MoF Issue 10

McKinsey on Finance

Where mergers go wrong 1Most companies routinely overestimate the value of synergies they can capture from acquisitions. Lessons from the front lines can help.

Running with risk 7It’s good to take risks—if you manage them well.

Viewpoint: The CFO’s central role 12Whether leading or supporting the effort, the CFO often ends up at the center of risk management.

What is stock index membership worth? 14Gaining—or losing—a place in a major stock index has only short-term impact on share price: about 45 days.

Viewpoint: Why the biggest and best struggle to grow 17The largest companies eventually find size itself an impediment to creating new value. They must recognize that not all forms of growth are equal.

Viewpoint: Investing when interest rates are low 21 Projects that wouldn’t have created value because interest rates were higher aren’t necessarily attractive when interest rates drop.

Perspectives on Corporate Finance and Strategy

Number 10, Winter 2004

McKinsey & Company is an international management consulting firm serving corporate and governmentinstitutions from 85 offices in 47 countries.

Editorial Board: Richard Dobbs, Marc Goedhart, Keiko Honda, Bill Javetski, Timothy Koller, Robert McNish, Dennis Swinford

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Copyright © 2004 McKinsey & Company. All rights reserved.

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McKinsey on Finance is a quarterly publication written by experts and practitioners in McKinsey & Company’sCorporate Finance & Strategy Practice. It offers readers insights into value-creating strategies and the translation ofthose strategies into stock market performance. This and archive issues of McKinsey on Finance are available online at http://www.corporatefinance.mckinsey.com

It’s known as the winner’s curse. Inmergers, it is typically not the buyer but theseller who captures most of the shareholdervalue created. On average, in fact, acquirerspay sellers all of the value created by themerger in the form of a premium thattypically ranges from 10 to 35 percent of thetarget company’s preannouncement marketvalue. But while the fact is well established,the reasons for it have been less clear.1

Our exploration of postmerger integrationspoints to an explanation: the origins of thecurse2 lie in the average acquirer materiallyoverestimating the synergies that can becaptured in a merger.3 Even a good faithacquisition effort can stumble over whatappears to be a remarkably small marginfor error in estimating synergy values.

No question, acquirers face an obviouschallenge in coping with an acute lack ofreliable information. They typically havelittle actual data about the target company,limited access to its managers, suppliers,channel partners, and customers, andinsufficient experience to guide synergyestimation and benchmarks. Even highly

experienced acquirers rarely capture theirdata systematically enough to improve theirestimates for their next deal. And externaltransaction advisers—usually investmentbanks—are seldom involved in the kind ofdetailed, bottom-up estimation of synergiesbefore the deal that are necessary fordeveloping meaningful benchmarks. Fewerstill get involved in the postmerger work,when premerger estimates come face to facewith reality.

Lessons learnedTo address this challenge, we have begundeveloping a detailed database of estimatedand realized merger synergies, grounded inour experience in postmerger integrationefforts across a range of industries,geographies, and deal types. We haveaccumulated data from 160 mergers so far,and combining it with industry andcompany knowledge we believe that thereare practical steps executives can take toimprove their odds of successfully capturingacquisition synergies.

For starters, they should probably cast agimlet eye on estimates of top-line synergies,which we found to be rife with inflatedestimates. They ought to also look hard atraising estimates of one-time costs andbetter anticipate common setbacks or dis-synergies likely to befall them. They mightalso vet pricing and market shareassumptions, make better use of benchmarksto deliver cost savings, and get a better fix onhow long it will take to capture synergies.When applied together, especially by savvyacquisition teams chosen for maximumexpertise and ability to counter gaps ininformation, we believe acquirers can domore than merely avoid falling victim to thewinner’s curse—they can improve thequality of most of their deals.

Where mergers go wrong

Most companies routinely overestimate the valueof synergies they can capture from acquisitions.Lessons from the front lines can help.

Where mergers go wrong | 1

Scott A.Christofferson,Robert S. McNish,and Diane L. Sias

Reduce top-line synergy estimatesWall Street wisdom warns against payingfor revenue synergies and, in this case, theconventional wisdom is right. The area ofgreatest estimation error is on the revenueside—a particularly unfortunate state ofaffairs, since the strategic rationale ofentire classes of deals, such as thosepursued to gain access to the target’scustomers, channels, and geographies, isfounded on these very synergies. Nearly 70 percent of the mergers in our databasefailed to achieve the revenue synergiesestimated by the acquirer’s management(Exhibit 1).

Acknowledge synergy setbacksAnother regular—and large—contributor torevenue estimation error is that fewacquirers explicitly account for the common

revenue dis-synergies that befall mergingcompanies. Sometimes these stem fromsimple disruption of business as usual, butoften they are the direct result of costreduction efforts. For example, in retailbanking, one of the most important costsavings comes from consolidating branches.Some customers may leave, but the costsavings are expected to more than make upfor the losses. When one large US bankacquired a competitor with substantialgeographic overlap, however, it sufferedunusually high losses among the targetcompany’s customers, rendering the dealunprofitable and making the entire company vulnerable to takeover. Duediligence on the target’s customer basewould have revealed that they were heavybranch users and thus especially likely todefect during an integration that closedmore than 75 percent of the acquiredcompany’s branches. This company’scustomer loss experience may be at the high end, but according to our research, the average merging company will see 2 to5 percent of their combined customersdisappear.4

Most acquiring companies can do better,especially in industries that have undergoneconsiderable consolidation. Data on theseverity of customer loss experienced bymerging parties in retail banking, forexample, can be gleaned from a variety ofsources: industry associations, regulatoryfilings, and press articles. Examples arenumerous enough not only to identifyhelpful benchmarks (e.g., 8 percent ofretail deposits at closing branches will belost to competitors) but also underlyingdrivers of whether a deal will see lossesabove or below the benchmark (e.g., thenumber of customers who also bank with acompetitor, the distance to the next-

2 | McKinsey on Finance | Winter 2004

Top-line trouble: 70 percent of mergers failed to achieve expected revenue synergies

Source: McKinsey (2002) Postmerger Management Practice client survey; client case studies

Typical sources of estimation error

• Ignoring or underestimating customer losses (typically 2% to 5%) that result from the integration

• Assuming growth or share targets out of line with overall market growth and competitive dynamics (no “outside view” calibration)

23

�30% 91–100%

81–90%

71–80%

61–70%

51–60%

30–50%

�100%

5

13

6

14

8

13

17

Mergers achieving stated percentage of expected revenue synergies, percent N � 77

EXHIBIT 1

closest remaining branch, or the presence of competitors to take over closingbranches). In other industries, a search may yield only two or three goodprecedents and only limited data on those;even this can greatly improve management’srevenue estimates.

Increase estimates of one-time costsMany deal teams neglect or underestimatethe impact of one-time costs. For example,one chemicals manufacturer publiclycommitted itself to reducing annual costsby $210 million at a one-time cost of$250 million.5 Had it put as much duediligence into that one-time figure as theannual synergy target, it would have founda few relevant precedent transactionssuggesting that it was unlikely to spend lessthan $450 million. In trying to fulfill theiroriginal commitment, the company endedup running over budget, under-deliveringon promised synergies, and falling wellshort of revenue growth targets.

Compare pro forma projections withmarket and competitive realitiesMany acquirers rely too heavily onassumptions about pricing and market sharethat are simply not consistent with overallmarket growth and competitive reality.Instead, acquirers must calibrate theassumptions in their pro-forma analysiswith the realities of the market place. Forexample, one global financial concernestimated that a recent acquisition wouldnet i1 billion in mostly top-line synergieswithin 5 years and 13 percent profit growthin the first year. With limited overall marketgrowth, these goals could be achieved onlyby using cross-selling to increase marketshare without triggering a competitiveresponse. Actual profit growth was a mere2 percent.

Apply outside-in benchmarks to cost synergiesWhile managers in about 60 percent ofmergers can be commended for deliveringnearly all of their planned cost synergies,we find that about a quarter overestimatecost synergies by at least 25 percent(Exhibit 2). That can easily translate into a 5 to 10 percent valuation error.6

One route to overestimating cost synergiesstarts by failing to use the benchmarks thatare available as outside-in sanity-checks.One European industrial company, forexample, planned on cost savings ofi110 million from selling, general, andadministrative (SG&A) cost savings, even


Cost-synergy estimation is better, but there are patterns emerging in the errors

Source: McKinsey (2002) Postmerger Management Practice client survey; client case studies

Mergers achieving stated percentage of expected cost savings, percent N � 92

Typical sources of estimation error

• Underestimating one-time costs

• Using benchmarks from noncomparable situations

• Not sanity-checking management estimates against precedent transactions

• Failing to ground estimates in bottom-up analysis (e.g., location-by-location review of overlaps

3

�30% 91–100%

81–90%

71–80%

61–70%

51–60%

30–50%

�100%

5

1

4

1213

25

36

EXHIBIT 2

though precedent transactions suggestedthat a range of i25 million to 90 millionwas more realistic, and the companyneglected to conduct bottom-up analysis

to justify the higherfigure. Worse, thiswas an especiallyrisky area in whichto aim high,because cuttingsales and marketingexpense putsrevenue growth at risk, and the net present value

of pre-synergy revenue growth was roughly four times more valuable than allsynergies combined.

Temper expectations for synergytiming and sustainabilityDeal teams often make simplistic andoptimistic assumptions about how long itwill take to capture synergies and sustainthem. Important deal metrics such as near-term earnings and cash flow accretion can end up looking better thanthey deserve as a result, leading to asubstantial overestimates of synergy netpresent value.

One company we worked with hadbudgeted headcount cost savings (includingseverance) as if they were spread out evenlyover each quarter. In practice, however,managers tended to wait until the lastmonth of the quarter before makingreductions. As it happens, this example did not have a material impact on the netpresent value of the transaction, but it didcause the post-merger integration leaders tomiss their projections for first-yearsynergies, thereby undermining thecredibility of their process.

Neglecting to “phase out” certain synergiescan be equally problematic. Companiesoften plan to reduce operating costs bysqueezing production capacity and logisticsacross the merged organization. But if themerging companies are growing quickly ona standalone basis, sloppy incrementalanalysis will attribute benefits to the mergerthat would have been realized by thestandalone companies. Indeed, one medicalproducts company, growing at 10 to15 percent a year, estimated that it wouldbe using the full capacity of existing plantswithin three to four years without a merger.So many of the savings from closing orstreamlining plants could not rightly beexpected to last long, as the affectedfacilities would be quickly reopened. Manysavings, while real, are not perpetual, andmust be phased out. In general, we believethat it is overly optimistic to include the fullamount of targeted annual synergies in the“continuing value” calculation of a netpresent value model.

Moreover, the problem isn’t just one ofproperly translating synergy timing intopresent values: bad timing can even affectwhether synergies are captured at all.Persistent management attention matters incapturing synergies. We have found someevidence to suggest that synergies that arenot captured within, say, the first fullbudget year after consolidation may neverbe captured, overtaken as they are bysubsequent events. We have also observedthat synergies are captured more quicklyand efficiently when the transaction closesat the start of the two companies’ annualoperational planning and budgeting process.One financial institution even learned thatits plans to migrate IT systems had to beradically altered (i.e., move onto theacquirer’s platform rather than the target’s)


Synergies that are not

captured within, say, the

first full budget year after

consolidation may never be

captured, overtaken as they

are by subsequent events.

accommodate the relatively narrow windowof opportunity between peaks in thelending season.

Forming effective deal teamsEstimating synergies is difficult, but thepractice is critical and needs moreinvestment than it usually receives.Companies we’ve studied have used a varietyof ways to improve their synergy estimates.

Involve key line managersInvolving line managers in problem solvingand due diligence not only improves thequality of estimates but also builds supportfor postmerger integration initiatives.Synergy analysis also illuminates issues that will shape due diligence, deal structure,and negotiations.

For example, one client had its head ofoperations take the lead in estimating thesavings from rationalizing manufacturingcapacity, distribution networks, andsuppliers. His knowledge of the unusualmanufacturing requirements of a keyproduct line and looming investment needsat the acquirer’s main plant helped improvethe estimates. He also used a due diligenceinterview with the target’s head ofoperations to learn that they had recentlyrenegotiated their supply contracts and hadnot yet implemented an enterprise resourceplanning (ERP) system; both of these factsrefined synergy estimates even more. All ofthis helped during negotiations and dealstructuring (e.g., knowing that it was allright to promise that the target’s mainEuropean location would be retained, but to make no promises about their mainUS facility). Moreover, his involvementensured that he was prepared to act quicklyand decisively to capture savings once thedeal closed.

Another company with substantial acquisi-tion experience left synergy estimation up tothe mergers and acquisitions department,and paid the price. Based on accurate buthigh-level financial analysis (total cost percustomer served), they concluded that therewas no value in integrating customer serviceoperations. Line managers would probablyhave discovered during due diligence that the target’s smaller centers had much lowerlabor productivity but compensated for thiswith an innovative Web servicing program.Consolidating operations could have bothimproved labor productivity and brought the Web servicing program to the acquirer’slarger service center. But they missed the“unfreezing” time immediately following themerger announcement, and the acquirer lostthe opportunity.

Codify experiencesInternal M&A teams should do more tocodify and improve their synergy estimationtechniques. Every deal represents a valuablelesson. Some specific actions we have seenmake a difference include: holding a formalpost-integration debrief session with boththe integration and M&A teams (whichideally should overlap); requiring futureM&A and integration leaders to review the results of past deals; tracking synergiesrelative to plan for two years; andcalculating after the fact what the netpresent value of the transaction turned out to be.

On the other hand, one must not overstatewhat can legitimately be learned fromexperience, since not all deals are alike. One bank balanced what it learned from oneacquisition quite skillfully against theidiosyncrasies of its second majoracquisition. The first had gone badly; the bank underestimated integration costs


by a factor of three. The second went betterbecause executives leading the dealunderstood that they needed to get the cost(and deposit loss) estimates right. Instead of

simply applying theloss data from thefirst merger, whichdid not involvenearly as muchgeographic overlapas the second, theyinvolved a linemanager who hadbeen part of arecent branch

closure program. By applying benchmarkscarefully and involving line management, thebank avoided making the same estimationerror twice.

What’s next?Companies with access to reliable data candevelop sound benchmarks for estimatingrealizable synergies, insights into the sourcesand patterns of error in estimating synergies,and tools to estimate deal synergies.Obviously, these efforts can be thorny, but in our experience they are well worththe effort.

Once companies have a database in place,they can explore other strategic issues, suchas whether some synergies are consistentlyimbedded in the acquisition premium paidwhile others are captured by the acquirer,or whether the stimulating effect of atransaction is even necessary to improve thestandalone performance of an acquirer. The former will obviously inform price-setting and negotiation strategies foracquiring companies, while the latter willlead companies to consider tactics otherthan an acquisition to accomplish the sameends. It’s important to recognize, however,

that a well-designed post-merger integrationeffort can sometimes even do better.7

Companies with access to reliable data can develop sound benchmarks forestimating realistic synergies. They can also find insight into the sources and patterns of error when estimating them.

Scott Christofferson (Scott_Christofferson

@McKinsey.com) is a consultant and Rob McNish

([email protected]) is a principal in

McKinsey’s Washington, DC, office. Diane Sias

([email protected]) is a principal in the New

Jersey office. Copyright © 2004 McKinsey & Company.

All rights reserved.

1 See, for example, Hans Bieshaar, Jeremy Knight, andAlexander van Wassenaer, “Deals that create value,” TheMcKinsey Quarterly, 2001 Number 1, pp. 64–73.

2 Richard H. Thaler, The Winner’s Curse: Paradoxes andAnomalies in Economic Life, Princeton, New Jersey:Princeton University Press, 1992.

3 Based on our experience assisting in the postmergerintegration of about 160 recent mergers and acquisitions.These synergies include such elements as economies ofscale and scope; best practice, capability, and opportunitysharing; and, often, the simple stimulating effect of thecombination on the stand-alone companies.

4 Based on the 124 mergers for which we have relevantdata, these are the 25th and 75th percentile figures. Not allmerging parties experienced customer loss, but some sawmore than 30 percent.

5 In this and other examples derived from our clientexperience, we have altered the figures (but not theproportions) as needed to disguise the company’s identity.

6 For example, in the most recent deal one of the authorswas involved in, the net present value (NPV) of the target(stand-alone value plus “base case” synergies) would havebeen $2.3 billion instead of $2.5 billion if cost synergyestimates had been off 25 percent.

7 In our experience, companies are routinely amazed to findthat the “unbeatable” deal they negotiated with a supplieris inferior to the deal their merger counterpart has—sometimes with the same supplier!

MoF


One client had its head of

operations take the lead in

estimating the savings from

rationalizing manufacturing

capacity, distribution

networks, and suppliers.

Risk is a fact of business life. Taking risk and managing risk are part of whatcompanies must do to create profits andshareholder value. But the corporatemeltdowns of recent years suggest thatmany companies neither manage risk well nor fully understand the risks they are taking.

Indeed, a 2002 survey by McKinsey and thenewsletter Directorship showed that36 percent of participating directors felt theydidn’t fully understand the major risks theirbusinesses faced. An additional 24 percentsaid their board processes for overseeing riskmanagement were ineffective, and 19 percentsaid their boards had no processes. Thedirectors’ unfamiliarity with riskmanagement is often mirrored by seniormanagers, who traditionally focus onrelatively simple performance metrics, suchas net income, earnings per share, or WallStreet’s growth expectations. Risk-adjustedperformance1 seldom figures in thesemanagers’ targets.

Moreover, our research indicates that theproblem goes well beyond a few high-profile

scandals. McKinsey analyzed theperformance of about 200 leading financial-services companies from 1997 to 2002 andfound some 150 cases of significantfinancial distress at 90 of them.2 In otherwords, every second company was struck atleast once, and some more frequently, by a severe risk event. Such events are thus areality that management must deal withrather than an unlikely “tail event.

Companies that fail to improve their risk-management processes face a different kindof risk: unexpected and often severefinancial losses (Exhibit 1) that make theircash flows and stock prices volatile andharm their reputation with customers,employees, and investors.

Improving risk management includes boththe provision of effective oversight by theboard and the integration of riskmanagement into day-to-day decision-making. Companies in some industries havebegun investing in developing sound risk-management processes. For example, manyfinancial institutions—prodded byregulators and shaken by periodic crises likethe US real-estate debacle of 1990, theemerging-markets crisis of 1997, and the bursting of the technology andtelecommunications bubble in 2001—haveworked to upgrade their risk-managementcapabilities over the past decade. In othersectors, such as energy, basic materials, andmanufacturing, most companies still havemuch to learn.

Lining up the essential elementsTo manage risk properly, companies mustfirst understand what risks they are taking.The following steps will go a long waytoward improving corporate riskmanagement.

Running with risk

It’s good to take risks—if you manage them well.

Running with risk | 7

Kevin S. Buehlerand Gunnar Pritsch

Achieving transparencyTo manage risk properly, companies need toknow exactly what risks they face and thepotential impact on their fortunes. Oftenthey don’t. One North American lifeinsurance company had to write offhundreds of millions of dollars as a result of its investments in credit products thatwere high-yielding but structured in a riskymanner. These instruments yielded goodreturns during the 1990s, but the severity of subsequent losses took top managementby surprise.

Each industry faces its own variations onfour broad types of risks; each companyshould thus develop a taxonomy that buildson these broad risk categories. Inpharmaceuticals, for instance, a companycould face business-volume risk if a rivalintroduced a superior drug and higheroperational risk if an unexpected productrecall cut into revenues. In addition, thecompany would have to consider how tocategorize and assess its R&D risk—if a newdrug failed to win approval by the US Food

and Drug Administration, say, or to meetsafety requirements during clinical trials.

Less obviously, a company needs anintegrated view of how the risks differentbusiness units take might be linked and theeffect on its overall level of risk. AmericanExpress, for example, might discover that asharp slump in the airline industry hadexposed it to risk in three ways: business-volume risk in its travel-related servicesbusiness, credit risk in its card business (the risk of reimbursing unused but paid-fortickets), and market risk from investmentsmade in airline bonds or aircraft leases byits own insurance unit.

One way of gaining a transparent,integrated view is to use a heat map: asimple diagram showing the risks (brokendown by risk category and amount) eachbusiness unit bears and an overall view ofthe corporate earnings at risk. Heat mapstag exposures in different colors to highlightthe greatest risk concentrations; red mightindicate that a business unit’s risk accounted


Partly cloudy with a chance of catastrophic loss

1 Through Q1 2003.Source: McKinsey analysis

Disguised example of global financial services firm

–800

–600

–400

–200

0

200

400

600

800

Quarterly cash flows,$ million

Trend line

Quarterly cash flows

1980 1984 1988 1992 1996 2000 20031

090 60120 30 –30 –60 –90 –120 –150 –210 –240 –270 –280 –300 –330 –360Percentage of deviation from trend

Deviation of quarterly cash flows from trend, number of occurrences, Q1 1980–Q1 2003

Negative deviation from trend

Losses are infrequent but can be severe

16

4

15

2

45

3 3 2 0 2 0 0 0 0 0 1 0

EXHIBIT 1

for more than 10 percent of a company’soverall capital, green for more than5 percent. (Exhibit 2 shows a risk heat mapthat flags high credit risk in two units.) Tomake risks transparent—and to draw up anaccurate heat map—companies need aneffective system for reporting risk, and thisrequires a high-performing risk-managementorganization.

Top management should review the heatmaps frequently (perhaps monthly) and theboard should review them periodically (forinstance, quarterly) to foster dialogue and todecide whether the current level of risk canbe tolerated and whether the company hasattractive opportunities to take on more riskand earn commensurately larger returns.

Deciding on a strategyFormulating a risk strategy is one of themost important activities a company canundertake, affecting all of its investmentdecisions. A good strategy makes clear thetypes of risks the company can or is willingto assume to its own advantage, the

magnitude of the risks it can bear, and thereturns it demands for bearing them.Defining these elements provides clarity anddirection for business unit managers whoare trying to align their strategies with theoverall corporate strategy while makingrisk-return trade-offs.

The level of returns required will varyaccording to the risk appetite of the CEO,who should define the company’s riskstrategy with the help of the board. Somemight be happy taking higher risks in pursuitof greater rewards; others might beconservative, setting an absolute ceiling onexposure regardless of returns. At aminimum, the returns should exceed the cost of the capital needed to finance thevarious risks. Instead, the risk profile ofmany companies today evolves inadvertently,every day, by dozens of business andfinancial decisions. One executive, forexample, might be more willing to take risksthan another or have a different view of aproject’s level of risk. The result may be a risk profile that makes the companyuncomfortable or can’t be managedeffectively. A shared understanding of thestrategy is therefore vital.

One common approach for defining anacceptable level of risk is for companies todecide on a target credit rating and thenassess the amount of risk they can bear giventheir capital structure. Credit ratings serve asa rough barometer, reflecting the probabilitythat companies can bear the risks they faceand still meet their financial obligations. Thegreater the level of risk and the lower theamount of capital and future earningsavailable to absorb it, the lower the creditratings of companies and the more they willneed to pay their lenders. Companies thathave lower credit ratings than they desire


A heat-seeking approach

1 Includes equity market and interest rate risks.2 Includes lending, investment, and counterparty risks.Source: McKinsey analysis

Annualized earnings at risk for disguised global financial services company, $ million

Risk concentration

High (>10% of capital)

Medium (>5% of capital)

Credit risk2

Operational risk

Business-volume risk

Total earnings at risk

Total market risk1

5

10

15

720

432

1,290

395

2,837

5

2

5

12

25

10

40

15

90

275

150

625

10

1,060

60

30

125

25

240

270

210

350

275

1,105315

N/A N/A

N/A

Business unit

Other TotalFEDCBA

80

30

150

55

EXHIBIT 2

will likely need to reduce their risk exposureor to raise costly additional capital as acushion against that risk.

As with any strategy, a company’s riskstrategy should be “stress-tested” againstdifferent scenarios. A life insurancecompany, for example, should examine howits returns would vary under differenteconomic conditions and ensure that it feltcomfortable with the potential market andcredit losses (or with its ability torestructure the portfolio quickly) in difficulteconomic times. If it isn’t comfortable, thestrategy needs refining.

Creating a high-performing risk-management groupThe task of a risk organization is toidentify, measure, and assess riskconsistently in every business unit and thento provide an integrated, corporate-wideview of these risks, ensuring that their sumis a risk profile consistent with thecompany’s risk strategy. The structure ofsuch organizations will vary according tothe type of company. In a complex anddiverse conglomerate, such as GE, eachbusiness might need its own risk-management function with specializedknowledge. More integrated companiesmight keep more of the function under thecorporate wing. Whatever the structure,certain principles are nonnegotiable.

Top-notch talent. Risk executives at boththe corporate and the business-unit levelmust have the intellectual power to advisemanagers in a credible way and to insistthat they integrate risk-return considerationsinto their business decisions. Riskmanagement should be seen as an upwardcareer move. A key ingredient of manysuccessful risk-management organizations is

the appointment of a strong chief riskofficer who reports directly to the CEO orthe CFO and has enough stature to be seenas a peer by business unit heads.

Segregation of duties. Companies mustseparate employees who set risk policy andmonitor compliance with it from those whooriginate and manage risk. Salespeople, forinstance, are transaction driven—not thebest choice for defining a company’sappetite for risk and determining whichcustomers should receive credit.

Clear individual responsibilities. Risk-management functions call for clear jobdescriptions, such as setting, identifying, andcontrolling policy. Linkages and divisions ofresponsibility also need to be defined,particularly between the corporate risk-management function and the business units.

Risk ownership. The existence of acorporate risk organization doesn’t absolvebusiness units of the need to assume fullownership of, and accountability for, therisks they assume. Business units understandtheir risks best and are a company’s firstline of defense against undue risk taking.

Encouraging a risk cultureThese elements will go a long way towardimproving risk management but are unlikelyto prevent all excessive or recklesslyconservative risk taking. Companies mightthus impose formal controls—for instance,trading limits. Indeed, the recently adoptedSarbanes-Oxley Act in the United States,makes certifying the adequacy of the formalcontrols a legal requirement. Yet sincetoday’s businesses are so dynamic, it isimpossible to create processes that coverevery decision involving risk. Instead,companies need to nurture a risk culture.


The goal is not just to spot immediately themanagers who take big risks but also toensure that managers instinctively look atboth risks and returns when makingdecisions.

To create a risk culture, companies need aformal, company-wide process to reviewrisk, with individual business unitsdeveloping their own risk profiles, whichare then aggregated by the corporate center.Such reviews help ensure that managers atall levels understand the key risk issues andknow how to deal with them. Drawing up amonthly heat map is one way of establishinga formal risk-review process.

But more needs to be done. By focusing onrisk-adjusted performance, not just ontraditional accounting measures, businessmanagers will develop a better under-standing of the risk implications of theirdecisions. For businesses that require largeamounts of risk capital, suitable metricsinclude shareholder value analysis and risk-adjusted returns on capital. A risk-adjustedlens helped one credit card companyunderstand, contrary to expectations, thatreturns from new customers and customersabout whom it had little information weremore volatile than returns from existingcustomers, even if these groups had the sameexpected customer value. Now the approvalprocess also takes into account the higherrisk that is associated with new customers.

Companies must also provide education andtraining in risk management, which formany managers is quite unfamiliar, andestablish effective incentives to encouragethe right risk-return decisions at the frontline. Judging the performance of businessunit heads on net income alone, forinstance, could encourage excessive risk

taking; risk-adjusted performance should beassessed, too. Ultimately, people must beheld accountable for their behavior. Goodrisk behavior should be acknowledged andrewarded and clear penalties handed out toanyone who violates risk policy andprocesses.

Finally, to convey the message that thepotential downside of every decision mustbe considered as carefully as the potentialrewards, CEOs should be heard talkingabout risk as well as returns, in order toemphasize the importance of risk/returntrade-offs. The CEO’s open recognition ofthe importance of good risk managementwill influence the entire company.

Even world-class risk management won’teliminate unforeseen risks, but companiesthat successfully put the four best-practiceelements in place are likely to encounterfewer and smaller unwelcome surprises.Moreover, these companies will be betterequipped to run the risks needed to enhance the returns and growth of theirbusinesses.

Kevin Buehler ([email protected]) is a

principal and Gunnar Pritsch (Gunnar_Pritsch

@McKinsey.com) is an associate principal in

McKinsey’s New York office. Copyright © 2004

McKinsey & Company. All rights reserved.

1 Measures of risk-adjusted performance revise accountingearnings to take into consideration the level of risk acompany assumed to generate them.

2 For this analysis, we defined financial distress as abankruptcy filing, a ratings-agency downgrade of two ormore notches, a sharp decline in earnings (50 percent ormore below analysts’ consensus estimates six monthsearlier), or a sharp decline in total returns to shareholders(at east 20 percent worse than the overall market in anyone month).

MoF


The CFO’s central role

Whether leading or supporting the effort, the CFO

often ends up at the center of risk management.

A company’s CEO may be the person who

sets broad risk guidelines and approves an

overall strategic risk plan. But to build and

maintain an effective risk-management

approach, it often falls to the chief financial

officer to play the central executive role.

Although the nature and extent of their role

varies, CFOs are uniquely situated to build

and communicate an integrated risk view,

optimize business decisions, and build a

strong risk culture.

In some organizations, such as financial

institutions and commodity trading companies,

the risk-measurement team typically reports

directly to the CEO. For others, such as

processing companies or consumer-services

companies, the risk group reports to the CFO.

Whatever reporting structure is chosen, the

crucial element is that the CFO and the chief

risk officer must be closely aligned. In this way

the CFO and the risk-measurement group can

provide solid direction to boards and senior

management who are currently struggling to

understand risk.

The CFO’s financial-reporting role

provides natural insight into the universe of

risks across various business units and the

impact that those risks, either alone or in

combination, can have on the corporation as

a whole. The CFO can leverage the finance

organization’s existing infrastructure to build

an integrated-risk view, such as a risk heat

map, and earnings-risk profile. A better

understanding of risks and their impact on

earnings can significantly improve the

planning/budgeting and investor-

communication processes. It allows

companies to communicate the impact of

certain market events—for example, a dollar-

per-barrel increase in the cost of oil—

on their overall earnings and adjust

expectations accordingly.

Unique risk insights can permit a CFO to

drive more effective strategy and business

decisions, particularly in lining up the

organization’s capital structure with its

strategy. This is a dynamic process that shifts

with company strategies and external market

changes. Obviously, an overly aggressive

balance sheet can lead to higher risk of

downgrade and even bankruptcy. Conversely,

an overly conservative balance sheet can also


Joseph M. Cyriacand Bryan Fisher

Viewpoint

be undesirable, leading to lower utilization of

tax shields.

CFOs can also assist in mitigating the price

risk of certain business decisions. For

example, after the risk organization at one

processing company

executed a hedging

strategy to mitigate

the earnings risks

embedded in fixed-

price contracts, it

enabled a business

unit to sell such

contracts to

customers. It was the

CFO’s organization

that quantified the risk

premium to embed in customer contracts and

that determined which hedging contracts the

company should buy to mitigate risk. This

resulted in increased sales to customers who

preferred this contracting arrangement (versus

a formula price) and increased earnings

certainty for the organization. Elsewhere, the

CFO of a basic-materials company was

instrumental in aligning sales and purchasing

practices to ensure that market shifts in terms

of prices and risks were considered in future

contracts and pricing.

Finally, CFOs can also play a significant role in

building a strong risk culture. This should

include providing greater transparency into

business-unit-level performance and

implementing a full complement of risk-related

performance metrics across the organization.

For example, at one manufacturing company,

one business-unit president’s performance was

historically based on the overall profitability of

the division—even though the business-unit

president controlled only 15 percent of the

factors driving profitability. By isolating and

measuring controllable factors, including sales

contracts and marketing expenditures, from

factors such as commodity price swings that

cannot be controlled, the CFO initiated more

accurate and transparent measurements of

actual performance. In one large industrial

processing company, management was unable

to measure the performance of its purchasing

organization due to the blending of different

activities (e.g., hedging, commercial

optimization) into one general guideline. The

CFO steered the company toward clearly

articulating levels of risk it could accept and

related metrics and guidelines that made the

links between performance goals and overall

risk policy clearer.

Joseph Cyriac ([email protected])

is an associate principal in McKinsey’s New York

office, and Bryan Fisher (Bryan_Fisher

@McKinsey.com) is an associate principal in the

Houston office. Copyright © 2004 McKinsey &

Company. All rights reserved.

MoF

Viewpoint: The CFO’s central role | 13

Unique risk insights can

permit a CFO to drive more

effective strategy and

business decisions,

particularly in lining up the

organization’s capital

structure with its strategy.

What is stock indexmembership worth?

Gaining—or losing—a place in a major stockindex has only short-term impact on shareprice: about 45 days.

What is it worth for a company to beincluded in an important equity index suchas the S&P 500? A great deal, it wouldappear, judging by how frequently executivesadmit that the planning and timing ofacquisitions, divestitures, and other strategymoves are influenced by the effect theiractions may have on gaining or preservingmembership in an equity index club.

Or is it? Research we conducted into thephenomenon of inclusion in the S&P 500indicates that executives are right to believethat gaining entry to or dropping out of amajor index does indeed move a company’sshare price. But that effect is short-lived,we found, and inclusion in a major index isnot a factor in a company’s long-termvaluation in the capital market.1 Theimplication: executives should plan andpursue a strategy irrespective of whether itexcludes them from a major index or gainsthem access to one.

On the surface, the arguments for being amember of an index have appeal becausemany large, institutional investors trackindexes such as the S&P 500 by investing

in its stocks. Once a stock is added to theindex, it is argued, demand will increasedramatically—and along with it the shareprice—as institutional investors rebalancetheir portfolios. And as long as that demand continues, so will the stock’s price premium.

Adjustments to the S&P 500 index in 2002did nothing to dispel the myth. When sevennon-US companies—including Unilever,Nortel, and Shell—were removed from theindex and replaced by the same number ofUS-domiciled companies, the departingcompanies on average lost nearly7.5 percent of their value in the three days following announcement. Newentrants—including UPS, Goldman Sachs,and eBay—gained around 3 percent overthe same period.

A short-lived premiumWe decided to test whether inclusionprovided a longer-term strategic advantage,and we analyzed the price effect of theinclusion of 1032 US-listed stocks in theS&P 500 index since December 1999.Academic research3 has focused largely onshort-term price patterns around indexchanges to determine how investors mightstructure profitable trading strategiesaround inclusion. We focused instead onlonger-term price effects to see whether aplace in the index creates a lasting price premium.

To determine whether or not index inclusionmade a difference, we estimated theabnormal stock returns over an 80-day testperiod (from 20 days before the effectivedate of inclusion to 60 days after). Clearly,the best measure of abnormal returns4 iswhether the new entrants enjoy a pattern oflasting positive returns, driven by the


Marc H. Goedhartand Regis Huc

inclusion itself. This was clearly not thecase. Indeed, although abnormal returns inthe ten days prior to the effective date didamount to a maximum average around7 percent and a median around 5 percent,they returned to zero within 45 days afterthe effective date (Exhibit 1). In terms ofstatistically significant positive returns, theeffect disappears even sooner—after a mere20 days.

This result is consistent with thephenomenon of liquidity pressure driving upshare prices initially as investors adjust theirportfolios and prices subsequently revertingto “normal” when portfolios are rebalanced.In the end, there was no permanent pricepremium for new entrants to the S&P 500.This underlines the fact that the value of astock is ultimately determined by its cashflow potential, unrelated to membership in amajor equity index. As the S&P 500 isprobably the most widely and intensively

tracked index worldwide, we speculate thatthis holds for other major equity indexes,such as the FTSE 100 and the Dow JonesIndustrial Average, as well.

We also looked at deletions from the S&P500 index over the same period and foundsimilar patterns of temporary price changesaround announcement (Exhibit 2). The pricepressure following exclusion from the S&P500 faded after 40 to 50 days.

Implications for executivesSince no lasting effect on a company’s shareprice can be expected from the simpleinclusion or exclusion effect alone,executives should not refrain from spin-offsand divestitures that would exclude acorporation from a major index. Nor shouldthey pursue major transactions solelybecause these would gain them entry. Ofcourse, other factors behind suchtransactions could well influence a

What is stock index membership worth? | 15

Hello . . .

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

Abno

rmal

retu

rns,

per

cent

2

Number of days

Median

Date of index inclusion1

Average

–20–20 –10 0 10 20 30 40 50 60

–15

–10

–5

0

5

10

15

20

EXHIBIT 1

company’s share price and should be takenvery seriously.

On the other hand, extending our findingsand recommendations to emerging-marketstocks may be inappropriate, because theirinclusion in international equity indexescould represent a form of “recognition” ofquality, sparking analyst coverage andinvestor interest in US or European markets.There, the result could well be a permanentincrease in the company’s stock price as itgains access to these equity markets.

Marc Goedhart ([email protected]) is

an associate principal in McKinsey’s Amsterdam office,

where Regis Huc ([email protected]) is a

consultant. Copyright © 2004 McKinsey & Company.

All rights reserved.

1 See also, for example, B. G. Malkiel and A. Radisich, “Thegrowth of index funds and the pricing of equity securities,”The Journal of Portfolio Management, 2001, Vol. 27,Number 2, pp. 9–21; R. A. Brealey, “Stock prices, stock

MoF

indexes and index funds,” Bank of England QuarterlyBulletin, 2000, Vol. 40, Number 1, pp. 61–8; R. Dash,“Price changes associated with S&P 500 deletions,”Standard & Poor’s, July 9, 2002.

2 A total of 116 stocks were added to the S&P 500 duringthis period including 1 due to a name change, 4 that weresubsequently acquired or delisted and 8 that we eliminatedas outliers because of their extremely negative returns afterinclusion. (Excluding the outliers had no effect on ourconclusions; including them would have resulted in evenlower abnormal returns for the entire sample.)

3 See, for an exception, M. Beniesh and R. Whaley [2002],“S&P 500 index replacements: a new game in town”,Journal of Portfolio Management, Vol. 29, Number 1,pp.1–60. The authors conclude that there is a permanentprice impact from index inclusion when measuring excessreturns of added (or deleted) stocks versus the marketreturn. They acknowledge significant excess returns ofadded stocks versus the market already long before indexinclusion, but they do not incorporate this in their analysis.

4 To account for the return patterns of new entrants prior toindex inclusion, we first estimated a simple market modelfor each of the included stocks over the 250 trading dayspreceding the start of the test period. From this weestimated the abnormal buy and hold returns (BAHR)i forincluded stocks around the effective date of inclusionfollowing the method used by S. P. Kothari and J. B.Warner [1997], “Measuring long-horizon security priceperformance, Journal of Financial Economics, Vol. 43,Number 3, pp. 301–339.


. . . and goodbye

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

Abno

rmal

retu

rns,

per

cent

2

Number of days

Average

Date of index inclusion1

Median

–20–20 –10 0 10 20 30 40 50 60

–15

–10

–5

0

5

10

15

20

EXHIBIT 2

The largest, most successful companies

would seem to be ideally positioned to createvalue for their shareholders through growth.After all, they command leading market andchannel positions in multiple industries andgeographies; they employ deep benches oftop management talent utilizing provenmanagement processes; and they often have healthy balance sheets to fund theinvestments most likely to produce growth.

Yet after years of impressive top- andbottom-line growth that propelled them tothe top of their markets, these companieseventually find they can no longer sustaintheir pace. Indeed, over the past 40 yearsNorth America’s largest companies—those,say, with more than about $25 billion inmarket capitalization—have consistentlyunderperformed the S&P 500,1 with onlytwo short-lived exceptions.

Talk to senior executives at theseorganizations, however, and it is difficult tofind many willing to back off fromambitious growth programs that aretypically intended to double their company’sshare price over three to five years. Yet in

all but the rarest of cases such aggressivetargets are unreasonable as a way tomotivate growth programs that create valuefor shareholders—and may even be risky,tempting executives to scale back valuecreating organic growth initiatives that maybe small or long-term propositions,sometimes in favor of larger, nearer-term,but less reliable acquisitions.

In our experience, executives would bebetter off recognizing the limitations ofsize and revisiting the fundamentals of howgrowth creates shareholder value. Byunderstanding that not all types of growthare equal when it comes to creating valuefor shareholders, even the largest companiescan avoid bulking up on the businessequivalent of empty calories and insteadnourish themselves on the types of growthmost likely to create shareholder value.

What holds them back?At even well-run big companies, growthslows or stops—and for complex reasons.Ironically, for some it’s the natural result ofpast success: their portfolios are weigheddown by large, leading businesses that mayhave once delivered considerable growth, butthat have since matured with their industriesand now have fewer natural avenues forgrowth. At others, management talent andprocesses are more grooved to maintain, notbuild, businesses; and their equity- and cash-rich balance sheets dampen the impactgrowth has on shareholder value. For all ofthem, their most formidable growthchallenge may be their sheer size: it takeslarge increments of value creation to have ameaningful impact on their share price.

The other crucial factor is how managementresponds when organic growth starts tofalter. This is often a function of

Why the biggest and beststruggle to grow

The largest companies eventually find size itselfan impediment to creating new value. They mustrecognize that not all forms of growth are equal.

Viewpoint: Why the biggest and best struggle to grow | 17

Nicholas F. Lawler,Robert S. McNish,and Jean-HuguesJ. Monier

Viewpoint

compensation that ties bonuses to bottom-line growth. In any case, management isoften tempted to respond as if the slowingorganic growth were merely temporary,rejecting any downward adjustment to near-term bottom-line growth.

That may work in the short run, but asindividual businesses strip out controllablecosts, they soon begin to cut into themuscle and bone behind whatever value-richorganic growth potential remains—salesand marketing, new product development,new business development, R&D. At oneindustrial company we are familiar with,management proudly points to each savingsinitiative that allows them to meet quarterlyearnings forecasts.

But the short-term focus on meetingunrealistically high growth expectations canundermine long-term growth. Ultimately,the scramble to meet quarterly numbers willcontinue to intensify as cost cutting furtherdecelerates organic growth. If the situationgets more desperate, management may turnto acquisitions to keep bottom-line growthgoing. But acquisitions, on average, createrelatively little value compared to theinvestment required, while adding enormousintegration challenges and portfoliocomplexity into the mix. Struggling underthe workload, management can lose focuson operations. In this downward spiralmanagement chases growth in ways thatcreate less and less value—and in the endwinds up effectively trading value forgrowth.

Some companies seem to have recognizedthe danger in constantly striving to exceedexpectations. One company’s recent decisionto vest half of its CEO’s stock award forsimply meeting (rather than handily beating)

the five-year share price appreciation of theS&P 500 may be one such bow to goodreason. Ironically, relieving the CEO ofthe pressure to substantially outperform themarket may have given him the freedom heneeds to focus on longer-term investmentsin value-creating organic growth.

All growth is not created equalThe right way for large companies to focuson growth, we believe, is to differentiateamong entire classes of growth on the basisof what we call their value creationintensity.2 The value creation intensity of adollar of top-line growth directly dependson how much invested capital is required tofuel that growth—the more invested capital,the lower the value creation intensity.Sorting growth initiatives this way requiresunderstanding the timeframe in whichshareholder value can be created—as shortas a matter of months for some acquisitionsor more than a decade for some R&Dinvestments. It also requires assessing thesize of an opportunity by the amount ofvalue it creates for shareholders, not merelyhow much top-line revenues it adds. Theseare the particularly crucial factors for verylarge companies, where smaller investmentscan get lost on the management agenda,long-term investments fail to capturemanagement’s imagination, and thetemptation is to invest in highly visible near-term projects with low value creationintensity.

To illustrate, we dipped into M&A researchto see how much value creation even top-notch acquirers can reasonably expect. Wehave also modeled the value creationintensity of four different modes oforganic growth, by estimating results forprototypical organic growth opportunitiesin the consumer packaged goods industry.


While this specific hierarchy of valuecreation intensity may not hold for everyindustry, it can serve as a useful example.

New product/market development tends tohave the highest value creation intensity. Itprovides top-line growth at attractivemargins, since competition is limited and the market is growing. We estimate that theprototypical new product in the consumergoods industry can create between $1.75and $2.00 in shareholder value for everydollar of new revenue. Ironically, while thistype of growth creates the most value, it’sparticularly difficult for really largecompanies. Creating new demand for aproduct that did not previously exist requiresoutstanding innovation capabilities—and bigcompanies that have tightened the screws onoperational performance are notorious forcutting away at research and developmentspending.

Expanding into adjacent markets typicallyrequires incremental invested capital thatleads to lower, though still very attractive,value creation intensity in the range of$0.30 to $0.75 per dollar of new revenue.Facilitating adjacent market expansionrequires outstanding execution skills andorganizational flexibility.

Maintaining or growing share in a growingmarket requires substantial incrementalinvestments to make the product and itsvalue distinctive. But as long as the marketis still growing, margins are not competedaway. As a result, we estimate value creationin the range of $0.10 to $0.50 per dollar ofnew revenue.

Growing share in a stable market does notalways create value. While incrementalinvestments are not always material,

competition for share in order to maintainscale is typically intense, leading to lowermargins. We estimate that increasing sharein a relatively mature market may destroy asmuch as $0.25 or create as much as $0.40of shareholder value for every dollar of newrevenue. And for companies whose growthis already stalling, growth in a stable marketmerely postpones the inevitable.

Acquisitions. While they can drive amaterial amount of top-line growth in the relatively short order, it is now widelyaccepted that the average acquirer capturesrelatively little shareholder value from itsdeals.3 In fact, the numbers suggest thateven an acquirer who consistently enjoys atop-quartile market reaction in each of its deals will create only about $0.20 inshareholder value for every $1 million in revenues acquired.4

Obviously, the size and timing of growthopportunities are determined by businessfundamentals within each industry.Typically, though, they tend to come inrelatively small increments and mature overmultiple years. In the packaged consumergoods industry, one study5 found thatalmost half of product launches had firstyear sales of less than $25 million, and thelargest was only a little more than$200 million. The number of these sorts of top-line growth projects needed to movethe needle for the biggest companies isdaunting. When we stand back from thisanalysis, we can’t help but draw a verydispiriting observation for very largecompanies: there are remarkably fewgrowth opportunities that are large andnear-term and highly value creating all atthe same time. Put another way, the amountof top-line growth required to achieve adoubling in shareholder value varies

Viewpoint: Why the biggest and best struggle to grow | 19

dramatically by mode of growth, and ishuge in even the most favorable modes ofgrowth (Exhibit).

Some executives will no doubt finduncomfortable the shift to a perspective thatemphasizes the value creation intensity ofgrowth initiatives. Though such a shiftwould serve shareholders well, it may alsolead to lower overall levels of top-line andearnings-per-share growth.

Executive credibility will be on the line in communicating this message to themarkets. One executive we’ve worked with,for example, recognized that his companylacked the credibility to quickly lower hisoverall EPS growth targets in favor of aricher mix of value-creating growthwithout getting pummeled by the markets.Instead, the company made one more big

push on operations, letting only enough ofthe savings fall to the bottom line to meetthe company’s short-term growthprojections. The rest of the savings wasredirected toward slower, but more valuecreating, organic growth, with theexpectation that once the company hadbuilt some credibility in that respect withshareholders, it could more easily make itscase to the markets.

When growing gets tough in the largestcompanies, tough executives must learn toget growing in value creating ways. Ratherthan bulk up on the business equivalent ofempty calories, they should explore thevalue creation intensity of different modesof growth to build shareholder valuemuscle.

Nick Lawler ([email protected]) and

Jean-Hugues Monier (Jean-Hugues_Monier

@McKinsey.com) are consultants in McKinsey’s New

York office. Rob McNish (Rob_McNish

@McKinsey.com) is a principal in the Washington, DC,

office. Copyright © 2004 McKinsey & Company. All

rights reserved.

1 Credit Suisse First Boston, “The pyramid of numbers,” The Consilient Observer, Volume 2, Issue 17. September23, 2003

2 Shareholder value creation per dollar of top-line revenuegrowth.

3 See, for example, Hans Bieshaar, Jeremy Knight, andAlexander van Wassenaer, “Deals that create value,” TheMcKinsey Quarterly, 2001 Number 1, pp. 64–73.

4 It is important to note, however, that market-entering orcapability-building acquisitions designed to fuelsubsequent organic growth are more likely to create valuethan market-consolidating acquisitions designed tocapture cost efficiencies.

5 Innen, Steve, Ed. “Innovation awards 2002,” FoodProcessing, December 2002, pp. 35–40.

MoF


Modes of organic growth vary in value creation intensity— consumer goods industry

1 Stylized results based on consumer products examples.2 Assumes a $50 billion market cap, all-stock company with $23 billion of revenue expected to grow at GDP rates and constant return on invested capital (ROIC)

3 Examination of 338 deals revealed short-term value creation for acquirer of 11% for 75th percentile deals and –1% for 50th percentile deals.

Source: McKinsey analysis

New-product market development

Expanding an existing market

Maintaining/growing share in a growing market

Competing for share in astable market

Acquisition (25th to 75th percentile result)3

1.75–2.00

0.30–0.75

0.10–0.50

–0.25–0.40

–0.5–0.20

5–6

13–33

20–100

n/m–25

n/m–50

EXHIBIT

Category of growth

Shareholder value created for incremental $1 million of growth/target acquisition size1

Revenue growth/acquisition size necessary to double typical company’s share price,2 $ billions

Call it investment limbo. After nearly threeyears of historically low interest rates, it’sthe rare company investment strategist whoisn’t puzzling over his or her next move.With interest rates near 40-year lows, someprojects whose returns couldn’t havematched the cost of capital just a few yearsago now have allure. But if strongereconomic growth pushes interest rates up,those projects could spill red ink. Similarly,planners must consider the chance thatprojects with lower returns on investedcapital (ROIC) than they’ve becomeaccustomed to might pay off—but wouldlower a company’s average return.

In our experience, companies need to beaware of the temptations and traps thatlurk in this environment. With signs ofeconomic recovery becoming morewidespread, it will take close analysis todetermine if today’s marginal projects willbecome tomorrow’s winning growthplays—or if a turnaround in interest rateswill threaten their value altogether. Thesmartest response, we believe, includes anobjective look at real investment costs anda thorough reexamination of what

constitutes realistic returns. Only then cancompanies confidently assess investmentoptions and pursue growth strategies ratherthan sit passively on the sidelines whilecompetitors capture the best availableinvestment opportunities.

Reexamining the cost of capitalIf management teams could lock in today’slow cost of capital as easily as a home ownerlocks in a long-term interest rate, investingwould be easy. Since they cannot,1

companies must be particularly careful inassessing a project’s potential value. The bestassessment should not only take into accountboth the real cost of capital and an estimateof inflation. It should also ensure that thesame inflation rate is explicitly included inanalyses of a project’s cash flow as is used inestimates of cost of capital. The fact is thatin general projects that were unattractive inthe past do not magically become attractivejust because interest rates drop.

This is a crucial point for many companies,particularly those whose various investmentteams either don’t interact or don’tunderstand the varying approaches theyemploy to estimate a prospective project’scost of capital and approximate cash flow.As a result, companies sometimes overlookthe fact that lower inflation rates shouldproduce lower nominal cash flow forecasts,offsetting a lower discount rate. Forexample, in November the inflationexpectations as reflected in ten-yearUS Treasury bonds were about 2 to2.25 percent, nearly a full point lower thanin January 1997. Companies evaluatinginvestment projects in November, therefore,should have assumed a 2 to 2.25 percentinflation rate when calculating both thecost of capital and when calculatingnominal growth rates and revenues. If a

Investing when interestrates are low

Projects that wouldn’t have created value becauseinterest rates were higher aren’t necessarilyattractive when interest rates drop.

Investing when interest rates are low | 21

Timothy M. Koller,Jiri Maly andRobert N. Palter

Viewpoint


team analyzing an investment updated itscost of capital calculations but not itsgrowth and revenue calculations, its overallassessment of any given project would

inevitably overstatethe project’s value.

Another criticalpoint oftenoverlooked bycompanies is thatlower real interestrates on governmentbonds don’t alwayslead to lower real

costs of equity. For example, with realgovernment bond rates around 2 percent atthe time of this writing—after more than15 years of hovering around 3 percent—many companies also reduced their estimatesof the cost of equity. Over the past year, wehave seen nominal cost of equity estimates inthe range of 7.5 to 8 percent.2 However,recent research by some of our colleagues3

demonstrates that the nominal cost of equityis probably closer to 9 percent, including a7 percent real cost of equity and a 2 percentexpected inflation rate.4 Indeed, the real costof equity appears to be more stable than thereal risk-free rate, suggesting that whileinterest rates may decline, investors’demands for higher risk premiums likelyoffset the effect of interest rate declines onthe nominal cost of equity.

Setting a better hurdle rateFinance theory suggests that companiesshould invest in all projects that earn justslightly more than the cost of capital—the rate at which investors will discountcash flows to estimate a company’s value.Even when the analytics are correct,companies are often concerned that such

low-return projects run a high risk ofwinding up destroying value, since theyprovide no margin for shareholders and will always run some risk of encounteringnegative developments.

Theory aside, there are valid reasons forcompanies to set hurdle rates above—and insome cases, even well above—the cost ofcapital. A better approach, we believe, is tobase hurdle rates on a periodic assessmentof industry microeconomic fundamentals to determine the likely range of returns forthe industry over an appropriate cycle. Thisapproach ensures that project teams arepursuing only the best opportunitiesavailable within a sector and not settling forprojects that may be easier to identify andexecute but that will yield lower returns.

For example, companies in industries suchas pharmaceuticals and branded consumerproducts frequently earn returns on capitalexceeding 30 percent after-tax. For thesecompanies, it is harder to find and developmanagement talent than it is to get thenecessary capital to pursue availableopportunities. So it makes sense not toinvest in projects with returns at only10 percent—even though that maytechnically be more than the company’s cost of capital.

Oil companies provide a good example ofevaluating projects based on expected long-term industry fundamentals. While crudeprices are relatively high today by historicalstandards, and constitute an equivalent tolow costs of capital, the volatility in crudeoil prices driven by short-term supply/demand fluctuations through the past30 years has taught petroleum companies to use a crude price based more on

The fact is that in general

projects that were

unattractive in the past do

not magically become

attractive just because

interest rates drop.

Investing when interest rates are low | 23

fundamentals to evaluate new projects. Assuch, today, most leading crude companiesundertake their assessment at $18 to $20per barrel, which is more representative of alonger-term average price for crude. If newdevelopments are economically attractive atthis price level, oil majors will likelyproceed with an investment, even thoughthe price is well below current oil prices.

Dealing with ROIC dilutionCompanies also express concerns thatinvesting today even in projects that aremodestly positive on a net present value

basis runs the riskof diluting averagereturn on investedcapital. Manyprojects developedwhen interest rateswere higher nowearn returnsconsiderably abovethe currentweighted average

cost of capital, and today’s investmentopportunities have difficulty matching them.Many managers are therefore reluctant tomake such investments and are inclinedsimply to sit on their capital, waiting for abetter investment environment.

That may be a dangerous practice. Investors value both growth and return oninvested capital, and managers need tofigure out the best trade-offs andcommunicate their decisions to the market.The decision to dilute a company’s averagereturn on capital is a difficult one and thereare no universal solutions. We thinkcompanies should address this issue byasking themselves several questions: Havethe long-term economics of the industry

declined as the industry matured, and doyou therefore need to reduce your expectedreturns on capital? Does the stock marketalready incorporate its expectations of lowerfuture returns in industry share prices? Willyou get shut out of future growthopportunities by passing up investmentstoday that will make you stronger over thelong term? If a company answers yes tosome or all of these questions, it might betime to start preparing for lower averagereturns on capital.

Getting the most out of today’s low interestrates isn’t as simple as refinancing a home.To navigate the crosscurrents of this low-interest-rate environment, companiesrequire realistic assessment of theirinvestment costs, their breakeven points,and their need to stay active with newinvestments rather than waiting passivelyfor a new interest rate environment toimprove their competitive position.

Tim Koller ([email protected]) is a principal

in McKinsey’s New York office, Jiri Maly (Jiri_Maly

@McKinsey.com) is an associate principal in the

Toronto office, where Rob Palter (Robert_Palter

@McKinsey.com) is a principal. Copyright © 2004

McKinsey & Company. All rights reserved.

1 While it is possible for a finite period to lock in the low costof debt (through fixed interest rate obligations), it is notpossible to lock in the cost of equity.

2 Risk-free rate of 4 percent plus 3.5 to 4 percent equity riskpremium.

3 Marc H. Goedhart, Timothy M. Koller, and Zane D.Williams, “The real cost of equity,” McKinsey on Finance,Number 5, Autumn 2002, pp. 11–15.

4 The real cost of equity is very stable at about 7 percent,and the equity risk premium varies inversely with realinterest rates.

MoF

Theory aside, there are

valid reasons for companies

to set hurdle rates above—

and in some cases, even

well above—the cost of

capital.

Number 9, Autumn 2003■ Restructuring alliances in China ■ Alliances in China: The view from the

corporate suite■ Smarter investing for insurers■ A closer look at the bear in Europe

Number 8, Summer 2003■ Multiple choice for the chemicals industry■ Living with lower market expectations■ Managing your integration manager■ Accounting: Now for something really different

Number 7, Spring 2003■ An early warning system for financial crises■ Are emerging markets as risky as you think?■ Time for a high-tech shakeout■ Getting what you pay for with stock options■ Much ado about dividends

Number 6, Winter 2003■ The special challenge of measuring industrial

company risk■ Anatomy of a bear market■ Better betas

■ Merging? Watch your sales force■ More restructuring ahead in media and

entertainment

Number 5, Autumn 2002■ Restating the value of capital light■ Measuring alliance performance■ The real cost of equity■ The CFO guide to better pricing

Number 4, Summer 2002■ Divesting proactively■ What makes your stock price go up

and down?■ Who’s afraid of variable earnings?■ Stock options—the right debate

Number 3, Winter 2002■ Beyond focus: Diversifying for value■ Time for CFOs to step up■ Moving up in a downturn■ Corporate governance develops in

emerging markets■ A new way to measure IPO success

Index of articles: 2002–2003Past issues can be downloaded from the McKinsey website at http://www.corporatefinance.mckinsey.com.

A limited number of past issues are available by sending an e-mail request to the address above.

AMSTERDAMANTWERP

ATHENSATLANTA

AUCKLANDAUSTIN

BANGKOKBARCELONA

BEIJINGBERLIN

BOGOTABOSTON

BRUSSELSBUDAPEST

BUENOS AIRESCARACAS

CHARLOTTECHICAGO

CLEVELANDCOLOGNE

COPENHAGENDALLAS

DELHIDETROIT

DUBAIDUBLIN

DÜSSELDORFFRANKFURT

GENEVAGOTHENBURG

HAMBURGHELSINKI

HONG KONGHOUSTONISTANBULJAKARTA

JOHANNESBURGKUALA LUMPUR

LISBONLONDON

LOS ANGELESMADRIDMANILA

MELBOURNEMEXICO CITY

MIAMIMILAN

MINNEAPOLISMONTERREY

MONTRÉALMOROCCO

MOSCOWMUMBAIMUNICH

NEW JERSEYNEW YORK

OSLOPACIFIC NORTHWEST

PARISPITTSBURGH

PRAGUEQATAR

RIO DE JANEIROROME

SAN FRANCISCOSANTIAGO

SÃO PAULOSEOUL

SHANGHAISILICON VALLEY

SINGAPORESTAMFORD

STOCKHOLMSTUTTGART

SYDNEYTAIPEI

TEL AVIVTOKYO

TORONTOVERONAVIENNA

WARSAWWASHINGTON, DC

ZAGREBZURICH

MoF Issue 10

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Transcript of MoF Issue 10