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McKinsey onFinance
Perspectives on
Corporate Finance
and Strategy
Number 18, Winter
2006
How to make M&A work in China 1
The conditions are right for Chinas nascent M&A market to flourish.
Companies should try a new approach to deal making.
Capital discipline for Big Oil 6
The oil and gas industry has a history of overinvesting at the topof a cycle. This time it should break the habit.
Making capital structure support strategy 12
A companys ratio of debt to equity should support its business strategy,not help it pursue tax breaks. Heres how to get the balance right.
Better cross-border banking mergers in Europe 18
For those who take a tough stance, such mergers can be lucrative.
Data focus: A long-term look at ROIC 21
Finance theory isnt enough when companies set their expectations forreasonable returns on invested capital. A long-term analysis of marketand industry trends can help.
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McKinsey on Finance is a quarterly publication written by experts
and practitioners in McKinsey & Companys Corporate Finance practice.
This publication offers readers insights into value-creating strategies
and the translation of those strategies into company performance.
This and archived issues ofMcKinsey on Finance are available online at
www.corporatefinance.mckinsey.com.
Editorial Contact: [email protected]
Editorial Board: James Ahn, Richard Dobbs, Marc Goedhart, Bill Javetski,
Timothy Koller, Robert McNish, Herbert Pohl, Dennis Swinford
Editor: Dennis Swinford
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Cover illustration by Ben Goss
Copyright 2006 McKinsey & Company. All rights reserved.
This publication is not intended to be used as the basis for trading in theshares 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.
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How to make M&A work in China
The conditions are right for Chinas nascent M&A market to
flourish. Companies should try a new approach to deal making.
James Ahn,
Thomas Luedi, and
Isiah Zhang
and beer industries, for example, are wide
estimated to have overcapacity of more th
50 percent.
Although transactions more than tripled
over the past seven years (Exhibit 1), the
average inbound deal is still valued at less
than $20 million. That too seems destined
to change. In the first ten months of 2005
for example, investment in Chinas bankin
market alone has exceeded $10 billion
more than five times the maximum amou
that multinational companies invested in
banking sector in previous years.
Multinational companies hoping to tap
Chinas M&A potential will have to maste
some well-documented challenges: they
must ensure that transactions are driven
by strategic considerations and that they
are properly equipped on the local level
to complete deals. Aspiring buyers must
also consider the peculiar dynamics of
the Chinese marketspecifically, the fact
that conventional approaches to M&A ar
inappropriate in China. First, corporate
control is more important than ownership
to the Chinese, and overseas companies
cannot secure or maintain control in the
same way that they might do elsewhere
in the world. Next, traditional valuation
is often impossible, since benchmarks and
reliable financial information are rare.
Often, option value is everything. Finally,
forecasting methods used routinely in mo
mature markets do not apply to China.
Companies must thus be prepared to spenmore time on due diligence.
Structuring a deal for control
Most strategic investors seek control of a
business believing that they can run it mo
effectively than the current owner and
generate greater value. In the developed
world, control is commensurate with equi
ownership; majority ownership gives a
Multinational companies spent more
than $60 billion on new businesses and
joint ventures with Chinese companies in
2004. Cross-border mergers and acquisitions,
by contrast, have yet to induce anything
like the same level of investment fever.
Inbound cross-border M&A deals were
worth less than 12 percent of total foreign
direct investment and individual deals have
been small. By comparison, among the ten
countries, apart from China, that attract
the greatest amount of foreign capital, the
average ratio of inbound M&A to foreign
direct investment was 47 percent in 2004.
Chinas weak M&A market might in
part be a legacy of a time when foreign
investment was restricted largely to joint
ventures. Now, though, the limitations on
investment in many industries are being
removed, and cross-border M&A activity is
poised to increase. State-owned enterprises
are cleaning up their asset portfolios
and improving standards of disclosure,
making them attractive targets for foreigninvestors. A number of private companies
better managed than their state-owned
peersare also emerging as candidates.
In addition, the overcapacity resulting
from Chinas excessive investment in fixed
assets suggests that local and multinational
companies could pick up assets and
businesses inexpensively when the inevitable
restructuring takes place. The automotive
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2 McKinsey on Finance Winter 2006
buyer the right to operate the acquired
business. In China, though, government
regulations still prohibit majority foreign
ownership in more than 25 industries,
including banking, telecommunications,
and auto manufacturing. Furthermore,
Chinese owners often desire control,
or the appearance of control, for
social or personal reasons.
Where buyers cannot acquire majority
ownership, they must exert control by other
means. A deal can be structured to give an
investor adequate board representation,
for example. Few joint-stock companies
listed in China have an accumulative voting
system, so foreign investors cannot assume
that their representation on the board of a
target company will be in proportion to the
stake they purchase. They must thus ensure
that their board standing reflects the true
economics of the transaction and that they
have a say in the election of independent
directors. The use of governance provisions
in this way by some multinational
companies has led to different levels of
control in different industries (Exhibit 2).
Buyers can also insist on the right to
fill crucial posts, such as those of chief
financial officer and chief technology
officer. One global consumer goods
company, for example, needed this kind
of authority before it could meet certain
important goals: to integrate an acquired
companys operations with an existing
management-information-system platform
and to implement proprietary production
techniques designed to eliminate waste and
improve efficiency by up to 40 percent.
Another successful approach to structuring
deals involves outlining important areas
of decision making and establishing
mechanisms to exercise control over them.
If direct control of the board is impossible,
a buyer might push decisions down to
a level where it can exercise authority
through day-to-day operational decisions.
The general manager of a chemical joint
venture, for example, was appointed by
the multinational partner. This manager
was given the right to make almost all
important decisionsincluding decisions
relating to budgeting, hiring, and firingexcept for those that by law must be made
unanimously by the board.
Some multinational companies, aiming
to win as much control as possible, use
several of these techniques in parallel.
Often multinationals combine them with
an agreement to increase ownershipand
controlover time. Some arrangements will
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be easier than others for a Chinese seller to
accept, so it is imperative that buyers mix
and match according to the specific context
of a deal. One global consumer goods
company negotiated the right to nominate
three out of nine board members directly,
to select and approve three independent
directors, to appoint the vice chairman,
to establish and nominate executive
committees, and to oversee essential
functional tasks. The company thus wielded
the degree of control necessary at least to
voice its opinions at the board level and to
influence board committees.
Determining intrinsic value
Many buyers confess that valuing companies
in China is guesswork. There are few
benchmark transactions or publicly traded
companies to act as a guide and few
completed transactions in any one industry.
Relying heavily on a multiples-based
valuation1 can lead to highly distorted results,
while the Chinese market is too dynamic f
discounted-cash-flow analysis to be accura
forecasting cash flows beyond three to five
years is mere conjecture. In addition, Chin
counterparties often use a statutory valuat
which is similar to valuing assets at book
value but does not take into account the
level of cash flow the assets could generate
It is no surprise, then, that a statutory
valuation might undervalue or overvalue
an asset. Chinese negotiators just dont
think in future-cash-flow terms, says one
negotiator from a multinational company.
The Chinese, for their part, complain that
foreigners routinely offer purchase prices
below the minimum required by law, so
the deals are just not viable (Exhibit ).
These contrasting views highlight the
importance both of calculating a range of
valuations based on different scenarios in
order to arrive at an acceptable value rang
and of using the right methodology. Most
overseas companies say that they will not
pursue a deal unless it fits within their valu
metrics or their framework for return on
investment. Some attempt to account for
the additional downside risk by including
a large risk premium in the discount factor
Uncertainty has upside as well as downside
potential in China, however, and buyers th
use the wrong methods of valuation might
forgo strategically important deals. In our
experience, a few practical tips are useful.
Use a wider range of valuations and let
strategy be your guidePast growth rates and margins do not
provide an accurate guide on how an
industry will develop in China. Yet the
boards of multinational companies often
insist that their valuation teams come up
with a single, bottom-line number. As a
result, deal teams frequently feel pressure
under- or overprice a purchase rather than
explain why the value realized could be
1For example, price-to-earnings (P/E) ratios oreconomic value (EV) to earnings before interest,
taxes, depreciation, and amortization (EBITDA).
How to make M&A work in China
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4 McKinsey on Finance Winter 2006
higher or lower, depending on the industrys
evolution. Using a wider range of valuations
would give a buyer leeway to assess the most
likely outcomes and to base its decisions on
the way China fits into the overall company
and industry strategy.
Be realistic about synergies
Buyers often look to the synergies of deals to
justify investments. But capturing synergies
in China is difficult. Cross-selling products,
for example, is unrealistic if brands and
products are positioned for different market
segments: it is just not feasible to try tocross-sell, say, a premium brand of beer
through a largely rural distribution network.
Synergies in revenues and labor (through
massive layoffs of workers) are also hard to
achieve. In addition, buyers must be aware
of potential postacquisition cost increases
owing to the expense of an expatriate
staff and spending on health and safety
improvements. Savings in production and
operations are easier to capture, although
sometimes a deals value resides not in its
synergies but in its long-term option value:
capturing the potential and growth of the
sizable Chinese market.
Share upside and downside risk
When differences over the valuation of a
company cannot be bridged, buyers should
seek to structure a deal so that it takes
this uncertainty into account. In one joint
venture, the multinational partner agreed
that it would make an additional payment
three years after the transaction date if the
venture achieved an agreed-upon earnings
target and if tax regulations changed. Such
earn-out mechanisms are useful when
opinions vary over other external factors,
such as industry growth and the cost of
key inputs. The trick with earn-outs is to
focus on matters that are generally beyond
the influence of either negotiating party;
otherwise, there is room for gamesmanship,
which should be avoided.
A detective force for due diligence
Due diligence is the core of acquisition
procedures. In our experience, buyers tend
to be either overly cautious (thus missing
potentially attractive opportunities) or
overly optimistic (and likely to find surprises
later on). The information needed for robust
due diligence is elusive in China, where IT
systems are generally weak, databases lack
breadth and capacity, and legal systems and
requirements remain opaque. Furthermore,
agreements are often oral, and the highproportion of cash deals makes it difficult to
validate the true ownership of stated assets.
For these reasons, investors should expect
a high level of liability and risk exposure
and make sure that any team conducting
due diligence on their behalf has enough
time and people to dig for information.
Accounting and legal advisers with local
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experience are essential. Wherever possible,
teams should be based locally and have the
insider knowledge and relationships needed
to understand target companies fully.
The most delicate due-diligence issues for
negotiations in China include the following:
Asset ownership. Many newly formed
Chinese companies do not have adequate
documentation to show what assets
belong to them. Furthermore, problems
often arise in transactions between related
parties, where there is little evidence
on the nature and details of such deals.
Buyers should confirm the ownership of
assets, investigate related companies, and
ascertain whether acquired assets are
subject to a bank pledge.
Business scope licenses. Companies are
normally allowed only a narrow scope for
business in their articles of incorporation
and business licenses. Certain specialized
lines of business require licenses from
government agencies, and Chinese law
does not always permit the transfer of
these licenses in M&A transactions. In
addition, foreign ownership can often
affect applications and license renewals.
Due-diligence teams should sort out
these matters.
Land use rights. In China, land is
owned by the state, and companies and
individuals hold allocated or granted
land use rights. When Chinese partnerscontribute capital to a deal in the form
of land, it is essential to understand what
land use rights are attached to it.
Tax and financial liabilities and benefits.
Different legal entities might be entitled
to different tax and financial benefits
and incentives from the local or central
government. These incentives might not
transferable to a foreign owner. In addit
Chinese companies are often exposed
to off-balance-sheet liabilities. Buyers
should draft and sign indemnification
agreements to protect themselves
against damage from hidden liabilities.
If an overseas company remains unsure of
a target companys value after due diligen
has been carried out, it could insist on a
clause requiring the shares it has bought t
be repurchased at a fixed price in certain
circumstances. The acquisition of Bank
of China shares by the Royal Bank of
Scotland, in September 2005, provides an
example. If additional due diligence finds
any surprises, the price per share will
change in Royal Bank of Scotlands favor
and if Bank of China does not pursue an
initial public offering within three years, i
will be required to buy back all of Royal
Bank of Scotlands shares. This type of
structure gives a multinational company
more confidence when acquiring a busine
and puts the Chinese seller under pressure
to implement proposed changes. It also
ensures that both the buyers and the
sellers objectives are aligned for value.
Multinational companies planning M&A
ventures in China will be breaking new
ground. To succeed, they must be prepare
to adapt their deal-making mechanisms to
the characteristics of the local market. Mo
James Ahn ([email protected]) is an
associate principal in McKinseys Hong Kong office
and Thomas Luedi ([email protected]
is a partner in the Shanghai office, where Isiah Zha
([email protected]) is a consultant.
Copyright 2006 McKinsey & Company. All
rights reserved.
How to make M&A work in China
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6 McKinsey on Finance Winter 2006
Capital discipline for Big Oil
The oil and gas industry has a history of overinvesting at the top
of a cycle. This time it should break the habit.
Richard Dobbs,
Nigel Manson, and
Scott Nyquist
Cash is gushing into international oil
companies after the recent jump in the price
of oil and gas. According to our estimates,
the five largest corporations generated
more than $120 billion in cash flow before
capital expenditure in 2005equivalent to
about twice their capital expenditure over
each of the past few years and more than
one and a half times the annual cash flow
recorded during the industrys last boom,
from 1979 to 1981.1 Suppliers are also
benefiting: oil field service companies are
expected to report increases of more than
50 percent in full-year 2005 profits over the
figures for 2004.
What should companies do with the
extra cash? Although executives might
be expected to relish such a problem, the
decisions they make will have ramifications
far beyond the oil industry. On the one
hand, companies face pressure to invest
more in exploration, production, and
refining (where margins have also risen):
consumers and governments are angryabout high prices, the industrys large profits,
and the channeling of those profits into
share buybacks and dividends rather than
into investments that might bring down
prices. On the other hand, with the industry
outperforming the S&P 500 by almost
0 percent since 200, the capital markets
seem to be rewarding companies for the
share buybacks and dividendsamounting
in total to almost $120 billionthat have
been announced during this period.2
The conundrum is this: has the industry
entered an era of permanently higher oil
and gas prices and refining margins or is it
merely experiencing another market bubble?
If executives believe the former hypothesis,
they will focus their companies excess cash
on long-term investments, though at the risk
of precipitating the kind of price collapse
that would destroy the value of those
investments. If they believe the latter, they
will return the cash to shareholders and risk
missing opportunities to create value over
the long term if prices remain high.
We believe that such crucial decisions would
be better informed if the industry were to
reflect upon its historyin particular, its
inability to return its cost of capital over
four decades of boom and bust. Coupled
with an understanding of the economics
of new capacity and of alternative fuel
technologies, the evidence suggests that
dangers await companies that place too
large a bet on a fundamental structural
change by investing in projects that will
be profitable only if the market has indeed
altered for good. They would do better to
exercise discipline over capital spending and
to invest in opportunities to build sources
of competitive advantage that they can
sustain regardless of whether prices shift
structurally or revert to levels closer to the
long-term averages.
A familiar road
The history of the oil industry is long on
boom-and-bust cycles in crude prices and
refining margins and short on examples of
capital discipline. In the 25 years to 1998, the
industrys total return to shareholders (TRS)
was below that of the S&P 500 (Exhibit 1)
because the industry failed to return its cost
of capital over the cycle. During booms, oil
1Adjusted for inflation.
2This sum is based on the figures for 2004 and
estimates for 2005.
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companies would behave as if the world had
changed permanently, investing in projects
that could make a profit only if prices
stayed high. The exceptions were the larger,
globally integrated companies, such as BP,
ExxonMobil, and Royal Dutch/Shell, which
delivered TRS in line with the overall market.
These companies did show capital discipline:they made strategic investments in assets
and technologies, including very large oil
fields and deep-water drilling, that demanded
specialist capabilities and large amounts of
capital, as well as investments in refining
portfolios that use better technologies and
are located in economically attractive places.
In this way, they generated returns roughly in
line with the cost of capital over the cycle.
Since 1998, the industry has enjoyed its
longest boom in 40 years and consistently
earned returns above its cost of capital
(Exhibit 2). Recently, prices have been
pushed ever upward thanks to unexpected
increases in demand from the United
States and China, as well as a tightening
of supplies caused by delays in upstream
projects, the war in Iraq, and last autumn
hurricanes in the Gulf of Mexico. Margin
on refining have also risen. These externa
factors, combined with a fall in real
interest rates,4 have enhanced the value
of oil companies (Exhibit ). Since 1998,
the industrys TRS has been 1 percent,
compared with less than 1 percent for
the S&P 500.
Here we go again?
The executives who must decide which
direction the industry will take see
conflicting signals. Initially, the case for th
idea that a structural change has occurred
seems strong: most large oil fields are
maturing, a significant proportion of the
reserves is located in politically unstable
or unsafe areas, and the need for secure o
supplies is greater than everin develope
and developing economies alike. Indeed, i
demand, rather than constraints on supply
by OPEC,5 that differentiates the recent
spike in oil prices from earlier increases. I
refining, the chronic overcapacity of the
1980s and 1990s has also disappeared.
At the same time, though, the messages
from financial markets are decidedlymixed. The forward curve6 of prices
suggests a structural shift: crude futures
contracts appear to have abandoned the
$20-to-$25 range of the past decade and
are forecasting prices as high as $60 a
barrel until 2010. To justify the stock pric
of oil and gas companies, you would have
to believe that oil prices will be something
closer to $0 to $40 a barrel. Moreover,
Capital discipline for Big Oil
The industry has wrestled with this problemfor more than 150 years: in the early 1860s,
for example, overinvestment in Oil Creek,Pennsylvania, pushed down the price of crude
oil from $10 a barrel to 50 cents in less thansix months and to 10 cents within a year. See
Daniel Yergin, The Prize: The Epic Quest forOil, Money & Power, reissue edition, NewYork: Free Press, 199.
4A fall in real interest rates lowers the discountrate, thereby increasing the value of future cash
flows and thus share prices.
5Organization of Petroleum Exporting Countries.
6The forward curve may not be a reliableindicatorit lacks real liquidity and has been
consistently wrong in the past.
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8 McKinsey on Finance Winter 2006
predictions vary wildly from one analyst to
another, with long-run price forecasts for
crude oil ranging from as little as $30 to
more than $90 a barreland even a few
extreme forecasts of more than $200.
Executives must also factor in the
macroeconomic conditions, such as global
GDP growth, that influence margins.
Traditionally, economic growth slows as
oil prices rise, although high prices might
have less effect now than they had in
the past, given the combination of low
worldwide interest rates7 and what by
historical standards is a lower than usual
global dependency on crude oil. Even so,the developing worlds demand for oil is
vulnerable to a setback in Chinas fragile
banking system, for example, or to a
monsoon in India.
More difficult still is the task of forecasting
the behavior of other executives, national oil
companies, and new industry participants
and investors, such as private equity firms.
Their actionsparticularly in relation to
capital investment and the development of
alternative fuels and fuel efficiencycould
swiftly change the industrys outlook.
The old enemy
With so much cash available, companies
may be sorely tempted to loosen their
capital discipline. Many opportunities
to invest in refining and upstream assets
are highly attractive at current prices and
margins. Moreover, companies that in recent
years have invested in projects requiring
prices and margins to remain high have
reaped rewards, at least so far. And evidence
suggests that the level of investment is
rising rapidly: capital expenditure by
integrated players and by the exploration
and production business has nearly doubled
since 1999 (Exhibit 4).
There are three main reasons for the increase
in capital expenditure. One is inflationthe
result of higher prices for commodities
such as steel and of shortages in essential
inputs such as engineering resources and
drilling equipment. Another is incremental
investments (which can have quick
paybacks) in existing fields and refineries.
But the third is strategic bets on high long-
term oil prices and refining margins. In some
cases, such bets are being placed because
industry players have difficulty finding
investment opportunities that are attractive
at lower prices and because of pressure
to replace reserves.8 In hindsight, it will
be thought that these investments eitherreflected deep insights into a structural shift
in the oil industry or represented further
examples of its lack of capital discipline.
The risk is that lax discipline in pursuing
investments could severely erode margins.
McKinsey analysis suggests that if all private
sector and national oil companies increased
their capital spending from the current
7In the previous oil price spikes, countriestightened monetary policy to offset inflation,
but this approach also exacerbated theeconomic shock of higher oil prices.
8Ivo J. H. Bozon, Stephen J. D. Hall, and SveinHarald ygard, Whats next for Big Oil?TheMcKinsey Quarterly, 2005 Number 2, pp. 94
105 (www.mckinseyquarterly.com/links/19866).
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level of about 75 percent of cash flow to
90 percent (in line with the industry average
over the past decade), by 2010 worldwide
production and refining capacity would
rise by 10 to 15 percent of the current level,
in addition to the growth that is already
expected. Depending on how much demand
grows, a significant amount of this capacity
could be unused, leading to the familiar bust.
A further threat to oil and gas prices
comes from the rise of alternative fuelsand substitute technologies. The longer
crude prices and refining margins remain
high, the greater the incentive for outsiders
to invest in renewable generation, in
nonfossil fuels such as biodiesel, and in
hybrid-car technologyand the more
price-competitive these technologies
become as a result of scale effects.
Governments can also tilt the field toward
new technologies by providing incentives
for reducing carbon dioxide emissions.
Clearly, the industry faces more uncertain
than it has at any time in the past decade.
This uncertaintyand the accompanying
volatilitywill probably continue for
some time. Given these conditions, there
are three possible outcomes. In the first,
capital discipline could slip in the core
business while investment in alternative
technologies increased. The result would b
excess capacity and below-cost-of-capital
returns across the value chain. In the seco
scenario, the downturn might be limited t
refining and service areas such as shipping
since it is easier to add capacity there than
in exploration and production. Such an
outcome might lead to a softer landing of
adequate returns on capital in exploration
and production, where overinvestment is
less likely because exploration opportunit
are limited and often found in restricted
geographies, such as Iraq. In this scenario
exploration and production investments
might also benefit from OPECs support o
oil prices. The longer prices remain high,
however, the greater the opportunity for
overinvestmentand the worse the first tw
scenarios become. In the third scenario, th
whole industry could enjoy a soft landing
executives were to use discipline in placin
their bets and if investment in alternative
fuels were limited.
What will set the winners apart?
Faced with such uncertainty, how mightexecutives plot their strategies? First, they
need to move the focus of their discussion
with boards and investors beyond volume
based metrics such as market share and
reserves replaced. A preoccupation with
these measures increases the likelihood
of an indiscriminate capital expenditure
to meet a target. Instead, the emphasis
should be on the conditions needed for ne
Capital discipline for Big Oil
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10 McKinsey on Finance Winter 2006
reserves to create value. Next, since the
industrys immediate outlook is sound, the
logical move would be to pursue investment
opportunities that benefit from high current
and likely near-term margins but do not
depend on permanent structural price shifts.
In an uncertain climate, executives should
also keep the following principles in mind:
Think for the long term. In current
conditions, oil companies should be ableto build positions that are competitive
under most market conditions. They can
invest, for example, in new technologies
and capabilities, in new territories (as
ExxonMobil has done in Qatar and
Schlumberger in Russia), and in the
booming markets of China and India.
To give themselves options down the
road, they should also invest enough in
less common types of oil, such as heavy
crude and tar sands, and in alternatives
to oil and gas, such as wind power, solar
power, and biofuels.9 These options, which
could be attractive if costs came down
significantly or higher prices and margins
were sustained, must be balanced against
their longer-term strategic positioning.
Sell high. With so much money
available, now is a good time to dispose
of disadvantaged assets at attractive
prices to buyers who might also be
better placed to exploit them. Sellers
can then redeploy their human and
financial capital to other investments.
Focus M&A. Companies should
avoid deals whose value relies on the
sustainability of high margins. Mergers of
equals, asset swaps, and the purchase of
capabilities are all relatively independent
of future market prices. In addition,
if companies understand the margin
assumptions embedded in their own
share price, they can selectively use their
shares for acquisitions when prices are in
line with these assumptions. Companies
might be able to pay high prices by using
the futures market, hedging near-term
production to justify the acquisitions,
and then keeping the assets as a long-
term play. They might also undertake
strategic acquisitions, including assets or
capabilities to support future business
building, to enter new geographies, or to
acquire expertise in alternative fuels.
Maintain capital discipline. Rather than
spend excess cash on projects that require
high prices and margins, executives should
use them to increase dividends or buy back
shareseven if this approach affects the
companys ability to replenish reserves
or to bolster market shareand resist
pressure from governments and consumers
9Ivo J. H. Bozon, Stephen J. D. Hall, and SveinHarald ygard, Whats next for Big Oil?TheMcKinsey Quarterly, 2005 Number 2, pp. 94
105 (www.mckinseyquarterly.com/links/19866).
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to invest more. When deciding between
share buybacks and increased or special
dividends, executives must take into
account the valuation of their companies
instead of considering only the boost
in earnings per share. They should also
develop a deep understanding of the way
cash flows evolve over the economic cycle,
so that they have the flexibility to seize
opportunities both when cash is plentiful
and when it is not (see Making capital
structure support strategy, in the
current issue).
During all oil price booms, it becomes
possible to imagine that the industrys
economics have changed forever. But
history shows that the point when industry
observers start to say that things are really
different this time around usually marks
the top of the cycle. By then, the seeds of
the crash to come have germinated. In the
current boom, companies at all stages of
the value chain need to maintain investme
discipline. Executives should use excess ca
to build sources of competitive advantage
while shifting the focus to measures of tru
value creation. They will then be equipped
to generate value in a highly uncertain
environment and to break the pattern of t
past 40 years. MoF
The authors wish to acknowledge the contribution
to this article of Andre Annema, John Bookout,
Jiri Maly, Matt Rogers, and Jeneiv Shah.
Capital discipline for Big Oil
Richard Dobbs ([email protected]
and Nigel Manson (Nigel_Manson@McKinsey
.com) are partners in McKinseys London office, an
Scott Nyquist ([email protected]) is
a partner in the Houston office. Copyright 2006
McKinsey & Company. All rights reserved.
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12 McKinsey on Finance Winter 2006
Making capital structure support
strategy
A companys ratio of debt to equity should support its business
strategy, not help it pursue tax breaks. Heres how to get the
balance right.
Marc H. Goedhart,
Timothy Koller, and
Werner Rehm
CFOs invariably ask themselves two related
questions when managing their balance
sheets: should they return excess cash to
shareholders or invest it and should they
finance new projects by adding debt or
drawing on equity? Indeed, achieving the
right capital structurethe composition
of debt and equity that a company uses
to finance its operations and strategic
investmentshas long vexed academics
and practitioners alike.1 Some focus on the
theoretical tax benefit of debt, since interest
expenses are often tax deductible. More
recently, executives of public companies
have wondered if they, like some private
equity firms, should use debt to increase
their returns. Meanwhile, many companies
are holding substantial amounts of cash and
deliberating on what to do with it.
The issue is more nuanced than some
pundits suggest. In theory, it may be possible
to reduce capital structure to a financial
calculationto get the most tax benefits
by favoring debt, for example, or to boostearnings per share superficially through
share buybacks. The result, however, may
not be consistent with a companys business
strategy, particularly if executives add too
much debt.2 In the 1990s, for example,
many telecommunications companies
financed the acquisition of third-generation
(3G) licenses entirely with debt, instead of
with equity or some combination of debt
and equity, and they found their strategic
options constrained when the market fell.
Indeed, the potential harm to a companys
operations and business strategy from a bad
capital structure is greater than the potential
benefits from tax and financial leverage.
Instead of relying on capital structure to
create value on its own, companies should
try to make it work hand in hand with
their business strategy, by striking a balance
between the discipline and tax savings that
debt can deliver and the greater flexibility of
equity. In the end, most industrial companies
can create more value by making their
operations more efficient than they can with
clever financing.
Capital structures long-term impact
Capital structure affects a companys overall
value through its impact on operating cash
flows and the cost of capital. Since the
interest expense on debt is tax deductible in
most countries, a company can reduce its
after-tax cost of capital by increasing debt
relative to equity, thereby directly increasing
its intrinsic value. While finance textbooks
often show how the tax benefits of debt
have a wide-ranging impact on value, they
often use too low a discount rate for those
benefits. In practice, the impact is much
less significant for large investment-grade
companies (which have a small relevant
range of capital structures). Overall, the
value of tax benefits is quite small over
the relevant levels of interest coverage
(Exhibit 1). For a typical investment-gradecompany, the change in value over the range
of interest coverage is less than 5 percent.
The effect of debt on cash flow is less
direct but more significant. Carrying some
debt increases a companys intrinsic value
because debt imposes discipline; a company
must make regular interest and principal
payments, so it is less likely to pursue
1Franco Modigliani and Merton Miller, Thecost of capital, corporate finance, and the theory
of investment,American Economic Review,June 1958, Number 48, pp. 26197.
2There is also some potential for too little debt,though the consequences arent as dire.
Richard Dobbs and Werner Rehm, The valueof share buybacks,McKinsey on Finance,Number 16, Summer 2005, pp. 1620
(www.mckinseyquarterly.com/links/19864).
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frivolous investments or acquisitions that
dont create value. Having too much debt,
however, can reduce a companys intrinsic
value by limiting its flexibility to make value-
creating investments of all kinds, including
capital expenditures, acquisitions, and, just
as important, investments in intangibles
such as business building, R&D, and sales
and marketing.
Managing capital structure thus
becomes a balancing act. In our view, the
trade-off a company makes betweenfinancial flexibility and fiscal discipline
is the most important consideration in
determining its capital structure and
far outweighs any tax benefits, which
are negligible for most large companies
unless they have extremely low debt.4
Mature companies with stable and
predictable cash flows as well as limited
investment opportunities should include
more debt in their capital structure, since
discipline that debt often brings outweigh
the need for flexibility. Companies that fa
high uncertainty because of vigorous grow
or the cyclical nature of their industries
should carry less debt, so that they have
enough flexibility to take advantage of
investment opportunities or to deal with
negative events.
Not that a companys underlying capital
structure never creates intrinsic value;sometimes it does. When executives have
good reason to believe that a companys
shares are under- or overvalued, for exam
they might change the companys underly
capital structure to create valueeither b
buying back undervalued shares or by usi
overvalued shares instead of cash to pay f
acquisitions. Other examples can be foun
in cyclical industries, such as commodity
Making capital structure support strategy
4At extremely low levels of debt, companies cancreate greater value by increasing debt to more
typical levels.
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14 McKinsey on Finance Winter 2006
chemicals, where investment spending
typically follows profits. Companies investin new manufacturing capacity when
their profits are high and they have cash.5
Unfortunately, the chemical industrys
historical pattern has been that all players
invest at the same time, which leads to
excess capacity when all of the plants
come on line simultaneously. Over the
cycle, a company could earn substantially
more than its competitors if it developed a
countercyclical strategic capital structure
and maintained less debt than mightotherwise be optimal. During bad times,
it would then have the ability to make
investments when its competitors couldnt.
A practical framework for developing
capital structure
A company cant develop its capital
structure without understanding its future
revenues and investment requirements. Once
5Thomas Augat, Eric Bartels, and Florian Budde,
Multiple choice for the chemical industry,The McKinsey Quarterly, 200 Number ,pp. 1266 (www.mckinseyquarterly.com/
links/19865).
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those prerequisites are in place, it can begin
to consider changing its capital structure in
ways that support the broader strategy. A
systematic approach can pull together steps
that many companies already take, along
with some more novel ones.
The case of one global consumer product
business is illustrative. Growth at this
companywell call it Consumercohas
been modest. Excluding the effect of
acquisitions and currency movements, itsrevenues have grown by about 5 percent a
year over the past five years. Acquisitions
added a further 7 percent annually, and
the operating profit margin has been
stable at around 14 percent. Traditionally,
Consumerco held little debt: until 2001,
its debt to enterprise value was less than
10 percent. In recent years, however, the
company increased its debt levels to around
25 percent of its total enterprise value in
order to pay for acquisitions. Once they
were complete, management had to decid
whether to use the companys cash flows,
over the next several years, to restore its
previous low levels of debt or to return ca
to its shareholders and hold debt stable at
the higher level. The companys decision-
making process included the following ste
1. Estimate the financing deficit or surplus
First, Consumercos executives forecastthe financing deficit or surplus from its
operations and strategic investments
over the course of the industrys busine
cyclein this case, three to five years.
In the base case forecasts, Consumerco
executives projected organic revenue
growth of 5 percent at profit margins o
around 14 percent. They did not plan f
Making capital structure support strategy
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16 McKinsey on Finance Winter 2006
any acquisitions over the next four years,
since no large target companies remain in
Consumercos relevant product segments.
As Exhibit 2 shows, the companys cash
flow after dividends and interest will be
positive in 2006 and then grow steadily
until 2008. You can see on the right-hand
side of Exhibit 2 that EBITA (earnings
before interest, taxes, and amortization)
interest coverage will quickly return to
historically high levelseven exceeding
ten times interest expenses.
2. Set a target credit rating. Next,
Consumerco set a target credit rating
and estimated the corresponding
capital structure ratios. Consumercos
operating performance is normally stable.
Executives targeted the high end of a
BBB credit rating because the company,
as an exporter, is periodically exposed
to significant currency risk (otherwise
they might have gone further, to a low
BBB rating). They then translated the
target credit rating to a target interest
coverage ratio (EBITA to interest
expense) of 4.5. Empirical analysis
shows that credit ratings can be modeled
well with three factors: industry, size,
and interest coverage. By analyzing other
large consumer product companies, it
is possible to estimate the likely credit
rating at different levels of coverage.
3. Develop a target debt level over the
business cycle. Finally, executives set
a target debt level of 5.7 billion for2008. For the base case scenario in the
left-hand column at the bottom half of
Exhibit 2, they projected 1.9 billion
ofEBITA in 2008. The target coverage
ratio of 4.5 results in a debt level of
8. billion. A financing cushion of spare
debt capacity for contingencies and
unforeseen events adds 0.5 billion, for a
target 2008 debt level of 7.8 billion.
Executives then tested this forecast
against a downside scenario, in which
EBITA would reach only 1.4 billion
in 2008. Following the same logic,
they arrived at a target debt level of
5.7 billion in order to maintain an
investment-grade rating under the
downside scenario.
In the example of Consumerco, executives
used a simple downside scenario relative to
the base case to adjust for the uncertainty
of future cash flows. A more sophisticated
approach might be useful in some industries
such as commodities, where future cash
flows could be modeled using stochastic-
simulation techniques to estimate the
probability of financial distress at the
various debt levels illustrated in Exhibit .
The final step in this approach is to
determine how the company should move to
the target capital structure. This transition
involves deciding on the appropriate mix of
new borrowing, debt repayment, dividends,
share repurchases, and share issuances over
the ensuing years.
A company with a surplus of funds, such
as Consumerco, would return cash to
shareholders either as dividends or share
repurchases. Even in the downside scenario,
Consumerco will generate 1.7 billion of
cash above its target EBITA-to-interest-
expense ratio.
For one approach to distributing thosefunds to shareholders, consider the dividend
policy of Consumerco. Given its modest
growth and strong cash flow, its dividend
payout ratio is currently low. The company
could easily raise that ratio to 45 percent
of earnings, from 0 percent. Increasing the
regular dividend sends the stock market a
strong signal that Consumerco thinks it can
pay the higher dividend comfortably. The
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Making capital structure support strategy
remaining 1. billion would then typically
be returned to shareholders through share
repurchases over the next several years.
Because of liquidity issues in the stock
market, Consumerco might be able to
repurchase only about 1 billion, but it
could consider issuing a one-time dividend
for the remainder.
The signaling effect6 is probably the most
important consideration in deciding between
dividends and share repurchases. Companies
should also consider differences in the
taxation of dividends and share buybacks,
as well as the fact that shareholders
have the option of not participating in a
repurchase, since the cash they receive must
be reinvested.
While these tax and signaling effects are
real, they mainly affect tactical choices
about how to move toward a defined long
term target capital structure, which shoul
ultimately support a companys business
strategies by balancing the flexibility of
lower debt with the discipline (and tax
savings) of higher debt. MoF
Marc Goedhart ([email protected]
an associate principal in McKinseys Amsterdam of
Tim Koller ([email protected]) is a part
and Werner Rehm ([email protected]
a consultant in the New York office. Copyright 2McKinsey & Company. All rights reserved.
6The markets perception that a buyback
shows how confident management is that thecompanys shares are undervalued, for example,or that it doesnt need the cash to cover future
commitments, such as interest payments andcapital expenditures.
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Better cross-border banking mergers in Europe
harmonization of retail products and
services across European countries. But
the extent to which these factors prevent
acquiring banks from extracting cost
efficiencies is likely to be small, given
the domestic nature of retail banking.
Although bank secrecy, data protection,
and outsourcing laws may be more
complex when institutions operate across
borders, there is evidence that these
obstacles are not insurmountable.
If the transaction and efficiency barriers
specific to cross-border deals cannot explain
the value gap, what does? The answer lies in
the actions of national regulatory authorities,
unions, and incumbent managementand,
more specifically, in the way foreign
acquirers react to them. These measures
represent potentially serious impediments
to improved performance in all types of
deals. Typical steps by national stakeholders
include implicit threats (real or perceived)
against foreign acquirers in order to
frustrate any subsequent restructuring or to
limit access to local opportunities.
The responses to such behavior in the ten
completed transactions we examined reveal
a pattern. The acquirers management, in
an effort to maintain good relations with
local stakeholders, often entered into lengthy
and complex negotiations that ultimately
guaranteed the status quo at the target
bank, thus severely curtailing the acquirers
freedom to integrate it and to generate
stand-alone performance improvements.Such voluntary agreements covered issues
such as future head counts, the composition
and size of local management teams, the
continuation of bank sub-brands, and a
rigid commitment to the structure of the
regional headquarters.
Acquirers have not provided similar
guarantees to banks in Central and Eastern
Europe, where cross-border takeovers hav
been much more successful. In general,
such guarantees are uncommon there
because these countries have generally
welcomed foreign capital and recognized
the importance of banking skills to the
development of their markets.
Before this year, evidence had already
indicated that a tougher approach could p
off. When the Portuguese regulator wante
to use the prudence test to block Banco
Santander Central Hispanos fiercely resis
bid for Mundial Confianca, in 1999, the
Spanish bank promptly filed a complaint
with the European Commission. Thanks
to the pressure this move created, BSCH
was subsequently able to acquire Totta, a
subsidiary of Mundial Confianca. The tim
has come for other acquirersheartened
by the tougher attitude of the European
Commission and by recent events in
Germany and Italyto negotiate firmly,
thereby ensuring that banks can extract th
full value of cross-border deals.
ABN Amro, for instance, didnt back
down when the Bank of Italy opposed
the companys original bid for Banca
Antonveneta. Such tactics clearly
caught the attention of the Brussels
authorities, the international media,
and the European financial community
in general. Elsewhere, the terms of
UniCreditos pending offer for Germanys
HypoVereinsbank, put forth in the summ
of 2005, do not seem unduly restrictive.
Given experience and very recent events,
a future acquirer could choose to take a
tougher approach by informing a targets
management that voluntary guarantees of
the kind that marked previous deals are
unacceptable. Moreover, when manageme
is reluctant to provide general information
about market and operational risksor
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20 McKinsey on Finance Winter 2006
about the loan book, in particularthe
acquirer could mobilize other stakeholders
(such as shareholders and the press) or
sympathetic regulators. A bank could also
appeal to outside opinion, though any tough
stance should be accompanied by a clear
willingness to work with the regulatory body.
That said, unsolicited bids have a greater
chance of succeeding when the target is
perceived to be weak and the acquirer
strong. Shareholders in such cases will be
more inclined to sell, the potential for value
creation will be greater, and nationalistic
forces will be less likely to defend a badly
managed institution. MoF
The author would like to thank Guy Morton of
Freshfields Bruckhaus Deringer for his contribution to
this article.
Philipp Hrle ([email protected]) is
a partner in McKinseys Munich office. Copyright
2006 McKinsey & Company. All rights reserved.
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Data focus:
A long-term look at ROIC
Finance theory isnt enough when companies set their expectations
for reasonable returns on invested capital. A long-term analysis of
market and industry trends can help.
Bin Jiang and
Timothy Koller
Savvy executives know that the
decision to invest in a project often hangs
on reasonable expectations of its return
on invested capital. But what constitutes
reasonable? Companies that rely on the
wrong benchmark can overlook good
investments or pursue bad ones. We find t
empirical analyses ofROICsparticularly
those illustrating industry-specific pattern
over timecan help executives ground th
expectations in the collective long-term
experience of other companies.
We analyzed the ROIC histories of about
7,000 publicly listed nonfinancial US
companies from 196 to 2004. These
companies had revenues of more than
$200 million in 200 dollars, adjusted
for inflation. Our sample included active
companies as well as companies that were
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22 McKinsey on Finance Winter 2006
acquired or dissolved, and we looked at
patterns that both included and excluded
goodwill. The revenues of the companies
we studied account for 99 percent of those
of all nonfinancial US publicly traded
companies in 2004, or some 82 percent if
financial ones are included. Our work had
several key findings.
First, the average US company has returned
its cost of capital over time. From 196
to 2004, the US markets median ROIC,
excluding goodwill, averaged nearly
10 percent. That level of performance was
relatively constant and in line with the long-
term cost of capital (Exhibit 1). The stable
median ROIC may reflect a balance between
investment and consumption. Companies
that drive innovations in technology or
business systems may earn above-average
returns initially, but competition eventually
compels most businesses to pass the savings
along to consumers.
Second, historical ROICs can vary widely
by industry. In the United States, the
pharmaceutical and consumer packaged-
goods industries, among others, have
sustainable barriers, such as patents and
brands, that reduce competitive pressure
and contribute to consistently high ROICs.
Conversely, capital-intensive sectors (such
as basic materials) and highly competitive
sectors (including retailing) tend to generate
low ROICs.
These differences in the way industries
perform havent changed substantially
over time. In Exhibit 2, the ROIC ranking,
based on the ranking for 196 to 2004 as
a whole, largely mirrors the average for
the period from 1995 to 2004. In general,
the persistence of differences in ROIC
across sectors suggests that individual
companies should be benchmarked
against comparable ones operatingin similar or adjacent industries.
Finally, we found that the median or
mean returns of general, broadly defined
industry groups can be downright
misleading. Executives who look at the
mean or median ROIC of an industry
without understanding the distribution
ofROIC performance within it may not
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the industrys performance was so uneven
as to render this metric meaningless. Thes
wide variations suggest that the industry
comprises many distinct subgroups that
have very different structures and are sub
to very different competitive forces. To fo
reasonable expectations, it is often necess
to dig down to more refined subindustry
groupings. By contrast, the utility industry
median ROIC is only 7 percent, but
the spread from the best to the worst
companies is a slim 2 percent. Any execut
encountering projected returns outside th
of this relevant benchmark industry range
would do well to look on those forecasts
with a gimlet eye. MoF
Bin Jiang ([email protected]) is a consul
in McKinseys New York office, where Tim Koller
([email protected]) is a partner. Copyrig
2006 McKinsey & Company. All rights reserved
Data focus: A long-term look at ROIC
have sufficient information to assess a
company or to project its ROIC accurately.
Indeed, intra-industry differences are
sometimes far more dramatic than those
among sectors (Exhibit ). Take the software
and services industry. Its median ROIC
from 196 to 2004 was 18 percent, but the
spread between the top and bottom quartile
of companies averaged 1 percent. In fact,
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24 McKinsey on Finance Winter 2006
Index of articles, 20042005
Previous issues can be downloaded from McKinsey & Companys Web site at
www.corporatefinance.mckinsey.com. Individual articles are available to McKinsey Quarterly
subscribers at www.mckinseyquarterly.com. A limited number of past issues are available in
hard copy; please send a request by e-mail to [email protected].
Number 17, Autumn 2005
Measuring stock market performance
Reducing the risks of early M&A
discussions
Smoothing postmerger integration
Comparing performance when invested
capital is low
What global executives think about
growth and risk
Number 16, Summer 2005
Measuring long-term performance
Viewpoint: How to escape the short-term
trap
The view from the boardroom
The value of share buybacks
Does scale matter to capital markets?
Number 15, Spring 2005
Do fundamentalsor emotionsdrive the
stock market?
The right role for multiples in valuation
Governing joint ventures
Merger valuation: Time to jettison EPS
Number 14, Winter 2005
Outsourcing grows up
Finance 2.0: An interview with
Microsofts CFO
The hidden costs of operational risk
The right passage to India
Number 13, Autumn 2004
The right restructuring for US automotive
suppliers
Agenda of a shareholder activist
When payback can take decades
The scrutable East
Number 12, Summer 2004
Private equitys new challenge
A new era in corporate governance reform
Can banks grow beyond M&A?
Internal rate of return: A cautionary tale
Taming postmerger IT integration
Number 11, Spring 2004
High techs coming consolidation
When efficient capital and operations go
hand in hand
All P/Es are not created equal
Putting value back in value-based
management
Number 10, Winter 2004
Where mergers go wrong Running with risk
The CFOs central role
What is stock index membership worth?
Why the biggest and best struggle to grow
Investing when interest rates are low
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AAAAABBBjBBBBB
B ACCCCCCDDDDDDFGGHH
H KHI
JJK LLLL AMMMM CMMMMMMMN JN YO COP NPPPPR JRS FSS PS
SS VSSSSSTT ATTVVWW, DCZZ
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Copyright 2006 McKinsey & Company