondents,1 n = 625

1 A revised version of this question, with 3 additional answer choices, was asked as part of a short follow-up survey, which all respondents to the original survey were invited to take; respondents who answered “other,” “none,” or “don’t know” are not shown.

Survey 2011Board governanceExhibit 5 of 7Exhibit title: How to get better

Most effective factors for improving overall board performance

More time spent on company matters, both at formal meetings and through informal contact (assuming that appropriate compensation is given for the extra time)

48

More appropriate mix of skills/backgrounds among board members

47

Better people dynamics that enable tough, constructive boardroom discussions

45

Stronger incentives for directors to create shareholder value than those currently offered (eg, compensation in shares, a requirement to hold shares)

21

Access to company information that is timelier/of higher quality

32

More effective induction and better ongoing director assessment and training

More company-provided support (eg, a research staff) to support work on company matters

26

22

How to get better

27Governance since the economic crisis: McKinsey Global Survey results

The contributors to the development and analysis of this survey include Chinta Bhagat (Chinta_Bhagat@

McKinsey.com), a partner in McKinsey’s Singapore office; Martin Hirt ([email protected]), a partner in

the Greater China office; and Conor Kehoe ([email protected]), a partner in the London office.

The contributors would like to thank Bill Huyett and Eric Matson for their help with this work. Copyright © 2011

McKinsey & Company. All rights reserved.

toward long-term trends that could disrupt the

current business model.

• At many boards, there is plenty of room to

improve understanding of industry dynamics,

risk, and value creation. Enhanced training

of new directors and better information is one

way forward, but boards may also need

to shake up their composition by increasing the

number with a background in the company’s

industry, where board knowledge seems

particularly lacking.

• Many directors are calling for more constructive

board discussions. High-quality debates can

be fostered by methods such as challenging the

key assumptions behind management’s

proposals, exploring various biases that board

members bring to the table, and conducting

annual evaluations of individual directors to

assess the degree to which they contribute.

1 See, for example, “Corporate governance in financial institutions: Lessons to be drawn from the current financial crisis, best practices,” European Commission working paper, June 2010; and The Financial Crisis: Inquiry Report, US Financial Crisis Inquiry Commission, January 2011.

2 The online survey was in the field from April 5 to April 15, 2011, and received responses from 1,597 corporate directors, 31 percent of them chairs. We asked respondents to focus on the single board with which they are most familiar. Respondents represent 545 family-owned businesses, 334 firms owned by private-equity firms, and 330 publicly owned companies; the remainder work at other privately owned or government-owned firms. They represent the full range of regions, industries, and company sizes.

3 The original group of respondents was sent a follow-up survey with five questions—three of which asked about time spent on board work—that was in the field from June 6 to June 10, 2011, and received 625 responses.

4 Released in 2010 by the Financial Reporting Council, an independent UK regulator.

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Many executives strive for stable earnings

growth, but research shows that

investors don’t worry about variability.

Bin Jiang and Tim Koller

How the growth of emerging

markets will strain global finance

Surging demand for capital, led by

developing economies, could put

upward pressure on interest rates and

crowd out some investment.

Richard Dobbs, Susan Lund, and

Andreas Schreiner

McKinsey on Finance - McKinsey & Company

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Transcript of McKinsey on Finance - McKinsey & Company