McKinsey on Finance

Number 38, 2 16 27
Winter 2011 How the growth A return to The myth of smooth
of emerging markets deal making in earnings
Perspectives on will strain global 2010
Corporate Finance finance
and Strategy
10 21
How CFOs can keep Past lessons
strategic decisions for China’s new
on track joint ventures
McKinsey on Finance is a quarterly Editorial Board: David Cogman, Copyright © 2011 McKinsey & Company.
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 1

McKinsey on Finance
Number 38, Winter 2011

2 10 16
How the growth How CFOs can keep A return to deal
of emerging strategic decisions making in 2010
markets will strain on track M&A volumes rose last
global finance year for the first
The finance chief is often
Surging demand for well placed to guard time since the crisis.
capital, led by developing against common decision- Capital markets
economies, could put making biases. think deals created
upward pressure on more value too.
interest rates and crowd
out some investment.

21 27
Past lessons for The myth of
China’s new smooth earnings
joint ventures
Many executives strive
As multinationals revive for stable earnings growth,
interest in collaborating but research shows
with Chinese partners, the that investors don’t worry
lessons of past ventures about variability.
bear remembering.
2

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, Short-term doldrums aside, the world’s corpor- on the global financial system. The McKinsey
Susan Lund, and ations would seem to be in a strong position Global Institute’s (MGI) recent analysis finds that
Andreas Schreiner to grow as the global economy recovers. They enjoy by 2030, the world’s supply of capital—that is,
healthy cash balances, with $3.8 trillion in its willingness to save—will fall short of its demand
cash holdings at the end of 2009, and they have for capital, or the desired level of investment
access to cheap capital, with real long-term needed to finance all those projects.1 Indeed,
interest rates languishing near 1.5 percent. household saving rates have generally declined in
Indeed, as developing economies continue to pick mature economies for nearly three decades,
up the pace of urbanization, the prognosis and an aging population seems unlikely to reverse
for companies that can tap into that growth over that trend. China’s efforts to rebalance its
the next decade looks promising. economy toward increased consumption will
reduce global saving as well.
Yet all those new roads, ports, water and power
systems, and other kinds of public infrastructure— The gap between the world’s supply of, and demand
and the many companies building new plants for, capital to invest could put upward pressure
and buying machinery—may put unexpected strains on real interest rates, crowd out some investment,
 3

and potentially act as a drag on growth. Moreover, compared with about $11 trillion in 20083
as patterns of global saving and investment (Exhibit 1). When we examine alternative growth
shift, capital flows between countries will likely scenarios, we find that investment will still
change course, requiring new channels of financial increase from current levels, though less so in
intermediation and policy intervention. These the event of slower global GDP growth.
findings have important implications for business
executives, investors, government policy makers, The mix of global investment will shift as
and financial institutions alike. emerging-market economies grow. When mature
economies invest, they are largely upgrading
Surging demand for capital their capital stock: factories replace old machinery
Several economic periods in history have required with more efficient equipment, and people
massive investment in physical assets such as make home improvements. But the coming in-
infrastructure, factories, and housing.2 These eras vestment boom will involve relatively more
include the industrial revolution and the post– investment in infrastructure and residential real
World War II reconstruction of Europe and Japan. estate. Consider the fact that emerging economies
We are now at the beginning of another investment already invest in infrastructure at a rate more
boom, this time fueled by rapid growth in than two times higher than that of mature
emerging markets. economies (5.7 percent of GDP versus 2.8 percent,
respectively, in 2008). The gap exists in all
Across Africa, Asia, and Latin America, the categories of infrastructure but is particularly
demand for new homes, transport systems, water large in transportation (for instance, roads,
systems, factories, offices, hospitals, schools, airports, and railways), followed by power and
and shopping centers has already caused water systems. We project global investment
investment to jump. The global investment rate demand of about $4 trillion in infrastructure and
increased from a recent low of 20.8 percent $5 trillion in residential real estate in 2030,
of GDP in 2002 to 23.7 percent in 2008 but then if the global economy grows in line with the
dipped again during the global recession of consensus of forecasters.
2009. The increase from 2002 through 2008
resulted primarily from the very high investment A decline in savings
rates in China and India but reflected higher The capital needed to finance this investment
rates in other emerging markets as well. comes from the world’s savings. Over the
Considering the very low levels of physical-capital three decades or so ending in 2002, the global
stock these economies have accumulated, our saving rate (saving as a share of GDP) fell,
analysis suggests that high investment rates could driven mainly by a sharp decline in household
continue for decades. saving in mature countries. The global rate
has increased since then, from 20.5 percent of GDP
In several scenarios of economic growth, we project in 2002 to 24 percent in 2008, as household
that global investment demand could exceed saving rebounded in mature economies and many
25 percent of GDP by 2030. To support growth in of the developing countries with the highest
line with the forecasters’ consensus, global rates—particularly China—have come to account
investment will amount to $24 trillion in 2030, for a growing share of world GDP. Our analysis
4 McKinsey on Finance Number 38, Winter 2011

MoF 38 2011
MGI Global capital
Exhibit 1 of 3

Exhibit 1 In 2030, global demand for investment

is expected to reach $24 trillion.
Global investment1 for selected years, $ trillion Compound annual growth
rate (CAGR), %

1981–2008 2008–30
24.0 projected

4.9 Residential real estate 3.8 3.8

3.7 Infrastructure 3.3 4.0

10.7
2.1 Other productive
1.6 15.4 investment—eg, 3.0 3.7
4.6 commercial buildings,
0.8 factories, and machinery
0.7 7.0
3.1
1981 2008 2030
projected

1 Atconstant 2005 prices and exchange rates; forecast assumes price of capital goods increases at same
rate as other goods and assumes no change in inventory.
Source: Economist Intelligence Unit; Global Insight; Oxford Economics; World Development Indicators,
World Bank; McKinsey Global Institute analysis

suggests, however, that the global saving rate is not consumption, it would reduce the 2030 global
likely to rise in the decades ahead, as a result saving rate by around two percentage points
of several structural shifts in the world economy. compared with 2007 levels—or about
$2 trillion less than China would have accumulated
First, China’s saving rate will probably decline by 2030 at current rates.
as it rebalances its economy so that domestic
consumption plays a greater role. In 2008, China Moreover, expenditures related to aging populations
surpassed the United States as the world’s will increasingly reduce global saving. By
largest saver, with the national saving rate reaching 2030, the proportion of the population over the
over 50 percent of GDP. But if China follows age of 60 will reach record levels around the
the historical experience of other countries, its world. The cost of providing health care, pensions,
saving rate will decline over time as the country and other services will rise along with the
grows richer, as happened in Japan, South ranks of the elderly. Recent research suggests that
Korea, Taiwan, and other economies (Exhibit 2). spending for the retired could increase by about
It is unclear when this process will begin, but 3.5 percentage points of global GDP by 2030.5
already the country’s leaders have started to adopt All of this additional consumption will lower global
policies that will increase consumption and saving, either through larger government
reduce saving. 4 If China succeeds at increasing deficits or lower household and corporate saving.
 How the growth of emerging markets will strain global finance 5

Skeptics may point out that households in the Together, these trends mean that if the consensus
United States and the United Kingdom forecasts of GDP growth are borne out, the
have been saving at higher rates since the 2008 global supply of savings will be around 23 percent
financial crisis, especially through paying of GDP by 2030, falling short of global invest-
down debt. In the United States, household saving ment demand by $2.4 trillion. This gap could slow
rose to 6.6 percent of GDP in the second global GDP growth by around one percentage
quarter of 2010, from 2.8 percent in the third point a year. What’s more, sensitivity analysis of
quarter of 2005. In the United Kingdom, several scenarios suggests that a similar gap
saving rose from 1.4 percent of GDP in 2007 occurs even if China’s and India’s GDP growth
to 4.5 percent in the first half of 2010. But slows, the world economy recovers more slowly
even if38
MoF these rates persist for two decades, they
2011 than expected from the global financial crisis,
wouldGlobal
MGI increasecapital
the global saving rate by just or other plausible possibilities transpire,
Exhibit 2 of 3point in 2030—not enough
one percentage such as exchange-rate appreciation in emerging
to offset the impact of increased consumption markets or significant global investment to
in China and of aging. combat and adapt to climate change (Exhibit 3).

Exhibit 2 Historically, as countries grow wealthier their household

saving rates decline.
Household saving rate and GDP per capita for selected countries, 1960–2008

Saving rate, % of disposable

personal income
40
China
35
Taiwan
30
25
India Japan
20
15
Germany
10
5
South Korea United States
0
–5
0 5 10 15 20 25 30 35 40 45
Real GDP per capita,1
$ thousand

1 At constant 2005 prices and exchange rates.

Source: Bank of Japan, Bank of Korea; Directorate-General Budget Accounting and Statistics, Republic
of China; Global Insight; Reserve Bank of India; US Bureau of Economic Analysis; World Development Indicators,
World Bank; McKinsey Global Institute analysis
6 McKinsey on Finance Number 38, Winter 2011

Implications anticipate this structural shift. Furthermore, the

Our analysis has important implications for move upward isn’t likely to be a one-time
both business leaders and policy makers. adjustment, since the projected gap between
Businesses and investors will have to adapt to the demand for and the supply of capital
a new era in which capital costs are higher widens continuously from 2020 through 2030.
and emerging markets account for most of the
world’s saving and investment. Governments Capital costs could easily go even higher. Real
will play a vital role in setting the rules interest rates can also include a risk premium to
and creating the conditions that could facilitate compensate investors for the possibility that
this transition. inflation might increase more than expected.
History shows that real interest rates rise
Higher capital costs when investors worry about the possibility of
Nominal and real interest rates are currently unexpected spikes in inflation. Today, investors are
at 40-year lows, but both are likely to rise beginning to anticipate higher inflation resulting
in coming years. If real long-term interest rates from expansive monetary policies that major
returned to their 40-year average, they would governments have pursued.
rise by about 150 basis points from the level seen
in the autumn of 2010. The growing imbalance Finally, as the recent crisis demonstrated, short-
between the supply of savings and the demand for term capital isn’t always available in a capital-
investment
MoF 38 2011capital will be significant by 2020. constrained world. Companies should seek more
However, real long-term
MGI Global capital rates—such as the stable (though also more expensive) sources of
real yield 3
Exhibit onof
a ten-year
3 bond—could start rising funding, reversing the trend toward the increasing
even within the next five years as investors use of short-term debt over the past two decades.

Exhibit 3 Even if investment demand slows, the supply

of savings still falls short.
Global investment demand and saving rate as % of global GDP

2030 scenarios

Consensus Slower long-term Weak global

global growth growth in China recovery
and India
Global demand for investment 25.1 23.7 23.6

Global saving rate 22.6 21.3 22.7

2030 savings shortfall $2.4 trillion $2.2 trillion $0.8 trillion

Source: Economist Intelligence Unit; Global Insight; Oxford Economics; World Development Indicators,
World Bank; McKinsey Global Institute analysis
How the growth of emerging markets will strain global finance 7

As incomes in emerging markets rise and capital

markets develop, nonfinancial businesses
can expect healthy growth from investing in
both physical and financial assets.

The portion of all debt issued for maturities durables companies, for example, would find
of less than one year rose from 23 percent in the it increasingly difficult to achieve the high
first half of the 1990s to 47 percent in the returns of the recent past as the cost of funding
second half of the 2000s. Financing long-term increases. Companies whose sales depend
corporate investments through short-term on easily available consumer credit would find
funding will be riskier in the new world, compared growth harder to achieve.
with financing through equity and longer-term
funding. To better align incentives, boards Shifting investor strategies
should revisit some of their inadvertent debt- Investors will want to rethink some of their
oriented biases, such as using earnings per share strategies as real long-term interest rates rise.
(EPS) as a performance metric. In the short term, any increase in interest
rates will mean losses for current bondholders.
Changing business models But over the longer term, higher real rates
If capital costs increase, companies with higher will enable investors to earn better returns from
capital productivity—greater output per fixed-income investments than they have in
dollar invested—will enjoy more strategic flexibility the years of cheap capital. This change could shift
because they require less capital to finance some investment portfolios back to traditional
their growth. Companies with direct and privi- fixed-income instruments and deposits and
leged sources of financing will also have a away from equities and alternative investments.
clear competitive advantage. Traditionally, this
approach meant nurturing relationships with For pension funds, insurers, endowments,
major financial institutions in financial hubs such and other institutional investors with multidecade
as London, New York, and Tokyo. In the future, it liabilities, the world’s growing infrastructure
might also mean building ties with additional investment could be an attractive opportunity.
sources of capital, such as sovereign-wealth funds, Many of these institutions, however, will
pension funds, and other financial institutions need to improve their governance and incentive
from countries with high saving rates. structures, reducing pressure to meet quarterly
or annual performance benchmarks based on mark-
Moreover, for companies whose business models to-market accounting and allowing managers
rely on cheap capital, an increase in real long- to focus on longer-term returns. This change would
term interest rates would significantly reduce their be required as institutions come to manage
profitability, if not undermine their operations. portfolios with a growing proportion of less liquid,
The financing and leasing arms of consumer- long-term investments, since volatility in market
8 McKinsey on Finance Number 38, Winter 2011

prices may reflect market liquidity conditions encourage more saving and domestic investment,
rather than an investment’s intrinsic, long-term rebalancing their economies so they depend less on
value.6 consumption to fuel growth. Policy makers in
these countries, particularly the United Kingdom
Emerging markets, though they may present and the United States, should start by putting
attractive opportunities, also pose many in place mechanisms to sustain recent increases in
risks and complexities, and returns could vary household saving. They could, for instance,
significantly across countries. As incomes implement policies that encourage workers to
in emerging markets rise and capital markets increase their contributions to saving plans, enroll
develop, nonfinancial businesses can expect in pension plans, and work longer than the
healthy growth from investing in both physical and current retirement age. Further, governments can
financial assets. Returns to financial investors themselves contribute to gross national savings
are less certain, however, particularly in countries by cutting expenditures.
with low returns on capital or savings trapped
in domestic markets by capital controls or a “home To replace consumption as an engine of economic
bias” among domestic savers and investors.7 growth, governments in these countries also
These countries will remain susceptible to bubbles should adopt measures aimed at boosting domestic
in equity, real-estate, and other asset markets, investment. They could, for example, provide
with valuations exceeding intrinsic levels. Foreign accelerated tax depreciation for corporations, as
investors will need to assess valuations well as greater clarity on carbon pricing—
carefully before committing their capital. They the current uncertainty is holding back clean-tech
will also have to take a long-term perspective, investment. They should also address their
since volatility in these bubble-prone markets may own infrastructure-investment backlog, although
remain higher than it is in the developed world. this could require them to revise government
accounting methods that treat investment and
A call for government action consumption in the same way.
Governments will need to encourage the flow
of capital from the world’s savers to places In emerging economies, governments should pro-
where it can be invested in productive ways while mote the continued development of deep and
minimizing the risks inherent in closely stable financial markets that can effectively gather
intertwined global capital markets. Governments national savings and channel funds to the
in countries with mature markets should most productive investments. Today, the financial
How the growth of emerging markets will strain global finance 9

1 See the McKinsey Global Institute (MGI) report Farewell to

systems in emerging markets generally have
cheap capital? The implications of long-term shifts in global
a limited capacity to allocate savings to users of investment and saving, available free of charge on mckinsey
capital. We see this in these countries’ low level .com/mgi, as well as on Amazon.com and the Apple iBookstore.
2 Throughout this article, “investment” refers to investment
of financial depth—or the value of domestic in physical assets but not to investment in stocks,
equities, bonds, and bank deposits as a percentage bonds, or other financial assets. “Savings” refers to after-tax
income minus consumption, so any type of borrowing
of GDP.8 Policy makers should also create that increases consumption also reduces savings.
3 At constant 2005 prices and exchange rates. The consensus GDP
incentives to extend banking and other financial
forecast is an average of forecasts by the Economist Intelligence
services to the entire population. Unit, Global Insight, and Oxford Economics.
4 Officials of China’s government have said publicly that

increasing consumption, and hence reducing the

At the same time, policy makers around the world current-account surplus, will be a goal in the 12th five-year
plan. See also the MGI report If you’ve got it, spend it:
should create the conditions to promote long- Unleashing the Chinese consumer, available free of charge
term funding and avoid financial-protectionist on mckinsey.com/mgi.
5 See Fiscal Monitor: Navigating the Fiscal Challenges Ahead,
measures that obstruct the flow of capital. International Monetary Fund (IMF), Fiscal Affairs
This will require removing constraints on cross- Department, 2010; and Global Aging 2010: An Irreversible
Truth, Standard & Poor’s, 2010.
border investing, whether through restrictions 6 See the comments of Blackstone cofounder Stephen Schwarzman

on mark-to-market accounting during the Seoul G20 Business

on pension funds and other investors or on capital
Summit: Sewell Chan, “Schwarzman takes on an old foe:
accounts. Policy makers must also create the Accounting rules,” New York Times, November 11, 2010.
7 The home bias is the tendency of individuals to hold too little of
governance and incentives that enable managers their wealth in foreign assets to achieve the full benefits of
of investment funds with long-term liabilities, portfolio diversification. See, for instance, Karen Lewis, “Trying
to explain home bias in equities and consumption,” Journal
such as pension funds, insurance companies, and of Economic Literature, 1999, Volume 37, Number 2, pp. 571–608;
sovereign-wealth funds, to focus on long-term Harald Hau and Helene Rey, “Home bias at the fund level,”
American Economic Review, 2008, Volume 98, Number 2,
returns and not on quarterly results that pp. 333–38; and Kiichi Tokuoka, “The outlook for financing
reflect market movements and can deviate from Japan’s public debt,” IMF working paper, 10/19, January 2010.
8 See the MGI report Global capital markets: Entering a new era,
long-term valuations. available free of charge on mckinsey.com/mgi.

At this writing, global investment already appears

to be rebounding from the 2009 recession.
The outlook for global saving is less certain. A
climate of costlier credit will test the entire
global economy and could dampen future growth.
The challenge for leaders will be to address
the current economic malaise and simultaneously
create the conditions for robust long-term
growth for years to come.

Richard Dobbs ([email protected]) is a director of the McKinsey Global Institute (MGI) and
a partner in McKinsey’s Seoul office, Susan Lund ([email protected]) is director of research
at MGI, and Andreas Schreiner ([email protected]) is a consultant in the New York office.
Copyright © 2011 McKinsey & Company. All rights reserved.
10

How CFOs can keep strategic

decisions on track
The finance chief is often well placed to guard against common decision-
making biases.

Bill Huyett When executives contemplate strategic decisions, dynamics and biases, and can cite examples of past
and Tim Koller they often succumb to the same cognitive successes and failures. With the technical
biases we all have as human beings, such as support of the finance staff, they can also provide
overconfidence, the confirmation bias, or excessive hard data to counter the inherent biases of
risk avoidance.1 Such biases distort the way we other executives. Yet only a minority of CFOs are fully
collect and process information. Even in the rarefied leveraging their position to change the dynamics
context of the executive suite, judgment can of decision making—to promote institutional learning
be colored by self-interest leading to more or less in the interest of better strategic decisions.
conscious deceptions—for example, around
the assumptions critical to the valuation of potential To figure out why that might be so—and to look for
capital projects, M&A targets, divestitures, techniques CFOs can use when playing this
or joint ventures. critical role—McKinsey’s Bill Huyett and Tim Koller
recently talked with Olivier Sibony, a director in
CFOs are often the most disinterested parties to McKinsey’s Paris office and a coauthor of numerous
such decisions. They seldom chair the relevant articles on the subject of cognitive biases in
meetings, are often highly critical of decision-making business decision making.
 11

McKinsey on Finance: Why aren’t CFOs better disprove our hypotheses and overresearch things
at using their position to improve the quality that confirm them, and so on. But these biases
of decision making? are hardwired, and there’s not much we can do
about them as individuals. So we can will
Olivier Sibony: CFOs often struggle with ourselves to not be overconfident until we’re blue
a confusion of roles. They’re expected to be both in the face; we’ll still be overconfident.
the impartial challenger and an important
player in getting things done. They advise the CEO You can test this yourself. Ask a group of people
on M&A , but they also drive the discussions if they think they are above-average drivers.
with the targets. They have to make sure that the In the United States, nine out of ten will tell you
company has the right financing structure, they’re in the top 50 percent. Now, they all
and they’re also supposed to negotiate with the laugh when they get that feedback, but you ask
banks. Resolving that tension between roles them to do it again and you get the same results.
is where the CFO can do a better job. They all think that it’s all those guys around them
who are overestimating themselves.
The way to do that, I would argue, is for the CFO
to view herself not only as the impartial, cool- It’s the same in business. We may agree with the
headed adviser of the CEO, nor just as the executor proposition that businesspeople in general
of the mechanics of a decision, but primarily are overconfident. We may even accept that we’ve
as the owner of a safe and sound decision-making been overconfident ourselves in our past
process—which is a role that no one else plays. decisions, but we always think that this time will
And if there is one thing that we take away from be different. Here I’m using the example of
the study of behavioral economics, it is that overconfidence because it’s easy to demonstrate,
this role is vital. You need to have better processes but the same is true of other biases. Biases are very
to make decisions, because people can’t make deeply ingrained and impervious to feedback.
better decisions alone, but good processes can help
if they build on the insights and judgment of McKinsey on Finance: So you depend on
multiple people. I’m not saying the CFO is the only a multiperson process to control bias?
person who can build such a process, but she’s
in a uniquely good position to build one. Olivier Sibony: Exactly. You build a multiperson
process where your biases are going to be
McKinsey on Finance: Why does process challenged by somebody else’s perspective. And
matter so much? as CFO, if you manage this process, your goal
is to ensure that the biases of individuals
Olivier Sibony: Process matters in decision weigh less in the final decision than the things
making because we can’t learn from our mistakes that should weigh more—like facts. In other
the way we think we can. Cognitive biases words, you can’t improve your own decision
are everywhere, we all have them, and we pretty making in a systematic way, but you can do a lot
much know what they are. We know we’re to improve your organization’s decision
overconfident, we know we’re susceptible to an- making through a good process, and that’s what
choring, we know we underresearch things that CFOs are uniquely well placed to do.
12 McKinsey on Finance Number 38, Winter 2011

McKinsey on Finance: It sounds like you’re answer to every objection. So the judge
drawing a contrast between the processes decides, and the accused man is sentenced.
of human interaction and decision making and
the more obvious technical systems that the That wouldn’t be due process, right? So if you would
CFO runs—for example, around valuation find this process shocking in a courtroom,
procedures and merger-management procedures. why is it acceptable when you make an investment
decision? Now of course, this is an oversimplifi-
Olivier Sibony: There is a contrast and there cation, but this process is essentially the one most
is also a synergy. The contrast is that CFOs companies follow to make a decision. They have
already rely on processes to manage, as you point a team arguing only one side of the case. The team
out, the technical systems. But it’s very easy has a choice of what points it wants to make
for people to subvert technical systems to get the and what way it wants to make them. And it falls
answer they want. The typical example of this to the final decision maker to be both the
in M&A is when deal advocates work backward from challenger and the ultimate judge. Building a good
the price demanded to determine how much decision-making process is largely ensuring
in synergies the deal would require to make sense. that these flaws don’t happen.

What people spend a lot less time thinking about McKinsey on Finance: How do you build
are the interpersonal interactions—the pro- a process that has these features?
cesses of debate—that ensure high-quality decision
making. And that is where the synergy lies for Olivier Sibony: My coauthor, Dan Lovallo, and
CFOs: if you already own the technical processes, I did some quantitative research on this.2 We
you can build on them to improve the quality of asked executives to tell us about their investment
debate, for instance by adjusting the agenda, decisions—which ones worked and which ones
attendees, and protocols of key decision meetings. didn’t and what practices made the difference—
and we reviewed over a thousand of them.
McKinsey on Finance: What are some
examples of process changes that companies One of the practices that we found made the most
can use? difference was having explicit discussions
of the irreducible uncertainties in the decision.
Olivier Sibony: Let me start with an analogy. Notice the difference between that kind of
Imagine walking into a courtroom where the trial conversation and the one elicited by the typical
consists of a prosecutor presenting PowerPoint slide in a PowerPoint presentation, with the
slides. In 20 pretty compelling charts, he title “Risks we identified and risk-mitigating actions
demonstrates why the defendant is guilty. The we will take.” That’s the way you frame it
judge then challenges some of the facts of if you want to look like a confident presenter and
the presentation, but the prosecutor has a good want the meeting to go smoothly: you suppress
How CFOs can keep strategic decisions on track 13

the discussion of uncertainties. Instead, you is the more subtle issue of motivated error:
should be emphasizing them to make sure even people who sincerely believe that their
you have a debate about them. assessments are objective are in fact often biased
in the direction of their own interests.
Executives reported some other things making
a big difference—for example, whether the So in this case, it can help in some settings to field
discussion included points of view contradictory two deal teams, at least at some stage in the
to those of the person making the final decision. process: one to argue for the deal and a second to
In other words, did anyone voice a point of argue against it. In other settings, if companies
view that was contrary to what the CEO wanted find that people avoid the direct confrontation that
to hear or to what they thought he wanted two deal teams imply, managers might prefer to
to hear? And did the due-diligence team actually ask the same people to argue both sides of the case
seek out information that would contradict or to make the uncertainties explicit. There are
the investment hypothesis, as opposed to simply many different techniques to foster debate.
building a case for it? These types of things
can be hardwired into the process to make sure McKinsey on Finance: What other techniques
that they happen, and some companies do come to mind as effective in M&A situations?
this routinely.
Olivier Sibony: Another technique we find
McKinsey on Finance: Let’s talk about specific useful addresses the overconfidence bias.
techniques. Take M&A as an example—does it It is the “premortem,” invented by psychologist
help to assign people ahead of time to argue either Gary Klein, whom we interviewed in 2010.3
side of a decision, regardless of what they In a premortem, you ask people to project them-
actually believe? selves into the future and to assume that
a deal has failed—not to imagine that it could
Olivier Sibony: When evaluating an acquisition, fail, but to assume it already has. Then you
there is of course the issue of impartiality— ask them to write down, individually and in silence,
as Warren Buffett said, relying on one investment the three to five reasons why it failed. And that
bank to tell you if you should do a deal is like forces people to speak up about the risks and
asking your barber if you need a haircut. And there the uncertainties that they’ve kept to themselves
14 McKinsey on Finance Number 38, Winter 2011

The goal of the CFO is to ensure that the biases

of individuals weigh less in the final decision than
the things that should weigh more—like facts.

for fear of appearing pessimistic, uncommitted everybody around you wants to do a deal, you’re
to the success of the proposal, or disloyal to the very prone to suppressing evidence that might lead
rest of the deal team. you to not do it.

A third technique is, at some point in the process, Another technique we’ve used is to develop a tax-
to write a memo explaining why the CEO should onomy of deals and a checklist for each type
not do a deal, including the things the CEO would of deal. Companies that do a lot of deals, especially
need to believe to not do it. Because by the time private-equity companies, tend to function by
companies get to the actual decision meeting, association and by pattern recognition and to look
everybody has forgotten about those reasons. So at a deal and say, “Oh, this one is just like this
unless they’ve actually been recorded, no one’s left or that previous deal.” But usually the deals they’re
to argue the negative case. Everyone’s framing reminded of are not the failures but the great
the positive case, and all the reasons you used to successes. And once they latch onto that pattern
be worried about the deal have disappeared. recognition, it’s very difficult to see the broad
range of things that actually can make the
Here’s an example: when one company did a retro- analogy irrelevant.
spective analysis of a deal that went wrong, it
looked at a series of memos from the deal team to What you can do to remedy this bias is to use
the investment committee, two months, one techniques such as multiple structured
month, and two weeks before the deal was actually analogies or reference class forecasting.4 The
approved. The firm found that the top three names sound complicated, but the tech-
things on a long list of worries in the first memo niques are actually simple to apply. Essentially,
fell to the bottom of the list in the next memo they are ways of making sure that you look
and in the final memo had completely disappeared. at a range of examples, not just one, and
Apparently, those concerns had been resolved to explicitly analyze what makes those examples
to the team’s full satisfaction. But when the deal relevant and what could make them
was done and the acquirers prepared to take less relevant.
possession of the company, guess what were the
top priorities on their agenda: the same three If you do enough deals so that you can actually
things that had been swept under the rug in order recognize the different patterns, the way to
to do the deal in the first place. This illustrates the use this technique is to identify the different types
dynamics of deal frenzy: when you sense that of deals and the things that matter for each.
How CFOs can keep strategic decisions on track 15

For instance, the things that we need to check That’s precisely what you want to avoid. That’s
in a deal where we acquire complementary why you need a process and the habit of
product lines are not the same ones that we need following it, not just a tool kit of practices that
to check for when we are doing a cross-selling you use from time to time. That’s why in
kind of deal or a geographic-expansion kind areas where we don’t tolerate failure, we have
of deal. So we will have different deal processes routines. If you fly an aircraft, you don’t
and different due-diligence checklists. say, “The weather is really bad and we’re already
behind schedule, so let’s skip the takeoff
McKinsey on Finance: What advice do you checklist.” You say, “This is a flight like every
have for CFOs who want to incorporate these other one, and we’re going to use the checklist—
techniques into their decision-making processes? that isn’t negotiable.”

Olivier Sibony: The crucial thing to keep in 1 Dan Lovallo and Olivier Sibony, “Distortions and deceptions in

mind is that there isn’t one magic technique that strategic decisions,” mckinseyquarterly.com, February 2006.
2 Dan Lovallo and Olivier Sibony, “The case for behavioral
will strip out all biases. This is more about strategy,” mckinseyquarterly.com, March 2010.
3 “Strategic decisions: When can you trust your gut?”
putting in place a process that includes techniques
mckinseyquarterly.com, March 2010.
to correct for the biases to which you’ve been 4 Dan Lovallo, Patrick Viguerie, Robert Uhlaner, and John Horn,

susceptible in the past: probably not 20 techniques “Deals without delusions,” Harvard Business Review,
December 2007, Volume 85, Number 12, pp. 92–99.
but 2 or 3 that you can use to help you avoid
those biases in the future.

And once you put a process in place, it’s only

valuable if it’s used consistently. First,
because you’re going to learn and become better
at using the process. Second, because it is
precisely when you’re about to make a big mistake
that you’re likely to have made an exception.
The temptation, when you have a decision-making
process, is always to say that for a really
exceptional, difficult decision, we’re going to
bypass the process, since the decision is
an unusual one.

Bill Huyett ([email protected]) is a partner in McKinsey’s Boston office, and Tim Koller
([email protected]) is a partner in the New York office. Copyright © 2011 McKinsey & Company.
All rights reserved.
16

A return to deal making in 2010

M&A volumes rose last year for the first time since the crisis. Capital markets
think deals created more value too.

David Cogman The global M&A market ended two years of malaise created more value overall than they did in
and Carsten Buch in 2010, rebounding decisively in the second any year since we began tracking them, in 1997—
Sivertsen
half of the year. After languishing for the first six and that acquirers were more disciplined at
months in the wake of higher market volatility1 capturing this value for their shareholders. Other
and the sovereign-debt crisis in Europe, companies trends in M&A for the year included continued
ended the year having announced more than growth in cross-border M&A , an increase in
7,000 deals, at a value of $2.7 trillion. This marked the number of deals in Asia and Latin America,
the first increase in M&A deal numbers and and modest growth in private-equity deal volumes.
volumes since 2007, as well as a 23 percent increase
over 2009 levels, which were the lowest A measured rebound
since 2004.2 M&A activity recovered in 2010 but remained well
short of a deal frenzy. A rally in stock markets
Judging by share price movements before and around the world drove growth in the total value
after deals were announced, investors felt upbeat of deals: global market capitalization rose
in 2010 about the acquirers’ ability to extract to around 80 percent of the 2007 peak, up from
value from M&A . Our analysis found that deals around 65 percent in 2009. M&A activity for 2010
 17

as a share of market capitalization3 (a good such as telco América Móvil’s bid for Carso
indicator of overall deal sentiment) was slightly Global Telecom, the number of deals also stood
below the long-term average of 7 to 8 percent. close to an all-time high.
Despite the resurgence, M&A activity as a share
of market capitalization was still considerably • Private-equity activity recovered but remained
lower than it was in 1999, when volumes rose as concentrated in OECD countries. From late
high as 11 percent of global market cap. Last 2007 to mid-2009, as access to cheap debt ended
year’s other highlights included: abruptly, private-equity activity levels declined
steeply, falling to just 4 percent of global
• Cross-border activity regained momentum. deal activity. As many predicted, private-equity
The long-term trend of increasing cross-border activity picked up again in late 2009 and
M&A activity seemed to stall in 2009, throughout 2010 as credit spreads narrowed and
with a significant drop to just 25 percent of banks again started to offer financing for
global M&A volumes, down from 40 percent in leveraged buyouts, albeit at significantly higher
pre-crisis years. But cross-border activity prices. For 2010, private-equity M&A , at
returned to pre-crisis levels in 2010 as a result a bit above $200 billion, accounted for 8 percent
of both megadeals4 and numerous smaller of deals by volume. Although nearly double
cross-border transactions. the levels of 2009, this remains far from
the $700 billion peak seen in 2006 and 2007.
• Asia–Pacific outbound M&A continued to grow This rebound was, however, mostly a phenom-
impressively. Asia–Pacific5 acquirers increased enon of Organisation for Economic Co-operation
their share of cross-border activity in 2010. and Development (OECD) countries. In
Outbound M&A from that region into Europe 2010, as in previous years, private equity’s
and the Americas more than doubled (after share of M&A elsewhere remained small.
having slowed down the year before), growing Non- OECD countries constitute around 30 per-
around twice as fast as M&A volumes in the cent of global M&A but only 10 percent of
opposite directions. The Asia–Pacific became private-equity activity.
a net exporter of around $46 billion in M&A
deal volume, while Europe, the Middle East, and Positive market sentiment
Africa exported $9 billion and the Americas toward acquirers
imported $55 billion. The Asia–Pacific region Stock markets have typically assessed the value
accounted for 23 percent of all global activity of M&A to acquirers cautiously. Over the past
in 2010, up slightly from 2009. decade, capital market reactions to deals, as gauged
by share price reaction to deal announcements,
• Latin America saw by far its largest M&A suggested that investors perceived them as
volume ever. In 2010, M&A volumes in creating around 10 percent of their value for the
Latin America grew to $250 billion (more than seller and destroying around five and a half
double the 2009 level), accounting for almost percent for the acquirer. This perception reversed
9 percent of global M&A . The growth has sharply in 2010, however: for only the second
been continuous since 2005, and although 2010 time in the past decade, markets viewed the average
volumes were supported by a few megadeals, deal as creating value for both acquirer and
18 McKinsey on Finance Number 38, Winter 2011

MoF 2010
2010 M&A
Exhibit 1 of 3

Exhibit 1 Markets viewed the average deal as creating value

for both acquirer and seller.
DVA target
Average annual deal value- DVA total
added (DVA),1 % DVA acquirer

20
16
Average, %
12
10.0
8
4 4.6
0
–4
–5.4
–8
–12
–16
–20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Number of
90 126 139 133 89 39 49 78 93 154 242 106 77 102
deals

1 ForM&A involving publicly traded companies; DVA defined as combined (acquirer and target) change in market
capitalization, adjusted for market movements, from 2 days prior to 2 days after announcement, as % of transaction value.
Source: Dealogic; Thomson Datastream; McKinsey analysis

seller. The net value created by M&A , measured This level, which implies that investors thought
as deal value added (DVA),6 has fluctuated slightly above half of the deals created value
between 3 and 9 percent over the past 14 years, for the acquirers’ shareholders and slightly below
excluding 2000, when it fell to –6 percent. half destroyed value, is significantly better
It fell to around 3 percent during the past recession than the historic average of 60 percent, which we
but rose sharply in 2010, to 13 percent—the have observed since we began tracking this
highest level seen over the past 15 years and far metric in 1997. Yet premiums paid remained fairly
above the historic average of 4.6 percent high during 2010.
(Exhibit 1).
Markets often treat cash and share deals
Moreover, the data suggest that acquirers also differently, and that gap widened dramatically.
exercised more discipline in their deal making in Capital markets consistently perceive cash
2010. The proportion of deals in which the deals as creating more value than stock deals.
immediate market reaction caused the acquirer’s On average, cash deals create 11 percent of
share price to fall—the percentage of over- the deal value, partly as a result of the positive
payers7 (POP)—fell to 47 percent (Exhibit 2). signaling effects of using cash; in contrast,
 A return to deal making in 2010 19

markets typically perceive share deals as (Exhibit 3). While markets rewarded sellers
destroying around 3 percent of the deal value. equally, regardless of deal size, they on
The gap between the two funding methods average rewarded acquirers significantly less for
dropped to a mere 4 percent in 2008, widened large than for small deals. This pattern lines
again in 2009, and rose as high as 20 percent up with long-term averages, in which large deals
by 2010. Markets gave extremely positive have a slightly negative DVA , while small to
responses to cash-only deals in 2010, but they midsize deals have a positive 5 to 6 percent DVA .
also perceived share deals as creating value
on average, to the tune of 2 percent. The gap is not a result of higher premiums for large
deals, as premiums paid are fairly similar
Furthermore, small deals created significantly across deal sizes: for stock deals, there is also no
MoF 2011
greater value than larger ones. Indeed, deals substantive difference across deal sizes. For
2010 M&A
with a value above $5 billion had a significantly cash deals, however, a significant difference can
Exhibit 2 of 3
lower deal value-added (DVA), at 3 percent, be found: markets give a much better recep-
than smaller deals, at about 15 to 16 percent tion to small cash-financed deals than to large

Exhibit 2 Acquirers were also more disciplined in

their deal making.

1-week premium,1 %

80

70

60

50 % of overpayers
(POP)2
40
Median deal
30 premiums
20

10

0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Number of
90 126 139 133 89 39 49 78 93 154 242 106 77 102
deals

1 For M&A deals involving publicly traded companies; 1-week premium = price offered per share vs target company’s
share price 1 week before announcement.
2POP defined as proportion of transactions in which share price reaction, adjusted for market movements, was negative
for acquirer from 2 days prior to 2 days after announcement.
Source: Dealogic; Thomson Datastream; McKinsey analysis
20 McKinsey on Finance Number 38, Winter 2011

MoF 2011
2010 M&A
Exhibit 3 of 3

Exhibit 3 Markets see less value in big deals.

Average deal value-added (DVA),1 %

2010 vs long-term Breakout of long-term

averages averages, 1997–2010

Deal size, 2010 Acquirer Target Number of

$ billion 1997–2010 deals

<$1 15.1 –4.7

5.5 10.2 430

$1–5 16.2
6.5 –4.0 10.5 755

>$5 3.2
–0.7 –9.6 8.8 332

Total weighted 4.6 13.4 –5.4 10.0 1,517

average

1 DVA
defined as combined (acquirer and target) change in market capitalization, adjusted for market movements,
from 2 days prior to 2 days after announcement, as % of transaction value.
Source: Dealogic; Thomson Datastream; McKinsey analysis

1 The Chicago Board Options Exchange (CBOE) Volatility

cash-financed ones. Potential explanations
Index (or VIX) reached as high as 45, a level not seen since
for this negative attitude could be an anticipation March 2009.
2 M&A volume includes deals (announced and not withdrawn) of
of paying out cash as dividend, worry about
more than $25 million (total deal value including debt).
increased debt levels, or a need for a rights issue. 3 Market capitalization of World-DS Market Index as defined by

Thompson Datastream.
4 Deals of more than $5 billion.
5 Includes all Asian and Pacific countries, including Australia

and Japan.
6 For M&A involving publicly traded companies; DVA defined

The return of market confidence in deal making as combined (acquirer and target) change in market
capitalization, adjusted for market movements, from two days
during the latter half of the year was perhaps prior to two days after announcement, as percentage of
the most encouraging aspect of M&A in 2010. deal value.
7 For M&A involving publicly traded companies; POP defined as
Overall deal activity was measured rather than proportion of transactions in which share price reaction,
excessive, and capital markets looked favorably adjusted for market movements, was negative for acquirer from
two days prior to two days after announcement.
upon the resulting value creation. Companies
also once again seem willing to engage in more
ambitious cross-border deals. Barring any
major macroeconomic upsets in 2011, a positive
trend seems to have begun.

David Cogman ([email protected]) is a partner in McKinsey’s Shanghai office, and

Carsten Buch Sivertsen ([email protected]) is an associate principal in the Oslo office.
Copyright © 2011 McKinsey & Company. All rights reserved.
 21

Past lessons for China’s

new joint ventures
As multinationals revive interest in collaborating with Chinese partners,
the lessons of past ventures bear remembering.

Stephan Bosshart, It’s been ten years since multinationals first began joint ventures a more appealing option, and
Thomas Luedi, turning away from joint ventures in China so does a growing pool of healthier prospective
and Emma Wang
as the preferred way to take part in the world’s Chinese partners. All this is prompting some
hottest growth story. Many joint ventures multinationals to reconsider the joint-venture
failed to endure, and as multinationals gained approach as an alternate avenue for getting a stake
experience in China, and foreign investment in the continuing strength of China’s economy.
restrictions loosened, multi-nationals found it easier
in many sectors to start a business from scratch— But while the dynamics have changed, the funda-
or to acquire an existing one outright—than mentals have not: companies pursuing joint
to negotiate, establish, and manage a joint venture ventures would do well to reflect on the lessons of
in the long term. past deals to improve the chances of success.
In China, some of those lessons are especially
No longer. China’s hot growth has boosted valua- critical, such as choosing partners that can make
tions and increased competition for outright tangible business contributions, safeguarding
acquisitions of Chinese companies that are often intellectual property, ensuring operational
less interested in being acquired. That makes control of the joint venture, and managing talent.
22 McKinsey on Finance Number 38, Winter 2011

Others are critical for joint ventures in all Instead, multinationals should pair with local com-
geographies, such as aligning strategic priorities, panies that explicitly share their strategic
creating a structure that permits rapid goals. This doesn’t eliminate large, well-established
responses to change, and preparing up front Chinese companies. But it does open the
for eventual restructuring. door to faster-growing, privately owned, and
smaller companies that bring a strong commercial
Choosing better partners mind-set and tangible business assets to joint
When China first opened its doors to multina- ventures. The global pharmaceutical corporations
tionals, in the 1980s, some multinational GlaxoSmithKline and Novartis, for example,
corporations undertook joint ventures with local chose such partners in 2009 for their joint ventures
companies that appeared to be safe bets in the vaccine market. Thanks to partnerships
because of their access to and influence with the with smaller local companies—Shenzhen Neptunus
local or national government. Even today, Interlong Bio-Technique Company and Zhejiang
many foreign executives prefer to engage with Tianyuan Bio-Pharmaceutical, respectively—
large, well-established Chinese partners. both joint ventures had the access they needed to
government vaccine-procurement programs,
Yet that preference hasn’t benefited joint ventures, as well as a talent pool, R&D know-how, and an
typically because the parent companies didn’t entrepreneurial management mind-set for
share the same strategic or commercial interests. further rapid growth.
Multinationals, for example, have emphasized
profitability, even when growth is slow, while their One drawback that foreign companies may not have
Chinese partners have emphasized growth, encountered in China before: as Chinese
even without profitability. The result has been executives grow increasingly confident, many of
different priorities for investments and these smaller players themselves hope to
a lack of cooperation, both between the parent become national, regional, or even global players.
companies and within the mixed manage- That aspiration can make it difficult to agree
ment team. on the scope of the partnership if it’s to be limited
Past lessons for China’s new joint ventures 23

Multinational companies still struggle to protect

their intellectual property in China,
and joint ventures are particularly vulnerable.

to China or to specific products. One approach • Leaving the blueprints at home. Multinationals
is to outline the extent of cooperation both can protect their intellectual property by
domestically and globally—for instance, whether delivering equipment or technology ready to be
it includes access to overseas sales channels, installed, without detailed design specifications.
noncompete clauses for specific markets, and Negotiating agreements to do so can signal
agreement in principle on the potential evolution a lack of trust in the local partners, however,
of the partnership into additional product lines. and can increase costs if spare parts and
maintenance must be provided from overseas.
Safeguarding intellectual property
Multinational companies still struggle to protect • Keeping critical intellectual property completely
their intellectual property in China, and joint out of a joint venture. Some companies have
ventures are particularly vulnerable. Protection set up joint ventures that are restricted to those
in most developed markets occurs primarily steps in the value chain that involve limited
through legally binding agreements enforced in intellectual property, like assembling, packaging,
courts of law. But the concept of intellectual- or tailoring. Such an approach is feasible
property protection is still new in China, and only when local innovation lags behind global
recourse to the legal system can be lengthy standards and, obviously, when the critical
and inadequate. Companies have had some success intellectual-property component can easily be
with more pragmatic, operational efforts, separated into a step of the value chain.
including the following:
• Charging for intellectual property up front.
• Bringing only older technology to China. Some multinationals have chosen to
This approach works for products that may have sell their intellectual property to joint ventures,
been available in developed markets for either through up-front cash payments
some time but are still competitive in China’s or licensing fees. This approach can be chal-
market. It also works in industries—such lenging to execute, for while it resonates
as bacteria streams for fermentation, vaccines, well with local companies, they generally are
and certain motor engines—where innovation willing to pay for technology up front only
cycles are short. at a significant discount.
24 McKinsey on Finance Number 38, Winter 2011

Taking charge discussed, and so on, depending on the relative

In the past, foreign companies agreed to invest importance of the stakeholders and their
in joint ventures as minority or equal stake- specific agendas. The CEO of a leading global
holders, often failing to secure management insurer, for example, often teaches management
positions that were meaningful enough to guide practices at the Central Party School. His
the development of the joint entity. Such willingness to do so gives him credibility with
companies often found themselves relegated to joint-venture partners by allowing him to
providing know-how and capital, with little interact with current and future decision makers
influence other than board voting rights. In one who directly and indirectly influence the course
extreme case, a global multinational had set of business in China.
up multiple joint ventures with leading national
players in China. The company was unable Managing talent
to exercise sufficient operational control over, Most leading multinationals learned from the
for example, decisions around roll-out plans first round of joint ventures in China that
or product development. Ultimately, it had to sell getting the right managers in place was critical.
off its stakes in these ventures. Many of these companies had simply dispatched
available executives—often not top performers
The ability to influence the course of a joint but rather average executives searching for
venture depends largely on the partners’ new challenges. Most of these executives therefore
ability to build trust-based relationships at the had limited credibility with the corporate parent
working level, the joint-venture board level, and were ill-prepared to manage demanding
and even outside the joint venture, with the joint-venture partners. Today, experienced
government or other industry players. Successful multinationals recognize that a successful joint
multinationals map out critical stakeholders venture requires credible, high-performing
in and around the joint venture (from local executives supported by strong local teams.
management to central regulatory bodies) and
assign relationship responsibilities at multiple Yet with so many companies competing for
levels of the organization. the best local candidates, those men and women
can afford to be choosy, and they understand-
This approach requires developing interaction ably prefer leading companies that have a strong
protocols—the composition of any delegation, the image and offer good prospects for career
number of visits, the specific topics to be progression. So today, joint ventures must not

Experienced multinationals recognize that a successful

joint venture requires credible, high-performing executives
supported by strong local teams.
Past lessons for China’s new joint ventures 25

a shared understanding of its future business,

the markets it will compete in, and how it
will evolve over time. Differences of opinion that
are deeply rooted in competing expectations
of future performance can affect the joint venture’s
strategy and focus and eventually lead to
its failure.

Take, for example, four life insurance joint ventures

that failed in China over the past 12 months,
after an average of four to five years of unsatisfac-
tory business development and shareholder
disputes. Chinese life insurance partners have
been nonfinancial companies accustomed to short
breakeven periods of three years or less, with
an emphasis on top-line growth and profits. Foreign
only invest in their corporate brands but also insurers, on the other hand, take a longer-term
partner with top universities to sponsor view and emphasize sustainable growth in the
undergraduate and graduate students and value of the insurance policies underwritten rather
to establish a training platform for current than accounting profits. In the four failed joint
employees. CEIBS, a leading business school ventures, the inevitable tension over strategic
in China (and itself a joint venture), has priorities led to disagreements about, for example,
more than 80 corporate sponsors, which provide the right channels for pursuing lower-profitability
funding and in return can recruit on campus volume or whether to scale up an agency workforce
and send their executives on advanced more quickly, but with a lower level of skills, or
training courses. more deliberately, with a higher-quality workforce.

Finally, companies must continue their commit- These failures might have been avoided if the
ment even after candidates are hired. In CEOs of the parent companies and the
our observation, this means sending some of joint ventures’ future management teams had
a multinational’s best people to the joint spent time collectively developing business
venture to create a strong team, compensating plans and preparing for changes in market
employees at or above relevant market rates, dynamics. In contrast, at one of the three most
and fast-tracking the advancement of high successful foreign life insurers in China,
performers—even breaking away from more a standing business-development group and
tenure-based advancement systems.1 a part of the future management team went
through multiple iterations with its joint-venture
Aligning priorities partner to agree on key business priorities,
Regardless of where a joint venture is located, such as volume versus value, channels, products,
companies spend too little time building and target customer segments.
26 McKinsey on Finance Number 38, Winter 2011

Responding to change The result was improved cooperation with regu-

Once a joint venture is up and running, multi- lators and therefore faster approvals, more
nationals should aspire to manage it as if frequent interactions and deeper relationships
it were their own, putting in place short lines of between the senior management of the parent
reporting from the joint venture back to the companies, and closer alignment within the joint
parent company. This move is important in any ventures’ mixed management teams.
joint venture, to give senior managers the
timely information they need to assess its per- Preparing for breakup
formance. But it’s especially true in China, Even in developed markets, joint ventures are often
where the fast pace in many sectors requires both restructured within a decade of being set up.
partners to react quickly to changes in the But in a market as dynamic as China’s, partnership
marketplace or the regulatory environment. terms negotiated today might be ineffective in
a few years, and even strong partners may struggle
In this respect, multinationals can be at a disad- to survive. This dynamism and uncertainty
vantage. Decision-making processes for mean that the partners in a joint venture must
Chinese parent companies might include more include provisions for restructuring its contract if
people, but once decisions are made, managers the competitive landscape changes. HSBC,
execute them quickly. In contrast, foreign companies for example, in its credit card partnership with
are slower to react, often encumbered by China’s Bank of Communications, agreed to
layers of country and regional management. It is very specific steps if a change in regulation made
not uncommon for the foreign executives of a it possible to convert the partnership into an
joint venture to report back to the multinational’s independent credit card company. These detailed
China head, who reports to the head of the steps included the resulting board structure
international unit, who then eventually reports and the consideration to be paid to the partners.
back to the CEO.
Lacking such provisions, some multinationals
Some of the more successful multinationals we’ve have had to enter into tough negotiations
observed provide for direct reporting lines with their Chinese partners to reach agreement
to their CEOs. Others have assigned responsibility on exit conditions. Others have languished
for China to a member of their management in joint ventures that continued as formal partner-
boards, sometimes with a dual-reporting line into ships while either partner pursued other
the regional organization. When a European avenues for growth.
transportation company made China its second
1  See Jeff Galvin, Jimmy Hexter, and Martin Hirt, “Building
home market, for example, it elevated its
a second home in China,” mckinseyquarterly.com, June 2010.
China president to the global management board
and sent its global CEO to China at least six
times a year to meet with the joint-venture partners.

Stephan Bosshart ([email protected]) is an associate principal in McKinsey’s Shanghai office,

where Thomas Luedi ([email protected]) is a partner; Emma Wang ([email protected]) is
a consultant in the Hong Kong office. Copyright © 2011 McKinsey & Company. All rights reserved.
 27

The myth of smooth earnings

Many executives strive for stable earnings growth, but research shows that
investors don’t worry about variability.

Bin Jiang and Executives like their earnings smooth—even in pursuing them. If investors really preferred
Tim Koller normal times, they will go to great lengths to smooth earnings, you would expect companies that
achieve steady growth in earnings per share quarter achieve them to generate higher total returns
after quarter. As the economy emerges slowly to shareholders (TRS) and to have higher valuation
from recession, we encounter even more deference multiples, everything else being equal. Yet using
to the conventional wisdom that investors different techniques, company samples, and
prefer smooth earnings growth and shun earnings time frames, all the studies we examined1 reached
volatility. Those who make such claims have the same conclusion: there is no meaningful
long cited stable earnings growth as a rationale for relationship between earnings variability and TRS
strategic actions. In 2002, for example, the CEO or valuation multiples.
of Conoco justified that company’s then pending
merger with Phillips Petroleum in part by asserting To illustrate these findings, we compared the
that the deal would provide greater earnings TRS of 135 companies with above-average
stability throughout the commodity price cycle. earnings volatility and the TRS of 135 companies
with below-average volatility (Exhibit 1).
Our research shows that these efforts aren’t While the median return of the low-volatility
worthwhile and may actually hurt companies companies is higher, the statistical significance
28 McKinsey on Finance Number 38, Winter 2011

MoF 2011
Volatility (Value excerpt)
Exhibit 1 of 2

Exhibit 1 Earnings volatility and TRS are not linked.

Distribution of large, nonfinancial US companies by total returns to shareholders (TRS)

35
Less volatile1
30
earnings growth
Number of companies

25
20
More volatile1
15
earnings growth
10
5
0
–5
<–10% –10 to –5 to 0 to 5 to 10 to 15 to 20 to 25 to >30%
–5% 0% 5% 10% 15% 20% 25% 30%

Annualized TRS, 1998–2007, %

1 Based
on difference between each company’s second-highest and second-lowest levels of growth during the 10-year period;
135 companies in each category.

of the disparity vanishes when we factor in growth even slimmer. In fact, sophisticated investors tell
and returns on capital. More interesting, us they get suspicious when earnings growth
however, is the fact that plenty of low-volatility is too stable, since they know that isn’t how the
companies have low TRS, just as plenty of world works.
high-volatility companies have high returns.
You can also see that the very volatile companies Part of the explanation for the results of our
have more extreme TRS results. research is that smooth earnings growth
is a myth; almost no companies have it. Exhibit 2
Investors, we believe, realize that the world isn’t shows five that were among the least volatile
smooth. How could a company with five dif- 10 percent of all large companies by earnings
ferent businesses in ten different countries achieve growth from 1998 to 2007. The one with the most
a smooth 10 percent annual earnings growth stable earnings was Walgreens, with annual
for years? The chances of unexpected positive earnings growth between 14 and 17 percent from
results in one area exactly offsetting unexpected 2001 to 2007. But after Walgreens, we quickly
negative results are slim. The chances that ran out of companies to compare. We looked at
each business performs exactly as planned are 500 others and couldn’t find any with seven
 The myth of smooth earnings 29

such years of steady earnings growth. In fact, In some cases, such as gold-mining companies,
we could find only a handful of cases investors actually want exposure to changing
where it held steady for at least four years. prices. Companies therefore shouldn’t try
to reduce natural volatility, especially if it
Most low-volatility companies follow a similar means reducing expenses like marketing and
pattern. Anheuser-Busch, for example, product development.
had four years of steady growth, around 12 percent,
from 1999 to 2002. Then, after 7 and 8 percent Nor should they try to reduce volatility through
growth in 2003 and 2004, respectively, more diversified corporate portfolios. The
the company’s earnings dropped by 18 percent argument for them is that different businesses
in 2005. This pattern is common. Of the have different business cycles, so earnings
500 companies we examined, 460 experienced at the peak of one business’s cycle will offset
at least one year of earnings decline during the lean years of other businesses, thereby
MoF 2010
the period. stabilizing a company’s consolidated earnings.
Volatility (Value excerpt)
If earnings and cash flows are smoothed in
Exhibit 2 of 2
Investors expect the natural volatility associated this way, the reasoning goes, investors will pay
with industries in which companies participate. higher prices for the company’s stock.

Exhibit 2 Even among the least volatile companies, earnings

growth is rarely smooth.

Earnings growth of the 5 least volatile companies,1 1998–2007, %

Walgreens Anheuser-Busch Colgate-Palmolive Cisco PepsiCo

1998 23 5 13 7 31

1999 16 13 9 12 1

2000 24 11 12 25 4

2001 14 12 7 32 22

2002 15 11 7 14 22

2003 15 7 10 14 8

2004 16 8 –6 17 16

2005 16 –18 2 7 –2

2006 14 7 0 –12 37

2007 17 8 28 18 –2

1 Amongthe 500 largest, nonfinancial US companies; earnings defined as net income before
extraordinary items, adjusted for goodwill impairment.
30 McKinsey on Finance Number 38, Winter 2011

The facts refute this argument, however. First, we 1 See Brian Rountree, James P. Weston, and George Allayannis,

“Do investors value smooth performance?” Journal of

haven’t found any evidence that diversified Financial Economics, December 2008, Volume 90, Number 3,
companies actually generate smoother cash flows. pp. 237–51; John M. McInnis, “Earnings smoothness,
average returns, and implied cost of equity capital,” Accounting
When we examined the 50 companies from Review, January 2010, Volume 85, Number 1, pp. 315–42;
the S&P 500 with the lowest earnings volatility and Ronnie Barnes, “Earnings volatility and market valuation:
An empirical investigation,” LBS Accounting Subject Area
from 1997 to 2007, we found fewer than 10 working paper, ACCT019, November 2002.
that could be considered diversified, in the sense of
owning businesses in more than two distinct
industries. Second, and just as important, we
found no evidence that investors pay higher prices
for less volatile companies. In our regular
analyses for our clients, we almost never find that
the summed values of the business units of
a diversified company differ substantially from
its market value.

Investors expect the natural volatility associated

with the industry in which a company partic-
ipates. Instead of trying to manage volatility, senior
executives should spend their time making
decisions that fundamentally increase a company’s
revenues or its returns on capital.

Bin Jiang ([email protected]) is a consultant in McKinsey’s New York office, where Tim Koller
([email protected]) is a partner. This article is adapted from chapter nine of Value: The Four Cornerstones of
Corporate Finance, by Richard Dobbs, Bill Huyett, and Tim Koller (Wiley, 2011). Tim Koller is also a coauthor,
with Marc Goedhart and David Wessels, of Valuation: Measuring and Managing the Value of Companies (Wiley, 2010).
Copyright © 2011 McKinsey & Company. All rights reserved.
31
32 McKinsey on Finance Number 38, Winter 2011
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