As companies rethink their portfolios for the post-crisis world, they should ask themselves if they are still the best owners of their assets.
As the post-crisis thoughts of executives turn to mergers, acquisitions, and disposals, the familiar idea of “best owner” takes on renewed urgency. Discerning readers will be well aware that best owners are those companies whose distinctive characteristics enable them to create more value in a given business than other potential owners could. But the pace of rapid recovery in equity market valuations may be causing some executives to worry too much about being preempted by better-prepared competitors and too little about acquiring businesses where they themselves would hold a distinct advantage.
The risk is considerable. Reactivating deals that were put on hold may be unwise in some industries where fundamental changes during the crisis have weakened the competitive position of deal targets or hurt the structural attractiveness of their markets. Companies may also discover that they have lost competitive advantage in businesses they already own. Moreover, boards and management teams that assess the fundamental attractiveness of their potential acquisitions and disposals solely by growth and returns increase the likelihood that they will enrich only the sellers of the businesses they buy—or the buyers of the businesses they sell.
Is there a better owner for your business?
Author Richard Dobbs explores the implications of the better-owner concept for companies’ portfolio decisions.
If a board and management team want to create the most value for their own shareholders, they must be clear about how their company will add more value to a business than other potential owners can. If that isn’t the case, the company might best serve the shareholders’ interests by selling the business—or by not buying it in the first place.
What makes a better owner?
In reality, we can never know who the very best owner of a business might be; we can only know who is probably the better owner among competing alternatives. A better owner could be a larger company, a private-equity firm, a sovereign-wealth fund, or a family. It could also be an independent public company listed on a stock exchange, a mutual (owned by its customers), or even a government- or employee-owned entity. As better owners, each of these types of companies may add value to a business in a number of ways.
The most straightforward way that owners add value is through the links they can offer to other businesses they own, especially when such links are unique. Suppose, for instance, that a mining company has the rights to develop a coal field in a remote location far from any rail lines or other infrastructure, except for those built by another mining company, which already operates a coal mine just ten miles away. The second mining company might well be the better owner because its incremental costs to develop the mine would be lower than the first company’s. It could afford to purchase the undeveloped mine at a higher price and still earn an attractive return on capital.
These unique links can occur across the value chain, from R&D and manufacturing to distribution and sales. A large pharmaceutical company with an experienced oncology sales force might, for example, be the best owner of a small pharmaceutical company with a promising new oncology drug but no sales force or commercialization capacity.
In most cases, these linkages (and the value they create) are not unique to a single potential owner. IBM, for example, has successfully acquired dozens of small software companies to take advantage of the power of its global sales force. IBM as an owner was better able to sell the products globally than the previous owners were. Other companies, such as Oracle or SAP, may also have been better owners; ultimately, the best depends on both the theoretical potential—the specific matches of products and sales forces—and the effectiveness of postacquisition merger management.
Better owners may also have distinctive and replicable functional or managerial skills,1 1. It’s important to note that these skills must exist at the owner level—and that owners must be able to replicate them from business to business. Such skills, often derived from a deep bench of product-management talent, create a competitive advantage in M&A. Distinctive skills at the business level could be transferred to other owners. which can be found anywhere in the business system, from product development to manufacturing processes to sales and marketing. The skill set has to be a driver of success in the industry, however. A company with great manufacturing skills, for example, probably wouldn’t be a better owner of a consumer-packaged-goods business, because manufacturing costs aren’t large enough to affect its competitive position.
In contrast, distinctive skills in developing and marketing brands often make a packaged-goods company a better owner. Take P&G, which as of 2009 had 20 brands with over $500 million in net sales and 23 with over $1 billion, all spread across a range of product categories, including laundry, beauty products, pet food, and diapers. Almost all of the billion-dollar brands rank first or second in their respective markets. What’s special about P&G is that it developed these brands in different ways. Some, such as Tide and Crest, have been P&G brands for decades. Others, including Gillette and Oral-B, were acquired during the past ten years, while a number, such as Febreze and Swiffer, were developed from scratch. As a group, sales of these brands grew by 11 percent a year, on average, from 2001 through 2009.
Owners can also add value through better governance of a business, without necessarily having a hands-on role in its day-to-day operations. Better governance refers to the way a company’s owners interact with the management team to create the greatest possible long-term value—perhaps the way the owners appoint managers, structure their incentives, or challenge them on strategy. The best-performing private-equity firms excel at governance—giving them a crucial advantage over those that rely heavily on financial leverage. Indeed, prior McKinsey analysis found that in almost two-thirds of the transactions of the top-quartile funds we examined, improving the operating performance of a company relative to its peers created more value than financial leverage or good timing did.2 2. Joachim Heel and Conor Kehoe, “Why some private equity firms do better than others,” mckinseyquarterly.com, February 2005. The authors analyzed 60 successful investments by 11 leading private-equity firms.
Better governance is a key source of this outperformance. Private-equity firms don’t always have the time or skills to run their portfolio companies on a day-to-day basis, but they govern these companies very differently from the way listed companies do. Typically, private-equity firms introduce a stronger performance culture and are quick to bring in new managers when necessary. In addition, they encourage managers to abandon sacred cows and give those managers leeway to focus on improvements over a five-year horizon rather than the typical one-year time line common among listed companies. Private-equity directors also spend, on average, nearly three times as many days on their roles than directors at public companies do, and they spend most of those days on strategy and performance management rather than compliance and risk avoidance.3 3. Viral Acharya, Conor Kehoe, and Michael Reyner, “The voice of experience: Public versus private equity,” December 2008.
Companies that have insights into how a market or industry will evolve may be better owners of businesses that don’t even exist yet, if they can use those insights to innovate and expand existing businesses or to develop new ones. In the late 1990s, for example, Intuit noticed that many small businesses were using its Quicken software, originally designed to help individual consumers manage their personal finances. That observation led to an important insight: most accounting software was too complex for small-business owners. So Intuit designed a new product for them and within two years had claimed 80 percent of this burgeoning market.
A decade earlier, the US oil and natural gas concern Williams Companies had the foresight to see that fiber-optic networks would be the future of communications. But unlike other companies that anticipated the shift, Williams had an additional insight—and a key advantage: fiber-optic cable could be installed in its decommissioned oil and gas pipelines at a fraction of the cost its competitors would have to pay for comparable infrastructure. By combining its own network with those it acquired from other companies that had fiber-optic networks, Williams eventually gained control of 11,000 miles of cable and could send digital signals and natural gas from one end of the country to the other.
Williams’s insight, combined with its pipeline infrastructure, made it a good or best owner of this network in the emerging digital-communications industry. Williams also reduced its stake in fiber-optic cable at the right time—when prices were highly inflated: it sold most of its telecommunications business in 1994 for $2.5 billion.
This category applies primarily to companies in emerging markets, where running a business is complicated by inherently smaller pools of managerial talent, underdeveloped capital markets, and high levels of government involvement in business as customers, suppliers, and regulators. In these markets, diversified conglomerates, such as Tata and Reliance in India and Samsung and Hyundai in South Korea, can be better owners because their size, stability, and relatively abundant opportunities make them more attractive employers and because they have better access to capital or distinctive relationships with governments.
Better ownership is not permanent or static but rather can change over the life cycle of a business. Too many companies don’t recognize that even if their own distinctive capabilities remain the same, the needs of a business naturally change as it matures and the industry it competes in changes.
Typically, a business’s founders are its first best owners. Their entrepreneurial drive, passion, and commitment to the business are necessary to get the company off the ground. As it grows and requires larger investments, a better owner may be a venture capital firm that specializes in helping new companies grow by providing capital, improving governance, and enlisting professional managers to handle the complexities and risks of scaling up an organization. Eventually, the venture capital firm may need to take the company public, selling shares to a range of investors to finance further growth. As the public company grows, it might find that it can no longer compete with larger corporations because, say, it needs global distribution capabilities far beyond what it can build in a reasonable amount of time. It may thus sell itself to a larger company that’s the better owner because of an existing global distribution network, thereby becoming a product line within a division of the larger company.
As the division’s market matures, the larger company may decide to focus on faster-growing businesses. In this case, it might sell its division to a private-equity firm—a better owner if the firm can eliminate corporate overhead that’s inconsistent with the business’s slower growth and thereby leave the division with a leaner cost structure. Once the restructuring is done, the private-equity firm can sell the division to yet another better owner: a large company that specializes in running slow-growth brands.
The best-owner life cycle means that executives must continually seek out new acquisitions for which their companies could be the best owner while at the same time divesting businesses for which they no longer are. Since the best owner for businesses constantly changes, any corporation, large or small, should acquire and dispose of them regularly. Indeed, companies that do so generally outperform those that do not.4 4. Jay P. Brandimarte, William C. Fallon, and Robert S. McNish, “Trading the corporate portfolio,” October 2001.
For acquisitions, applying the best-owner principle often leads acquirers toward targets very different from those that traditional target-screening approaches might uncover. Traditional ones often focus on targets that perform well financially and are somehow related to the acquirer’s business lines. But through the best-owner lens, such characteristics might have little or no importance. It might be better, for instance, to seek out a financially weak company that has great potential for improvement, especially if the acquirer has proven performance-improvement expertise. Or it might be better to focus attention on tangible opportunities to cut costs or on the existence of common customers than on vague notions such as how related the target may be to the acquirer.
Keeping the best-owner principle front and center can also help with negotiations for an acquisition by keeping managers focused on what the target is worth specifically to their own company—as well as to other bidders. Many managers err in M&A by estimating only an acquisition’s value to their own company. Because they are unaware of the target’s value to other potential better owners—or how high those other owners might be willing to bid—they get lulled into conducting negotiations right up to their breakeven point. Of course the closer they get to it, the less value the deal would create for their own shareholders. Instead of asking how much they can pay, they should be asking what’s the least they need to pay to win the deal and create the most value.
Consider the example of an Asian company that was bidding against a private-equity firm to purchase a European contract pharmaceutical manufacturer. The Asian company estimated the target’s value to itself and also to the private-equity firm, which could add value by reducing overhead costs and attracting customers that hadn’t used the target’s services because it was owned by a competitor. The Asian company estimated that the contract company was worth $96 million to the private-equity firm.
The Asian company could make the same overhead cost reductions and add similar customers—but on top of this, it could move some of the manufacturing to its lower-cost plants. As a result, the target’s value to the Asian company was $120 million, making it the best owner and enabling it to pay a higher price than the private-equity firm would, while still allowing it to capture significant value. As a side note, the value of the target to its European parent was only $80 million.
Knowing the relative values, the Asian company could afford to bid, say, $100 million, pushing out the private-equity firm and gaining $20 million in potential value creation. The Asian company could further increase its share of the value to be captured, by announcing plans to enter the business even without making the acquisition. If the seller and the private-equity firm were convinced, they would have to reduce their estimates of the target’s value, and the Asian company could reduce its bid, capturing more value still.
For divestitures, including both sales and spin-offs, the best-owner principle allows managers to examine how the needs of the businesses they own may have evolved in different directions. For example, most pharmaceutical companies grew up as parts of diversified chemical companies because the basic manufacturing and research requirements were the same. But as the two industries specialized, their research, manufacturing, and commercial requirements diverged so much that they became distant cousins rather than sisters.
Today, running a profitable commodity chemical company demands scale, operating efficiency, and the ability to manage costs and capital expenditures. But creating value in a pharmaceutical company requires a deep R&D pipeline and large local sales forces, as well as specialized expertise in areas such as the regulatory-approval process and dealing with large public and private purchasers. While having both kinds of businesses under one owner made complete sense 50 years ago, it no longer does. That is why nearly all former chemical and pharmaceutical combines have split up over the past three decades; Zeneca, for example, separated from ICI in 1993, and Clariant and Sandoz parted ways in 1995.
Executives may worry that divestitures are seen as an admission of corporate failure or as a consequence of a company’s relatively small size. Yet the research shows that stock markets consistently react positively to divestitures—both sales and spin-offs.5 5. Audra L. Boone and J. Harold Mulherin, “Comparing acquisitions and divestitures,” Journal of Corporate Finance, 2000, Volume 6, Issue 2, pp. 117–39. Research has also shown that spun-off businesses tend to increase their profit margins by one-third during the three years after the completion of the transaction.6 6. Patrick Cusatis, Lehman Brothers, James A. Miles, and J. Randall Woolridge, “Some new evidence that spinoffs create value,” Journal of Applied Corporate Finance, 1994, Volume 7, Issue 2, pp. 100–7.
To maximize value for shareholders, a company’s board and management team must be clear—and current—about how they do or could add value to each business in their portfolio. At the very least, they must understand what makes them the best owner of what kinds of businesses and be prepared to act accordingly.
Richard Dobbs is a partner in McKinsey’s Seoul office, Bill Huyett is a partner in the Boston office, and Tim Koller is a partner in the New York office. This article is excerpted and adapted from the authors’ forthcoming book, Value: The Four Cornerstones of Corporate Finance (Boston: John Wiley and Sons, 2010).
The authors would like to thank Chris Bradley for his contributions to this article and John Stuckey, who led McKinsey’s earlier thinking on best ownership.