McKinsey on Finance. Number 42, Winter Understanding the Second Great Contraction: An interview with Kenneth Rogoff

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1 McKinsey on Finance Number 42, Winter 2012 Perspectives on Corporate Finance and Strategy 2 Testing the limits of diversification 7 Taking a longerterm look at M&A value creation 14 A mixed year for M&A 17 Understanding the Second Great Contraction: An interview with Kenneth Rogoff 22 Five steps to a more effective global treasury 28 Rethinking people development in finance 32 Choosing where to list your company

2 McKinsey on Finance is a quarterly publication written by corporate finance experts and practitioners at McKinsey & Company. This publication offers readers insights into value-creating strategies and the translation of those strategies into company performance. This and archived issues of McKinsey on Finance are available online at Corporate_Finance, where selected articles are also available in audio format. A series of McKinsey on Finance podcasts is also available on itunes. Editorial Contact: McKinsey_on_ Finance@McKinsey.com Editorial Board: David Cogman, Ryan Davies, Marc Goedhart, Bill Huyett, Bill Javetski, Tim Koller, Dan Lovallo, Werner Rehm, Dennis Swinford Editor: Dennis Swinford Art Direction: Veronica Belsuzarri Design and Layout: Jake Godziejewicz Managing Editor: Drew Holzfeind Data Visualization Editor: Mary Reddy Editorial Production: Kelsey Bjelland, Roger Draper Circulation: Diane Black External Relations: Katherine Boas Illustrations by Emiliano Ponzi Copyright 2012 McKinsey & Company. All rights reserved. This publication is not intended to be used as the basis for trading in the shares of any company or for undertaking any other complex or significant financial transaction without consulting appropriate professional advisers. No part of this publication may be copied or redistributed in any form without the prior written consent of McKinsey & Company. To request permission to republish an article, send an to Quarterly_Reprints@McKinsey.com.

3 1 McKinsey on Finance Number 42, Winter Testing the limits of diversification This strategy can create value, but only if a company is the 7 Taking a longer-term look at M&A value creation Companies that do many small deals can outperform 14 A mixed year for M&A Global deal activity slowed in August, though measures of value creation continued to improve. 17 Understanding the Second Great Contraction: An interview with Kenneth Rogoff best possible owner of businesses outside its core industry. their peers if they have the right skills. But they need more than skill to succeed in large deals. The economist and coauthor of This Time Is Different explains what history can teach us about the global downturn and why climbing out of it is still rife with risks Five steps to Rethinking people Choosing where to list a more effective development in your company global treasury finance How much does choice of Demands on the It s time to overhaul the listing location matter? corporate treasurer are way companies develop Investors will follow good changing, and many the careers of finance companies no matter are struggling to keep up. professionals. where they list. Here s where to start. Interested in reading McKinsey on Finance online? your name, title, and the name of your company to McKinsey_on_Finance@McKinsey.com, and we ll notify you as soon as new articles become available.

4 2 Testing the limits of diversification This strategy can create value, but only if a company is the best possible owner of businesses outside its core industry. Joseph Cyriac, Tim Koller, and Jannick Thomsen It s almost inevitable: to boost growth when a company reaches a certain size and maturity, executives will be tempted to diversify. In extreme cases the United States during the 1960s and 1970s, for example a corporation with a sharp focus on its core business can end up as a mix of strange bedfellows. One global oil enterprise famously acquired a computer business, another a retailer. And a major US utility once owned an insurance company. Although a few talented people over time have proved capable of managing diverse business portfolios, today most executives and boards realize how difficult it is to add value to businesses that aren t connected to each other in some way. As a result, unlikely pairings have largely disappeared. In the United States, for example, by the end of 2010 there were only 22 true conglomerates. 1 Since then, 3 have announced that they too would split up. Yet too many executives still believe that diversifying into unrelated industries reduces risks for investors or that diversified businesses can better allocate capital across businesses than the market does without regard to the skills needed to achieve these goals. Because few have such skills, diversification instead often caps the upside potential for shareholders but doesn t limit the downside risk. As managers contemplate moves to diversify, they would do well to remember that

5 3 in practice, the best-performing conglomerates in the United States and in other developed markets do well not because they re diversified but because they re the best owners, even of businesses outside their core industries (see sidebar, Conglomerates in emerging markets ). Limited upside, unlimited downside The argument that diversification benefits shareholders by reducing volatility was never compelling. The rise of low-cost mutual funds underlined this point, since that made it easy even for small investors to diversify on their own. At an aggregate level, conglomerates have underperformed more focused companies both in the real economy (growth and returns on capital) and in the stock market. From 2002 to 2010, for example, the revenues of conglomerates grew by 6.3 percent a year; those of focused companies grew by 9.2 percent. Even adjusted for size differences, focused companies grew faster. They also expanded their returns on capital by three percentage points, while the ROCs of conglomerates fell by one percentage point. Finally, median total returns to shareholders (TRS) were 7.5 percent for conglomerates and 11.8 percent for focused companies. As usual, the median doesn t tell the entire story: some conglomerates did outperform many focused companies. And while the median return from conglomerates is lower, the distribution s shape tells an instructive story: the upside is chopped off, but not the downside (exhibit). Upside gains are limited because it s unlikely that all of a diverse conglomerate s businesses will outperform at the same time. The returns of units that do are dwarfed by underperformers and therefore probably won t affect the entire conglomerate s returns in a meaningful way. Moreover, conglomerates are usually made up of relatively mature businesses, well beyond the point where they would be likely to generate unexpected returns. But the downside isn t limited, because the performance of the more mature businesses found in most conglomerates can fall a lot further than it can rise. Consider a simple mathematical example: if a business unit accounting for a third of a conglomerate s value earns a 20 percent TRS while other units earn 10 percent, the weighted average will be about 14 percent. But if that unit s TRS is negative 50 percent, the weighted average TRS will be dragged down to about 2 percent, even before other units are affected. In addition, the poor aggregate performance can affect the motivation of the entire company and how the company is perceived by customers, suppliers, and potential employees. Prerequisites for creating value What matters in a diversification strategy is whether managers have the skills to add value to businesses in unrelated industries by allocating capital to competing investments, managing their portfolios, or cutting costs. Over the past 20 years, the TRS of the high and low performers among the 22 conglomerates remaining in 2010 clearly differed on exactly these points. While the number of companies is too small for statistical analysis, we did find three characteristics the high performers shared. Disciplined (and sometimes contrarian) investors. High-performing conglomerates continually rebalance their portfolios by purchasing companies they believe are undervalued by the market and whose performance they can improve. When Danaher identifies acquisition targets, for example, those companies must be good candidates for higher margins, using the company s well-known Danaher Business System. By applying this strategy, over the past 20 years Danaher has consistently managed to increase the margins of its acquired companies. These include Gilbarco Veeder-Root,

6 4 McKinsey on Finance Number 42, Winter 2012 Exhibit The distribution of TRS for conglomerates is instructive: diversification often caps the upside potential for shareholders but doesn t limit the downside risk. Distribution of S&P 500 companies by total returns to shareholders (TRS), n = All conglomerates 2 Conglomerates, 2 excluding financial institutions % of companies Moderately diversified companies Focused companies >30 Annualized TRS, , % 1 Includes companies in 2010 S&P 500 that were also publicly listed on Dec 31, Defined as any company with 3 or more business units that do not have common customers, distribution systems, manufacturing facilities, or technologies. a leader in point-of-sale solutions, and Videojet Technologies, which manufactures coding and marking equipment and software. Both of those companies margins improved by more than 700 basis points after they were acquired. Aggressive capital managers. Many large companies base a business s capital allocation for a given year on its allocation the previous year or on the cash flow it generates. High-performing conglomerates, by contrast, aggressively manage capital allocation across units at the corporate level. All cash that exceeds what s needed for operating requirements is transferred to the parent com- pany, which decides how to allocate it across current and new business or investment opportunities, based on their potential for growth and returns on invested capital. Berkshire Hathaway s business units, for example, are rationalized from a capital standpoint: excess capital is sent where it is most productive, and all investments pay for the capital they use. Rigorous lean corporate centers. High-performing conglomerates operate much as better privateequity firms do: with a lean corporate center that restricts its involvement in the management of business units to selecting leaders, allocating

7 Testing the limits of diversification 5 Conglomerates in emerging markets The economic situation in emerging markets is sufficiently distinctive to make us cautious in applying insights gleaned from US companies. While we expect the conglomerate structure to fade away eventually, the pace will vary from country to country and industry to industry. In emerging markets, large conglomerates have economic benefits that don t exist in the developed world. These countries still need to build up their infrastructure such projects typically require large amounts of capital that smaller companies can t raise. Companies also often need government approval to purchase land and build factories, as well as government assurances that there will be sufficient infrastructure to get products to and from factories and sufficient electricity to keep them operating. Large conglomerates typically have the resources and relationships needed to navigate the maze of government regulations and to ensure relatively smooth operations. Finally, in many emerging markets, large conglomerates are more attractive to potential managers because they offer greater career development opportunities. We can already see the rough contours of change in the role conglomerates play in emerging markets. Infrastructure and other capital-intensive businesses are likely to be parts of large conglomerates as long as access to capital and connections is important. In contrast, companies including export-oriented ones such as those in IT services and pharmaceuticals that rely less on access to capital and connections tend to be focused on, rather than part of, large conglomerates. The rise of IT services and pharmaceuticals in India and of Internet companies in China shows that the large conglomerates edge in access to managerial talent has already fallen. As emerging markets open to more foreign investors, these companies advantage in access to capital will also decline. That will leave access to government as their last remaining strength, further restricting their opportunities to industries where its influence remains important. Although the time could be decades away, conglomerates large size and diversification will eventually become impediments rather then advantages.

8 6 McKinsey on Finance Number 42, Winter 2012 capital, vetting strategy, setting performance targets, and monitoring performance. Just as important, these firms do not create extensive corporate-wide processes or large shared-service centers. (You won t find corporate-wide programs to reduce working capital, say, because that may not be a priority for all parts of the company.) Business units at Illinois Tool Works, for example, are primarily self-supporting, with broad authority to manage themselves as long as managers adhere to the company s 80/20 (80 percent of a company s revenue is derived from 20 percent of its customers) and innovation principles. The corporate center handles only taxes, auditing, investor relations, and some centralized HR functions. Berkshire Hathaway s corporate center operates with no integration of cross-cutting functions. Value-destroying failures litter the history of diversification strategies. Executives considering one should ask themselves, first and foremost, whether they have the skills to be the best owners of businesses outside their core industries. 1 We define a conglomerate as a company with three or more business units that do not have common customers, distribution systems, technologies, or manufacturing facilities. Joseph Cyriac (Joseph_Cyriac@McKinsey.com) and Tim Koller (Tim_Koller@McKinsey.com) are partners in McKinsey s New York office, where Jannick Thomsen (Jannick_Thomsen@McKinsey.com) is a consultant. Copyright 2012 McKinsey & Company. All rights reserved.

9 7 Taking a longer-term look at M&A value creation Companies that do many small deals can outperform their peers if they have the right skills. But they need more than skill to succeed in large deals. Werner Rehm, Robert Uhlaner, and Andy West Measuring the value that mergers and acquisitions create is an inexact science. Typical analyses compare share prices before and after a deal is announced, using short-term investor reactions to indicate how much value it would be likely to create. One benefit of this approach is that it provides a measure of expected value unaffected by other variables, such as subsequent acquisitions or changes in leadership. Yet relying on market reactions to gauge value creation has drawbacks. It skews the results to larger deals, which have the heft to affect share prices, and underrepresents smaller ones even though they account for a majority of M&A. It can also underestimate the amount of value created by multideal strategies whose real worth develops over the longer term. Researchers also frequently collapse their data into a single average for the purpose of generalization. That obscures important differences between industries and M&A strategies. To address those shortcomings, we analyzed the excess shareholder returns 1 of the world s top 1,000 nonbanking companies, which completed more than 15,000 deals over the past decade. While it s clear that factors other than the deals themselves influenced excess returns over that time, the data are strong enough to show and compare distinct patterns of deal making. When we segmented companies by the scope of their M&A

10 8 McKinsey on Finance Number 42, Winter 2012 Exhibit 1 The excess shareholder returns of the world s top 1,000 nonbanking companies reveal distinct patterns of deal making. Global 1,000 nonbanking companies, (ie, 639 institutions for which data are available through 2010) High Large deals 112 Transformed company through at least 1 individual deal priced at above 30% of market cap Number of companies in given category Market cap acquired Selective Small number of deals but possibly significant market cap acquired 180 Programmatic Many deals and high percentage of market cap acquired 142 Organic Almost no M&A Low 66 0 Tactical Many deals but low percentage of market cap acquired 139 Many Number of deals per year Source: Dealogic; McKinsey analysis programs (Exhibit 1), we found that long-term returns vary significantly by deal pattern and by industry. The implication is that across most industries, companies with the right capabilities can succeed with a pattern of smaller deals, but in large deals industry structure plays as much of a role in success as the capabilities of a company and its leadership. Long-term returns to M&A Because we look at excess returns over a full decade, we re better able to correlate longer-term strategies with shareholder returns and company survival rates. The data confirm that the larger companies get, the more they rely on M&A to grow: 75 percent of those that remained in the top 500 used active M&A programs, including 91 percent of those that stayed in the top 100 (Exhibit 2). A majority of these companies completed many smaller deals, with no large ones. 2 This finding makes sense, since large deals tend to be hit or miss. A correlation of the identified patterns of M&A with long-term excess returns shows that the only companies that had, on average, negative excess returns were those that did large deals (Exhibit 3). The odds of positive excess returns were slightly better for shorter time frames after specific deals, with about half generating positive excess returns within two to five years of the deal. Companies using any of the other approaches to M&A showed positive excess total returns to

11 Taking a longer-term look at M&A value creation 9 shareholders (TRS) relative to global industry indices. Those with a more programmatic pattern of M&A (defined as many small deals that over time represented 19 percent or more 3 of the acquirer s market capitalization) on average performed better than companies relying on organic growth. They also had a higher probability of positive excess returns. 4 Finally, the data suggest that a growth strategy built around a series of small deals can actually be less risky than avoiding M&A altogether. Organic strategies showed the greatest variability in excess TRS between top performers and companies in the lowest quartile, while programmatic and tactical M&A had the smallest range. The importance of industry specifics As compelling as these global averages might be, they do not answer the question of whether an individual company in a specific industry at a given time should engage in M&A. Indeed, the averages conceal what are frequently the most relevant details, such as industry structure, the match of an asset with a well-articulated strategy, and the execution capabilities required to realize value. As our previous analysis showed, returns by M&A approach are widely distributed and can obscure individual results. 5 Consider the data on an industry-by-industry basis (Exhibit 4). The results vary widely but patterns do emerge. Large deals. Companies are more successful with large acquisitions those worth more than 30 percent of the acquirer s market capitalization in slower-growing, mature industries. Here, there is great value in reducing excess industry capacity and improving performance, and a lengthy integration effort is less disruptive. Exhibit 2 The larger companies get, the more they use M&A to grow. Distribution of survivors (companies that were in the global 1,000, top 500, top 250, or top 100 in both 1999 and 2010), % 100% = Selective Large deals Programmatic Survivors Global 1, Top Tactical 4 2 Organic Top 250 Top 100 Minimum market cap as of Dec 31, 1999, $ billion Percentages do not sum to 100%, because of rounding. Source: Dealogic; McKinsey analysis

12 10 McKinsey on Finance Number 42, Winter 2012 In contrast, large deals in faster-growing sectors 6 have been less successful, with 12 percent excess TRS in the five years after such deals, significantly lower than the 4 percent excess TRS for companies in slower-growing industries over a similar period. Why did companies in faster-growing sectors underperform? Many focused inwardly during the lengthy integration required for large deals, missing critical product or upgrade cycles. Others attempted to expand into complementary businesses, where targets had limited overlap in products and technology. In addition, over the period we reviewed, we found that these companies tended to do large deals in years when market valuations were generally high. Tech companies, for example, have fallen into all three of these traps. Of course, the success of large deals also depends on a company s strengths and its leadership s ability to guide it through a year or more of integrating a large acquisition, as well as other factors idiosyncratic to specific deals. 7 Programmatic deals. Companies across a variety of industries do well using the programmatic approach. In most sectors for which we had sufficient data, it tended to score in the top two strategies (based on excess returns over the last decade). Companies using the strategy completed many acquisitions that together represented a material level of investment as a percentage of market cap. 8 In addition, we found a volume effect the more deals a company did, the higher the probability it would earn excess returns. 9 Exhibit 3 Companies using a programmatic strategy are the most successful. Global 1,000 nonbanking companies, % Median excess total returns to shareholders (TRS), 1 Dec 1999 Dec 2010 Probability of excess return greater than 0 Average 95% confidence interval Excess TRS, difference between 25th and 75th percentile in percentage points Programmatic Selective Organic Tactical Large deal Outperformance against global industry index for each company. Source: Dealogic; McKinsey analysis

13 Taking a longer-term look at M&A value creation 11 Across most industries, companies with the right capabilities can succeed with a pattern of smaller deals, but in large deals industry structure plays as much of a role in success as the capabilities of a company and its leadership. Evidence shows that executing a high-volume deal program requires certain corporate capabilities but not necessarily a specific industry structure. Most programmatic acquirers prioritize one or two markets or product areas where they can build businesses with leadership positions. For example, IBM s program of acquiring smaller software firms succeeded because the company could offer acquired businesses access to global markets, which they had lacked. The program was so successful that IBM now publishes both metrics for success (in the form of improved growth and margins for targets after an acquisition) and its goals for additional profit from future acquisitions. In much the same way, most big pharmaceutical companies embark on a series of smaller deals and licensing arrangements with companies that do not have a global commercial footprint. In some cases, big companies are also looking to find new growth opportunities. In the late 1990s, German industrial conglomerate BASF, for example, determined that it could grow more quickly and profitably if it shifted its focus to specialty chemicals an area in which managers believed they could create value through their technical skills and understanding of customer needs. The company then shed its commodity chemical operations and acquired specialty companies and businesses, which it quickly integrated. In another series of deals, The Walt Disney Company acquired brands such as Baby Einstein and the Muppets, lending the power of Disney s global profile to expand their market and reach. Acquisitions of Club Penguin and Marvel Entertainment were similar: the former gave Disney a product in a new distribution channel; the latter allowed it to pick up content that s popular with teenage males a relatively tough demographic for the company. Tactical deals. Companies using a tactical approach to M&A also do numerous small deals, but those deals do not, combined, make up a large portion of the acquirer s market capitalization. Nonetheless, M&A still is an important part of the strategy. Tech companies were significantly more successful with this approach than with the others: they used M&A as part of an innovation and capability-building strategy, buying options and adding functions. Microsoft, for example, has a history of adding features to its core products through M&A to give users incentives to upgrade. Many smaller

14 12 McKinsey on Finance Number 42, Winter 2012 Exhibit 4 Returns by M&A approach are widely distributed and can obscure individual results, but they roughly indicate the top strategies by industry. Global 1,000 nonbanking companies, median excess total returns to shareholders (TRS), Dec 1999 Dec 2010, % Industries Top strategies in industry Top strategies Consumer discretionary Telecom PMP 1 High tech CPG 1 and retail Materials Manufacturing, other industrials Insurance and related Programmatic Selective Tactical Large deals Organic N/A N/A 2 N/A N/A PMP = pharmaceutical and medical products; CPG = consumer packaged goods. 2 Data not shown where category contained <5 companies. Source: Dealogic; McKinsey analysis products acquired by the company found their way to the next release of Excel, and the upgrade cycle provides continued revenue for the franchise. Manufacturer Foxconn Electronics executed more than 20 small strategic and equity outsourcing deals over the decade. Some were intended to expand its capabilities from PC assembly into digital cameras, handsets, and networking equipment, to name a few things. Others eased the company s vertical integration into components, with the goal of serving end customers better and thus helping the acquired businesses to grow. Industrial companies in this segment seem to use tactical M&A to fill gaps in products or channels. This approach is quite similar to programmatic M&A, but not on the same order of magnitude. Caterpillar, for instance, used M&A to round up its product portfolio by purchasing companies that made diesel engines, railroad and mining equipment, and specialized repair gear. In all likelihood, industrial companies in this category are somewhat limited by the number of small targets available in their industries. Selective deal making. Many companies do deals occasionally but don t appear to have an M&A capability or a proactive M&A strategy. Most of the companies in this segment spend less than 2 percent of their market cap a year on M&A. Their total shareholder returns are in all likelihood driven more by an organic-growth tailwind than by M&A strategy. The rest of the companies in the segment are individual cases, many stemming from unlucky one-off deals at the end of the 2001 tech bubble. It is therefore hard to conclude

15 Taking a longer-term look at M&A value creation 13 that the performance of this group is based on a clear M&A strategy. More likely, these were solid companies that engaged in occasional pragmatic deals to support the growth of the underlying business. It s possible to understand M&A performance better by taking a finer-grained look at patterns of deal activity. The success of large deals tends to depend more on the industry where they take place, the success of small ones more on the capabilities of the acquiring companies. 1 We measure excess total returns to shareholders (TRS) by assigning companies to subsectors and tracking the difference between a company s TRS and an index that follows the sector. In this analysis, we used 11-year excess TRS to avoid some of the issues resulting from the collapse of the high-tech bubble in the early 2000s. 2 Defined as a target acquired for at least 30 percent of the acquiring company s market value in the year the deal closed. 3 Among companies completing only small deals, we used the aggregated median acquired market capitalization, or 19 percent, as the cutoff between those with significant M&A programs (programmatic acquirers) and those that acquire small deals opportunistically (tactical acquirers). 4 However, the confidence intervals for average returns are overlapping. 5 See Andres Cottin, Werner Rehm, and Robert Uhlaner, Growing through deals: A reality check, mckinseyquarterly.com, April Defined as average annual growth above 7 percent. This data set included 82 deals worth more than 30 percent of the acquirers market cap. 7 See, for example, Ankur Angrawal, Cristina Ferrer, and Andy West, When big acquisitions pay off, mckinseyquarterly.com, May A median of 36 percent of market cap acquired with 33 deals over the time frame. 9 As with the other analyses, this is a correlation, not necessarily a causative relationship. Although we feel confident that the deal strategy contributed to the outperformance, it is possible that better-performing companies executed more deals in the wake of their success. The authors would like to thank Theresa Lorriman for her significant contribution to the research. Werner Rehm (Werner_Rehm@McKinsey.com) is a senior expert in McKinsey s New York office, Robert Uhlaner (Robert_Uhlaner@McKinsey.com) is a partner in the San Francisco office, and Andy West (Andy_West@McKinsey.com) is a partner in the Boston office. Copyright 2012 McKinsey & Company. All rights reserved.

16 14 A mixed year for M&A Global deal activity slowed in August, though measures of value creation continued to improve. Carsten Buch Sivertsen M&A activity slowed in 2011 as uncertainty surrounding the European sovereign-debt crisis continued to vex the global economy. The growth that characterized the first seven months of the year came to an abrupt halt in August as the crisis heightened, accompanied by a sharp 17 percent drop in the S&P 500 and a surge in volatility. 1 For the year, companies around the world announced 7,700 deals, valued at $2.7 trillion a meager 3 percent increase from Not surprisingly, activity among companies headquartered in Europe was most affected, falling by 26 percent between the first and second halves of 2011 compared with only an 18 and 9 percent drop among companies in the Americas and Asia, respectively. Overall, acquisitions by European companies constituted just 31 percent of M&A by volume, the lowest share for the region since Cross-border activity was also affected as Asian and US companies actively sought out deals in Europe. Although total activity for the year remained steady at the 2010 level, the amount of M&A into Europe by non-european acquirers increased to $220 billion because of a few large transactions and an increase in midsize and small acquisitions. Despite the crisis and slowdown in activity, investors remain sanguine about deals. Our analyses showed that in 2011 they created almost as much value, measured as share price movements

17 15 Exhibit 1 The net value created by M&A remained close to 2010 levels. Average annual deal value added (DVA), 1 % DVA target DVA total DVA acquirer Average, % Number of deals For M&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 Reuters Datastream; McKinsey analysis Exhibit 2 Acquirers also sustained discipline in their deal making. % of overpayers (POP) 2 1-week premium, 1 Average of overpayers (POP) % Median deal premiums Number of deals 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. 2 POP 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 Reuters Datastream; McKinsey analysis

18 16 McKinsey on Finance Number 42, Winter 2012 before and after the announcement, 2 as they did in 2010 the highest in our 15 years of tracking. The net value, measured as deal value added (DVA), dropped to 12 percent, from 13 percent in 2010, but remained considerably higher than the 15-year average of around 5 percent (Exhibit 1). Acquirers also remained disciplined at capturing this value for their shareholders: the proportion of deals followed by a decline in the acquirer s share price the percentage of overpayers remained low at 51 percent, significantly better than the historic average of 60 percent (Exhibit 2). This implies that investors expected that half of all deals in 2011 would destroy value for the acquirer s shareholders, even as continued high premiums suggested that shareholders of the companies sold weren t getting shortchanged. 1 Volatility peaked at 45 on the Chicago Board Options Exchange Volatility Index (VIX) during the crisis and hovered above 30 until early December, compared with a ten-year average VIX score of Announcement effects are useful to assess the impact of M&A on its own, as they strip out many other factors, beyond the M&A announcement, that can drive share price movements. But the market s initial response to deals can be either wrong or affected by factors other than its value (such as bid speculation before the deal, signaling, and tax and market liquidity issues). Announcement effects therefore cannot be used to assess the value that any individual deal creates. The author would like to acknowledge the contribution of Tarun Khurana to the development of this article. Carsten Buch Sivertsen (Carsten_Buch_Sivertsen@McKinsey.com) is an associate principal in McKinsey s Oslo office. Copyright 2012 McKinsey & Company. All rights reserved.

19 17 Understanding the Second Great Contraction: An interview with Kenneth Rogoff The economist and coauthor of This Time Is Different explains what history can teach us about the global downturn and why climbing out of it is still rife with risks. Bill Javetski and Tim Koller Continued economic stagnation in Europe and the United States, along with renewed uncertainty about the health of the debt-ridden global financial system, has been raising fresh concerns about the prognosis for economic recovery and even the potential for a relapse into crisis. A big part of the problem, as Harvard economist Kenneth Rogoff pointed out in This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, September 2009), the best-selling academic book he coauthored with fellow economist Carmen Reinhart, is that we are working through a recession linked to a deep financial crisis a powerful amplifying mechanism with long-lasting effects. Reinhart and Rogoff s work, based on investigations of empirical data from 800 years of financial crises, shows that such downturns are exceptionally deep and long lasting, as well as unprecedented in the United States since World War II. McKinsey s Bill Javetski and Tim Koller visited Rogoff in his Cambridge, Massachusetts, office to ask where we are in the recovery time line and why Rogoff thinks that a bout of moderate inflation may help the world regain economic health. Rogoff s outlook that the balance of current economic risks tilts more to the downside than the upside is sobering but essential reading for business leaders and policy makers trying to make sense of today s uncertain environment.

20 18 McKinsey on Finance Number 42, Winter 2012 McKinsey on Finance: What does history tell you about where we are on the time line of the economic contraction we ve been living through? traction, building on the title of Milton Friedman and Anna Schwartz s famous book about the Great Depression. 1 Kenneth Rogoff: The historical experience gives a very clear view that the aftermath of a financial crisis brings slow and halting growth, sustained high unemployment, and surging public debt with the overhang of public and private debt being the most important impediment to a normal recovery from recession. It has been utterly remarkable how the United States has been tracking the averages of postwar deep financial crises across a broad range of indicators. On average, it takes four and a half years to get back to the same per capita GDP where you started out and about the same amount of time for unemployment to stop rising. Indeed, we haven t yet gotten back to the same per capita GDP where we started. Our perspective is that we have never left the recession; we re still very much in it. I hope in another two or three years things will be feeling more normal. But there are a lot of difficulties to traverse before we get there. McKinsey on Finance: You distinguish between normal recessions and those accompanied by a deep financial crisis. Are there many recessions marked by such a crisis? Kenneth Rogoff: There have been many across the world, but for the United States this is the first one since World War II. A financial-crisis recession is a very different animal from a normal recession. At least quantitatively, it s not as bad now as it was in the Great Depression. Nevertheless, Reinhart and I argue that the right name for this downturn is the Second Great Con- McKinsey on Finance: Is there any way to accelerate our pullout from this contraction? Kenneth Rogoff: It s not easy, because a postfinancial-crisis recession is characterized by an overhang of private and public debt that is much more severe than it is after a normal recession. There are many mortgages still under water perhaps 25 percent and people are more cautious about extending their borrowing than they were before That leads to slower consumption growth. Businesses in turn invest more slowly. In 2008, policy makers placed too much confidence in the Keynesian idea that you can jump-start the economy with a big temporary stimulus and then step back and watch the private sector take over. Of course, Reinhart and I argued otherwise, based on the results of a seven-year research project, and our results certainly were acknowledged by practitioners, academics, and policy makers. Nevertheless, most policy makers and markets still insisted, Well, yes, maybe that is how things always were in the past, but this time it s different because the policy response was so aggressive. In fact, the policy response is always very aggressive. Every country does everything it can to claw its way back from a deep financial crisis. So, unfortunately, there is no easy out. Perhaps the best chance would be to find a way to get ahead of the mortgage defaults that is, to have restructurings and debt forgiveness, albeit with some kind of quid pro quo. That is very hard to do. But if there were a way to write down and forgive some of the mortgage debt, that would be money well

21 Understanding the Second Great Contraction: An interview with Kenneth Rogoff 19 spent. In ten years, we will probably end up forgiving a big chunk of it. As Carmen has noted, this is a little like Third World debt that was carried on the books forever, even though it was a joke. McKinsey on Finance: What other policy responses would make sense? Kenneth Rogoff: Beyond that, we need to think about long-run structural reform. Most financial crises have at their root very, very high leverage. To hit the nail on the head, I think we have to do something about the prevalence of nonindexed debt instruments. I would start with changing our corporate-tax law and any overt incentives that favor debt. Obviously, the US home mortgage tax deduction makes no sense, given the risk that debt entails. I understand the political imperative, but let s not subsidize debt in an overt way. I think public-finance experts need to methodically go through the system and strip debt subsidies out. And then I d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. 2 If in 200 or 300 years, we re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation Kenneth Rogoff Vital statistics Born March 22, 1953, in Rochester, New York Married, with 2 children Education Graduated with a BA in economics in 1975 from Yale University Earned a PhD in economics in 1980 from the Massachusetts Institute of Technology (MIT) Career highlights Harvard University (2008 present) Professor, economics and public policy Princeton University ( ) Professor, economics and international affairs University of California at Berkeley ( ) Professor, economics University of Wisconsin at Madison ( ) Professor, economics Fast facts Awarded Deutsche Bank Prize in Financial Economics in 2011 Served as economic counselor and director of the research department of the International Monetary Fund (August 2001 to September 2003) Elected member of the American Academy of Arts & Sciences and the Econometric Society Earned life title of international grandmaster of chess by World Chess Federation in 1978

22 20 McKinsey on Finance Number 42, Winter 2012 clauses into debt that make it a little less vulnerable to systemic risk. McKinsey on Finance: Financial innovation, in the form of derivatives, credit default swaps, and other instruments, was supposed to make the world a safer place. Did they have a role good, bad, or neutral in creating the crisis? Kenneth Rogoff: Financial innovation is always a piece of financial crises, and financiers are always ahead of the regulators. In This Time Is Different, we discuss how in the 1300s and 1400s the Catholic Church which was the regulator at the time, of course had very strict usury laws. The financiers got around them by thinking of very clever devices, including denominating loans to be repaid in a foreign currency. You give the money in a weaker currency and require the repayment in a stronger currency, which, of course, everyone perfectly well understood to be equivalent to paying interest. There are countless examples over the ages. The transatlantic cable led to huge financial innovation. Innovation is always ahead of the regulators. McKinsey on Finance: Does that mean we should be cautious about the supposed benefits of financial innovation? Kenneth Rogoff: I think financial innovation has been overly blamed for everything. Financialsector lobbying is another matter regulators of the financial sector lost sight of the risks. McKinsey on Finance: Is the size of the banks an important factor? Can they get too big? Kenneth Rogoff: I believe that size is overrated as the issue. There is this view that if we can just break up the big banks into smaller ones, we won t have a problem. But if you look at systemic crises, usually a lot of banks are doing the same thing. So if we take one big bank and break it up into ten smaller banks that act similarly, I m not sure how much we really would have bought ourselves. The incentives that would make a big bank go whole hog in one direction would probably make ten smaller banks do the same thing. McKinsey on Finance: You ve advocated allowing inflation to increase as one kind of remedy. Can you explain? Kenneth Rogoff: There are no quick fixes. But I do think that this is a period when we shouldn t be worried about raising inflation slightly. Indeed, moderate inflation, I would say, is exactly the prescription for a Great Depression type scenario or a Japan-type scenario. It lowers real interest rates, helps facilitate housing price adjustment (the real price still needs to come down in many places), and modestly shortens the typical long post-crisis deleveraging period. I ve pushed the idea, for some time, that we re in a Great Contraction, not in a typical recession, and one has to analyze the problem differently. Unfortunately, there is still a risk that this thing could get much, much worse. The biggest problem is the global overhang of debt. After publishing our book, Carmen Reinhart and I did a study that looked at the impact of public debt on growth. When debt gets over a certain level a good marker is 90 percent of GDP it is linked to lower growth. If elevated inflation I ve suggested 4 to 6 percent for a few years somewhat reduces real debt levels, that would be welcome. Of course, I do get a knee-jerk reaction from many people saying that even slightly elevated inflation is anathema; we d be going back to the bad old days of the

23 Understanding the Second Great Contraction: An interview with Kenneth Rogoff 21 70s. And my answer is that this could still be much worse than the 70s. I ve worked my whole career on designing central banks and promoting tools and institutions for containing inflation. But right now, given a once-in-80-years downturn, you have to balance the risks. McKinsey on Finance: Is that the right approach for Europe as well? Kenneth Rogoff: Absolutely, though of course they have a political tightrope to walk. Still, how much should they worry about whether inflation is under 2 percent right now when the euro could fall apart in the next year or two? Please understand, the European Central Bank is under tremendous political pressure, and they re not the main source of the problem. But I don t see how they would want to be in a situation where they d go out of business in a year and say, Well, the euro may have fallen apart, but we never had inflation expectations go above 2 percent. Inflation is not a panacea, but this is a once in eight or ten decades situation where it would be helpful. McKinsey on Finance: Is it naive to pretend that some or much of this debt isn t going to have to be restructured at some point? Kenneth Rogoff: By any historical benchmark, Greece, Portugal, and probably Ireland are way over the line. Their debts should be dramatically reduced for Greece by at least 60 percent or 70 percent. Portugal probably 40 to 50 percent. Ireland is more complicated because it s difficult to disentangle what s government debt and what s bank debt. The big problem is Ireland s bank debt. But the government has guaranteed it. Had the eurozone officials done all this a year ago and, importantly, cast an ironclad safety net over the remainder, perhaps we would be looking at this in the rear window. McKinsey on Finance: What indicators would you look to for signs that we re finally starting to get out of this? Kenneth Rogoff: Job growth and unemployment. I don t expect unemployment to come down again to 4 or 4.5 percent until the next time the economy overheats. That level was never normal. More likely, when this is all over, unemployment will settle down at around 6.5 or 7 percent. Until we ve seen unemployment come down to a level like that, things will remain precarious. I should note that the most reliable measure, though, isn t unemployment; it s employment. In addition to unemployment rising, the participation rate in the economy has fallen, and that too needs to come back. 1 Milton Friedman and Anna Jacobson Schwartz, The Great Contraction, , Princeton, NJ: Princeton University Press, Robert Shiller is a professor of economics at Yale University and cocreator of the Case Shiller House Price Index, one of the most widely used methods of measuring performance in that industry. Bill Javetski (Bill_Javetski@McKinsey.com) is a member of McKinsey Publishing and is based in McKinsey s New Jersey office; Tim Koller (Tim_Koller@McKinsey.com) is a partner in the New York office. Copyright 2012 McKinsey & Company. All rights reserved.

24 22 McKinsey on Finance Number 42, Winter 2012 Five steps to a more effective global treasury Demands on the corporate treasurer are changing, and many are struggling to keep up. Here s where to start. Tim Hesler, Kevin Laczkowski, and Paul Roche The rapid shift of economic activity from established markets in Europe and North America to developing ones in Africa, Asia, and Latin America has many CFOs asking treasurers to improve their performance. The pace of growth and regulation has left too many of them lagging behind on even core activities in their home markets: cash management, banking, debt and funding, investments, and risk management for currencies and interest rates. Such shortcomings are only magnified as companies expand into emerging markets, 1 where even world-class treasury departments struggle to navigate varied banking protocols and diverse languages and customs and often lack an operating model and infrastructure to connect their activities, portfolios, and risks. The cost can be heavy. Companies pay incremental interest expenses when they overborrow as a result of inaccurate cash flow forecasting and often lose money when they don t hedge exposures for currencies and for interest rates, commodity prices, or both. They pay unnecessary taxes when cash moves needlessly through tax-heavy regions. If inadequate controls or segregated financial responsibilities lead to fraud, companies face both financial losses and reputational damage. Those that miss their financial covenants with banks or fail to meet liquidity requirements can find themselves dealing with creditrating downgrades, a loss of credit flexibility, or even bankruptcy.

25 23 In an effort to help corporate treasurers improve their performance in core activities, we surveyed 120 of them over the past year and conducted inperson interviews with an additional 50. Those sources, as well as our experience working with treasurers, have led us to believe that companies should focus on five moves to improve their global treasury function. 1. Centralize the treasury function globally Historically, most companies have had a treasury department at their corporate headquarters, but it was siloed, managed only core activities, and often duplicated those of individual business units. As bank communications technology improved and treasury groups added new responsibilities, it made sense to consolidate functions that had been operating independently in different parts of the world. Many companies did centralize treasury functions at headquarters, supported by a few part-time treasury and finance professionals in developing markets. But most treasuries retain too many decentralized components, and few are as centralized in developing markets as they are in developed ones. Our survey found, for example, that among global companies operating in more than 50 countries, the average number of bank accounts held was greater than 850 considerably higher than the 200 or so we ve seen at the best performers. One treasurer we interviewed complained that her company didn t even know how many bank accounts it had overseas. And at one heavymaterials company, analysis of cash balances in 300 accounts held by 25 country locations showed a daily average of more than $80 million in uninvested cash over a three-month period. The ideal model would centralize policy setting, decision making, and execution though not necessarily personnel. Consolidating the treasury function under the global treasurer can help by giving managers an aggregate view of their cash flow and risk positions a view they need to optimize debt and investment portfolios and to minimize taxes and financial risk. Moreover, the operating model and infrastructure that connect a company s various activities, portfolios, and risks ensure that even regional treasury groups have the quickness and rigor needed to make the most of activities in volatile markets. They can therefore take advantage of local financial opportunities and avoid unnecessary losses. Such a treasury would have to be flexible and well controlled to receive inputs from regional treasuries. One caveat: a centralized treasury organization does come with trade-offs for instance, it might leave a company with less information about local banking and country-specific regulations. Moreover, business units in different regions may have to cede responsibility for activities, such as currency and commodity hedging, that have historically benefitted their local profit-and-loss statements. That can generate resistance from local managers. At one of the world s largest consumer goods companies, for instance, the CFO would like to eliminate duplicate treasury functions among businesses and centralize the treasury in one location. But doing so would require a battle with strong, independent businesses that adamantly defend their own treasury infrastructures and backoffice locations. Such battles are winnable. One global company, for example, upgraded its treasury in Asia to the same level as those in established markets by designing improvements to its operating model to take effect as the treasury function matured over a five-year period. Here the emphasis was on analytical sophistication, internal-client impact, automation, and integration.

26 24 McKinsey on Finance Number 42, Winter 2012 The company s treasurer organized a structured workshop, bringing everyone to a single geographical location free of operational distractions, to get buy-in from the global treasury managers and ensure that the treasury s mission and operating model were aligned with the company s mission and strategic plan. The CFO approved investments in new systems for cash management and for the front and back offices. The development of treasury policies and a treasury dashboard kick-started the initiative and extended the company s treasury capabilities to its regional businesses. Managers are pleased with the progress of this redesigned treasury, though the CFO reports that the company is still struggling with the reporting relationships between the global treasurer and the management of regional business units. able catastrophic events, whether they re natural disasters (such as hurricanes or tsunamis), political unrest, or even terrorist attacks. In our experience, such plans should be but often aren t tested regularly in all regions to highlight and correct operational-risk weaknesses. Unannounced tests are critical. The global treasurer at a US-based conglomerate, for example, woke up his direct reports with a 5:00 AM telephone call announcing a simulated disruption to normal activities and setting in motion a series of tests. These tests helped the function develop operational readiness and the ability to access and transact in markets, with no leakage. Ideally, treasury operations would appear undisrupted to senior management. 2. Strengthen governance Wherever there s money moving around, fraud and mismanagement are risks. That s particularly true in a company s treasury department, where funds move in real time, using complicated financial instruments and where an erroneous transaction can affect accounting, financial reporting, and internal controls. Add regional differences in protocols, governance, and oversight norms, and the problem can be a real headache for CFOs and treasurers alike, especially as their companies expand into some developing markets where governance is often weak or nonexistent. Strengthening treasury governance requires a thorough review of policies and processes for core activities, followed by testing to ensure that they work well in practice and by comprehensive training. One way to start is to test how processes work under stress. The treasurers we identified as most effective, for example, regularly test the business continuity plans that keep treasury operations running through unforesee- 3. Enhance treasury-management systems The rapid pace of software development over the past 20 years has brought to market a range of sophisticated tools that facilitate the treasury function. The conundrum has been that the earliest tools spreadsheet programs have dramatically improved. Some CFOs are not convinced that advanced systems are worth the cost, which can run as high as $1 million or more for integrated treasury-management systems and enterpriseresource-planning (ERP) modules. In our survey, we found that nearly half of the companies with less than $10 billion in revenue still used spreadsheets as their primary treasury system. Yet cost benefit analyses are unreliable in this case because it s difficult to measure the value of risk avoidance, a unified database, automation, integration, and enhanced management reporting. Quantifying the value of stronger governance, internal controls, and better analytical tools is a challenge too. And spreadsheet programs, powerful though they may be, are woefully inade-

27 Five steps to a more effective global treasury 25 Strengthening treasury governance requires a thorough review of policies and processes for core activities, followed by testing to ensure that they work well in practice and by comprehensive training. quate for a centralized global treasury. They re seldom well controlled, and few companies audit them closely enough to validate the logic of interconnecting calculations or even the formulas in individual cells. A single error in a single cell can ripple through an entire model, leading managers to borrow instead of invest, to hedge incorrectly, and to forget to fund operating accounts or to make debt payments. And often there s no integration: we continue to encounter treasurers whose management system includes as many as 50 or 100 distinct spreadsheets, often reflecting different systems used by businesses in different geographies. That approach can lead to unnecessary hedge transactions when managers unintentionally hedge exposures in different regions against each other, instead of aggregating the longs and shorts of currency exposures and then hedging the net position. 2 company, a simple data entry error led the US treasurer to wire $80 million inadvertently to the wrong payee in the wrong country. By the time managers discovered the error, currency rates had shifted, and returning the cash came at a substantial cost. 4. Increase the accuracy of cash flow forecasting Treasurers often admit that their global cash flow forecasts are poor or incomplete. The CFO of one international airline, for example, noted that when his company recently ordered new airplanes, it had no cash flow forecast and no idea if it could pay when the time came. If it couldn t, the airplane manufacturer would stop delivering planes, hobbling the airline s growth. That s an egregious example, to be sure. Yet in our survey, nearly one-half of the treasurers reported that their cash forecasting was less than 80 percent accurate. Even minor errors can cost a company many times the expense of a more sophisticated treasurymanagement system. At one North American utility company, for example, a simple spreadsheet error for energy auction bids led managers to enter into nonreversible contracts the company didn t need a mistake that cost it half of its operating earnings for the quarter. At an agrochemicals Improving the accuracy of forecasts isn t rocket science; it just requires a robust set of activities that companies don t or can t undertake. A company s treasury function should aggressively analyze cash flow forecasts and different cash scenarios, consult with the company s businesses in all global regions on how they might best utilize cash economically, run currency what if scenarios,

28 26 McKinsey on Finance Number 42, Winter 2012 and provide a multinational company with better intelligence for the use of cash. An effective program also acts as an early-warning system to anticipate potential liquidity gaps, which are a primary source of financial risk, particularly in emerging markets. Liquidity forecasts, measuring liquid assets and credit sources to predict whether a company will be able to pay its debts and obligations, can help it manage cash by testing stress scenarios for differing market conditions. The daily, weekly, and monthly monitoring of cash in all business regions helps treasurers keep track of progress; for example, it ensures that they have the information needed to decide which cash pools and funding options they should pursue to avoid a cash shortfall and lets them measure the impact of efforts to improve cash flow performance. Here again, an advanced treasury system is a powerful tool. But as with all technological solutions, it can t fix variances in global cash flow forecasts or automate the process completely. Cash flow forecasting is a structured and iterative process that requires treasurers to seek input from the field and various business locations. 5. Manage working capital in developing markets The concept of working capital seems like a simple one: current assets minus current liabilities equals the capital that a company uses in its dayto-day operations. Yet managing working capital globally is a challenge, especially in developing markets, where the task can be complicated by differences in business culture. Payment terms, for example, may vary markedly from the 30 days common in many developed markets to as much as 360 days in some South American and African countries. A lack of automated systems to process accounts payable and receivable introduces further complexity. Moreover, many companies in both developed and developing markets focus too closely on accountingtype measures, such as the cash flow statement or the profit-and-loss statement, without developing discipline in cash and working-capital management. That emphasis misses the real workings of a company and deflects attention from the fundamental principles of optimizing cash. The CFO of a business unit in a global industrial company, for

29 Five steps to a more effective global treasury 27 instance, recognized the progress of his treasury s efforts to reduce working capital in accounts payable and receivable. But he also stressed that efforts to improve inventory still needed to encompass the entire cash conversion cycle. to the organization. Indeed, two-thirds of the treasurers in our survey reported seeing workingcapital management as an opportunity and would like more involvement in it. Many executives are surprised to find that their companies hold excessive levels of working capital in regions where they aren t established. Managing working capital is complicated because it requires spending a lot of time with business units in their various regions to understand how they pay their suppliers and figure out customer behavior. It s not an easy task. Yet many treasurers find it a useful way to raise their profile and distinguish themselves as strategic financial advisers As companies assign new responsibilities to the corporate treasury function, treasurers must improve it with a global focus and streamline its performance. That may require an up-front investment, but the payback is worth it. 1 See, for example, Yuval Atsmon, Ari Kertesz, and Ireena Vittal, Is your emerging-market strategy local enough?, mckinseyquarterly.com, April See Bryan Fisher and Ankush Kumar, The right way to hedge, mckinseyquarterly.com, July Tim Hesler (Timothy_Hesler@McKinsey.com) is a senior expert in McKinsey s New York office, Kevin Laczkowski (Kevin_Laczkowski@McKinsey.com) is a partner in the Chicago office, and Paul Roche (Paul_Roche@McKinsey.com) is a partner in the Silicon Valley office. Copyright 2012 McKinsey & Company. All rights reserved.

30 28 Rethinking people development in finance It s time to overhaul the way companies develop the careers of finance professionals. Ankur Agrawal and Bill Huyett For all the innovation in financial management over the past 20 years, it s remarkable how little the process of hiring and developing finance talent has evolved. Many CFOs do so pretty much as they did a decade or two ago, recruiting talent from a largely homogenous pool of candidates, predominantly with accounting backgrounds or quantitative skill sets, and assigning most of them to budgeting and planning or to finance operations. Many believe that rotational assignments can create the breadth that finance function generalists and future CFOs need. Yet that approach isn t likely to deliver the leadership profiles needed to manage increasingly complex finance organizations and to serve business leaders broadly in the modern era. Turnover is high. Few new hires with an accounting background ever get the kind of sustained business experience that would hone their strategic and top-management advisory skills. CFOs report a growing tension between demand for traditional finance operations and demand for finance support elsewhere in planning and strategic analysis, reporting to shareholders and regulators, and coordinating activities across a complex web of outsourced and automated transaction providers. One way to develop the skills that the modern finance function requires is to differentiate development paths for distinct roles: specialists to handle traditional finance domains; advisers to counsel senior executives in business units and functions; and experts to manage areas such as investor

31 29 relations, risk management, treasury, or taxation. The recruiting pools and profiles for these segments would differ, as would their careerdevelopment paths (through rotations or formal training), and the people in them would be evaluated and compensated differently. Operational and financial-services specialists The individuals who bear responsibility for traditional transactional tasks managing financial processes (such as journal ledgers, accounts payable, and receivables) and basic reporting hold roughly half of the management roles in most finance functions. Many of these activities are now handled by shared-services groups that can standardize processes and take advantage of scale benefits. Staff members in these roles often provide finance transaction support for internal and external customers. Their development goal should therefore be to get broad customer service expertise and skills, including the ability to ensure zero error rates, continuous cost and quality improvements, and legal compliance, as well as the projectmanagement savvy to run teams dispersed across a number of locations. Finally, these specialists should be adept at information technology, given the increasing use of enterprise-resource-planning (ERP) systems, and at building relationships with the third-party vendors that often support finance subprocesses. Companies that aggregate these roles into a distinct professional track could not only recruit individuals for them beyond the typical pool of candidates with accounting degrees but also better define their career progression. For many people, a clear career path would make this track an attractive one by providing the kinds of skills motivating teams, driving quality assurance, improving processes that would prepare people for future roles running groups or projects that share similar management goals. A few companies have already adopted an approach along these lines. One leading transportation and logistics business, for example, has given the finance function a lean shared-services center that hires people with process rather than functional capabilities. Managers measure success by their ability to develop the organization s service quality and process skills rather than functional knowledge alone, and it now boasts one of the industry s lowest costs per transaction, high employee morale, and minimal turnover. Internal financial-performance advisers Much of the increasing demand on the finance function comes from business unit managers who want support for decisions that affect value creation and its recognition by equity markets. At the most senior level, CFOs spend most of their time in this role, but traditional hires as division finance directors are not always well prepared for it. The best candidates may hold advanced business and professional degrees, such as MBAs, or have experience in other parts of the business, for these people are more likely to have the technical, strategic, and competitive knowledge to integrate finance and strategic thinking. Depending on the industry, we estimate that the professionals in this track should account for around 25 percent of the management positions in the finance function. Ideally, these advisers would develop the analyses and reports that executives rely on to make sound, value-creating decisions for example, by explicitly illustrating the trade-offs among strategic options, such as the balance between internal and outsourced R&D. They would also participate more actively in individual M&A transactions (including quantifying and

32 30 McKinsey on Finance Number 42, Winter 2012 addressing revenue and cost synergies) and play a role in improving the competitive distinctiveness of the company s M&A capabilities: the quality of the pipeline, the speed of decision making, and the creation of repeatable merger-management capabilities. (They would, for instance, understand the kind of innovative business and portfolio modeling that adjusts for a shifting landscape of competitors, macroeconomic environments, and customers.) Finally, the advisers would build leadership capabilities to coach line executives, challenge inertia and wishful thinking in the allocation of resources to existing businesses, speed up and improve decision making, and educate line leaders (for example, about how capital markets behave). A number of companies already have such professional tracks. One large industrial conglomerate, for example, formally identifies and recruits people in different parts of the organization for finance leadership roles. It has a very aggressive, defined approach to rotations through different businesses, other functions (such as marketing), and line leaders who have different management styles. This breadth of exposure and on-the-job apprenticeship is coupled with an objective, stringent performance evaluation process ensuring that only people who combine technical expertise with top-management peer skills are retained. Other companies take a less formal approach, identifying talent by word-of-mouth networks within the finance function. We also see companies using major capital projects, new-product introductions, or acquisitions as opportunities to build the generalist skills of finance leaders. Both approaches can succeed, though the formal one is rare and typically lacks institutional support, while the informal one works only if the CFO actively partici- pates in recruiting, providing opportunities, and evaluating and mentoring. Finance function specialists Some professionals focus on specific, highly specialized work, such as investor relations, treasury, audit, risk management, or taxation. Although most of a controller s direct reports are likely to be operational and financial-services specialists, the controllership itself should be considered a specialist finance function position. If the finance function were separated into distinct career tracks, specialist roles would change relatively little. Many companies already define them clearly, and the experts performing them understand the expectations and likely career paths. Yet even companies that clearly define the roles often lack an element of formality in hiring and in career progression, which is often ad hoc and opportunistic. Such companies provide little encouragement or support for developing the external networks and reputations of finance function specialists critical to help them stay current with legal and regulatory developments. Clearer formal definitions would allow managers to provide more structured reviews and more targeted training and professional-development opportunities for functional specialists, to hire and promote them more systematically, and to give them a more exciting and compelling career experience. One global pharmaceutical company, for example, encourages its finance function specialists to develop relationships with academics and other professionals outside the company by attending symposia and conferences, as well as joining professional groups. The company also explicitly rewards people who develop an external reputation in the profession (for instance, through teaching

33 Rethinking people development in finance 31 assignments, membership in professional bodies, and mentoring affiliations). The result is a more motivated and excited professional staff with the added benefit of bringing home outside ideas and evolving best practices. That s also an advantage in recruiting, since the career tracks for many of these professionals should be part of a progression in a career started elsewhere, in similar roles at other companies or in major accounting firms. confront the new demands on it by creating nextgeneration recruiting and development programs. Separating the roles of people within it to match the range of activities they perform is a logical starting point for change. The traditional model of hiring, developing, and promoting talent can no longer deal with the expanding breadth of demands on the finance function. It s time for HR leaders in finance to Ankur Agrawal (Ankur_Agrawal@McKinsey.com) is an associate principal in McKinsey s New York office, and Bill Huyett (Bill_Huyett@McKinsey.com) is a partner in the Boston office. Copyright 2012 McKinsey & Company. All rights reserved.

34 32 McKinsey on Finance Number 42, Winter 2012 Choosing where to list your company How much does choice of listing location matter? Investors will follow good companies no matter where they list. David Cogman and Michael Poon Consolidation among the world s major stock exchanges continued in 2011 with Deutsche Börse s announced acquisition of the New York Stock Exchange (NYSE). If that merger goes through, it will be part of a trend that ultimately benefits listed companies: it is simpler to manage the reporting requirements for one exchange than for two or three. Yet consolidation is also likely to intensify competition among the remaining exchanges, especially as technology whittles away their traditional points of distinction: promises of a more diverse equity base, cheaper access to capital, or enhanced liquidity. Companies consider three things when choosing a listing location the actual out-of-pocket costs for establishing and maintaining the listing, the effects on valuation and liquidity, and the nonfinancial benefits. But for which of these if any is there a meaningful distinction between locations? Listing in multiple locations gradually fell out of favor in the late 1990s, as companies came to question whether there were real differences among them in valuation and liquidity. Yet in recent years, a belief in these differences has revived: the argument most often heard is for listings in Hong Kong. We find, however, limited evidence that a listing on any of the major global exchanges brings an advantage in valuation or liquidity. All the top-tier institutions including Euronext, the Hong Kong Stock Exchange (HKEx), 1 the London Stock

35 33 Exchange (LSE), Nasdaq, and NYSE have reached a sufficiently high level of maturity and internationalization that they can host companies from anywhere in the world: enough institutional capital will follow across national boundaries. Although the costs of listing differ slightly among locations, this of itself is probably not sufficient to swing the decision one way or another. Companies considering a listing should therefore focus on whether the nonfinancial benefits are compelling enough to prefer one exchange over another. The current Hong Kong IPO market provides a useful illustration. It attracted more capital in new primary listings in 2011 than any other equity market, 2 as it has done since 2009, and is the most successful of the major exchanges in attracting foreign listings. Yet our analysis of the 2010 and 2011 data finds that companies coming to Hong Kong for a second listing enjoy few direct financial benefits from doing so: the motivation lies elsewhere. Effects on valuation and liquidity If listing in a given market had quantifiable benefits, we should see evidence for them in the valuations or liquidity of the companies that list there. Yet when we look at the companies that executed a second listing in Hong Kong, the evidence doesn t support an economic argument for a move on the basis of liquidity or valuations. Companies listing in Hong Kong have not, on average, experienced a significant increase in their shares liquidity even if they have enjoyed, as some argue, increased exposure to a broader analyst and investor community and therefore better price discovery for those shares. Although there was a broad range, the average trading volume of companies adding a second listing in Hong Kong fell by 5 percent. When we adjusted for the size of an issue and looked at liquidity as a proportion of shares outstanding, less than a fifth of the companies listing experienced any material improvement, and the median company saw its liquidity fall by 37 percent. 3 Nor did a second listing in Hong Kong lead to higher average valuations for most companies. Our analysis of the P/E ratios of companies adding a second listing in Hong Kong in 2010 and 2011 found that multiples there have been, on average, 24 percent lower than those in the original listing location. Many of the companies listing in Hong Kong had already been listed on exchanges in mainland China, where they enjoyed substantially higher valuations. Still, many observers believe that valuations have a location-specific element that listing on some exchanges attracts higher multiples than on others and point to a few cases of Western companies listing in Hong Kong at higher multiples than they previously had on other exchanges. When we look systematically at valuations in the same sectors across exchanges, however, the evidence is mixed: it is hard to see a consistent pattern in which sector multiples are higher in one location than in another. In 2011, for instance, some industry sectors enjoyed higher valuations in one location at midyear, but in a different location at the end of the year. In July, 5 of 12 key industry sectors in Hong Kong had higher multiples than their US counterparts did, but that dropped to 3 of 12 by December. Similarly, 7 of 12 sectors had higher multiples in China than their UK counterparts in July, but in December, 9 sectors had an advantage in China (exhibit). Some sectors do appear to have consistent differences in multiples: however, this may simply reflect the mix of companies in those industries. Compared with other markets, Hong Kong has a higher proportion of mainland Chinese enterprises, which generally have better growth prospects than UK and US ones do but operate in a very different