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McKinsey on Finance

Perspectives on
Corporate Finance
and Strategy
Number 24,
Summer 2007

Preempting hostile takeovers 1

Companies that stick to valuation basics can capture any value that would
make them attractive for takeover bids.
The state of the corporate board, 2007:
A McKinsey Global Survey 6

Corporate directors want more information about their companies and industries,
and they say that investments by private-equity firms improve governance.
Investing in sustainability:
An interview with Al Gore and David Blood 12

The former US vice president and his partner in an investment-management

firm argue that sustainability investing is essential to creating long-term
shareholder value.
A quiet revolution in Chinas capital markets 18

Reforms that attracted little attention in the Western world mark a major step
forward in the modernization of Chinas capital markets.
The granularity of growth 25

A fine-grained approach to growth is essential for making the right choices

about where to compete.

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Preempting hostile takeovers

Companies that stick to valuation basics can capture any value that would
make them attractive for takeover bids.

Jenny Askfelt Ruud,

Johan Ns, and
Vincenzo Tortorici

The market for corporate control is undergoing a fundamental change: it is not only
growing M&A activity reached record levels in 2006, peaking at nearly $4 trillion
globallybut also getting more aggressive. Last year more than 100 hostile transactions,
valued at over $520 billion, were announced around the world (Exhibit 1). Thats
three times the previous record, in 1999, according to data from Dealogic.
This activity is driven in part by a host of
new playersincluding private-equity firms,
hedge funds, and activist shareholders
that seem more and more willing to put
companies in play at a moments notice.
Further complicating the landscape, notably
in Europe, is a recent flood of valuecreating cross-border opportunities that
have appeared as traditional barriers
to hostile pursuits erode.1

1 L ast year Europes share of worldwide hostile

activity rose to 60 percent as a result of the

increasing globalization and homogenization
of financial practices and laws, as well as
the reluctance of politicians and regulators to

Amid this frenzy, many managers wonder

uneasily how vulnerable their companies
might be to takeover and contemplate fixes
to ward off unwanted attention. Especially
when they are under attack, their first
reaction may not be the one that would
create the most value: they often take

last-minute defensive action to resist

hostile bids at all costs. Typically, such
responses aim only to protect a companys
independence, whether or not its
in the best interests of shareholders.
In our experience, the best approach
both to serve shareholders and to position
companies for long-term strategic independence is to think and act preemptively.
Even in todays intense M&A market,
companies can proactively assess the
extractable value that an alternative
owner might see and then move to capture
it themselves. Much of this approach is
simply good housekeeping: sticking to the
basics of corporate strategy and rigorously
implementing value-creating measures

Exhibit 1

A burst of hostility

Web 2007
Proactive defense
Exhibit 1 of 2
McKinsey on Finance
Summer 2007
Glance: The market for corporate control is increasingly aggressive.
Exhibit title: A burst of hostility

Announced unsolicited M&A deals1


The market for corporate control is

increasingly aggressive.

Value, $ billion

Number of deals







Share of global M&A
volume, %












deal (including withdrawn deals) provoking initial hostile response from board of target company; includes only deals
with a value >$25 million.
2Extrapolated based on value and number of unsolicited bids up to May 21, 2007 ($210 billion).
Source: Dealogic; McKinsey analysis

that the best managers have been

executing all along. In this way, a company
has the best opportunity to capture the
value of strategic, operational, financial,
and portfolio moves that might otherwise
make it an enticing target for an acquisition or hostile takeover by value-hungry
predators. Managers who neglect these
basics for too longoften as a consequence
of noneconomic constraints perceived
as unbeatablenot only destroy value by
failing to implement sound management practices but may also be hard pressed
to explain why a company wouldnt be
better off with new owners.
Yet, incumbent managers enjoy a natural
advantage over any potential acquirer
because they have superior information
about their companies operations and
overall status. So in theory, they should be

able to capture at least as much value

as any hostile predator envisions if they can
preempt whatever value creation measures
a predator may plan and execute them
with rigor. By tackling these opportunities
well in advance of a possible takeover bid,
managers will generate the greatest possible
value for current shareholders, even if a
hostile bidder never materializes. They will
also improve their companies positions
in the market for corporate control and help
prevent the accompanying trauma of
a hostile takeover. The value created from
such an aggressive stand-alone strategy
should be substantial and may therefore
induce potential buyers to look elsewhere
for buy-low opportunities.
A few enduring conceptual frameworks
offer managers a structure for diagnosing
the vulnerability of their companies to

Web 2007
Proactive defense
Exhibit 2 of 2
Preempting hostile takeovers
The corporate-strategy hexagon assists managers in diagnosing their own vulnerability
to a takeover.
Exhibit title: Back to basics: The corporate-strategy hexagon

Exhibit 2

Back to basics:
The corporate-strategy
The corporate-strategy hexagon
assists managers in diagnosing their
own vulnerability to a takeover.

Valuation and
perception gap


Current market

Total potential

Value as is


Value with
new owners

Value with
and disposals


Value with
and growth
New growth

Source: Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies,
fourth edition, Hoboken, NJ: John Wiley & Sons, 2005

takeover, identifying where outsiders may

see pockets of value waiting to be captured,
and planning a path forward (Exhibit 2).
Many companies have significant untapped
potential to create value by improving
their operations, restructuring their portfolios, managing their balance sheets,
and improving their governance. Management can also take measures to ensure
that current market valuations reflect
current strategy and performance, as well
as improvements over time.
Operational improvements. Companies

2 L orenzo Carlesi, Braam Verster, and Felix

Wenger, The new dynamics of managing the

corporate portfolio, McKinsey on Finance,
Number 23, Spring 2007, pp. 18.

with untapped operational potential

even solid but average performersmake
interesting restructuring candidates,
particularly for their leading industry
peers and for active-ownership companies
that could readily improve their performance. Management should conduct prag-

matic, objective private equitylike due

diligence to identify ambitiousyet
achievableperformance targets for all
levers that could create operational
value. Companies must identify and act on
such opportunities as quickly as possible
for example, by developing a stronger
performance culture through renewed
incentives, implementing lean processes, or
moving or outsourcing production.
 ortfolio restructuring. A company with

a significant part of its capital in businesses

that could be worth more or grow faster
under alternative owners will inevitably
attract interesteven if those businesses
are profitable to the current owners. The
lower the value to acquirers and the
greater the potential synergies with other
players, the more enticing they become.2
Companies can dampen that interest by

McKinsey on Finance

evaluating the business logic, future

strategy, and M&A tradability of their
own current portfolio and by looking
for opportunities to improve its composition. Companies can, for instance, sell
noncore assets and commit the proceeds
either to high-growth, high-return
businesses or to additional shareholder
dividends. In one recent example, a large
European telecommunications company
divested noncore assets worth 15 to 20 percent of its total corporate value to rid
itself of businesses and projects that made
it an attractive candidate to predators
eyeing its valuation if it were broken up.
Balance sheet management. An under-

performing financial structure will leave

any company vulnerable to acquisition,
though of all levers this is one of the fastest
(and often least contentious) to pull.
Indeed, the fact that appropriate measures
can be taken so quickly acts as a powerful enticement to outside investors
particularly private-equity firms. Extraordinary long-term cash balances, high
working-capital levels, and underleveraged
balance sheets all attract outside attention, for good as well as not-so-good
reasons. Management should analyze the
companys balance sheet to identify
any pockets of excess capital that can be
released (for example, in the form
of extra dividends to shareholders) while
retaining sufficient cash for productive
future growth. The impact of increased
leverage will be seen not only in a
companys immediate financial results but
also in stronger performance incentives,
such as a cash flow orientation among
managers and a renewed sense of urgency.
Better governance. Strong or weak gover-

nance weighs on all the measures

already mentioned. Perceptions of weak

Summer 2007

governance or a management group

whose interests arent aligned with those of
the shareholders can make a company
vulnerable to attack from both external
suitors and its own shareholders. For
example, once shareholder activists and
hedge funds acquired significant control
of the Stockholm-based insurance group
Skandia, they were able to use their
position to exercise material influence over
the boards composition and agenda.
Special events, such as option program
scandals and turbulent changes in
management and the board, made Skandia
vulnerable. When governance is an issue,
remedies include aligning the interests of
top managers with those of the shareholders, increasing the transparency of
governance, and making targeted
changes in the board of directors and the
management team to align the companys
core competencies with its current
challenges and, more generally, with global
best practices. Installing best-practice
performance-management and incentive
structures and linking potential upside
and downside effects to corporate performance (similar to what private-equity
firms implement for their portfolio companies) signal managements commitment
to increasing shareholder value.
Addressing perceptions. As managers

implement these strategies, it will be

crucial to eliminate any gaps in perception
between a companys market value and
its potential value after the improvements
it undertakes; companies trading at low
multiples compared with their industry
counterparts attract extra attention.
Differences in perceptions develop when
investors dont see or understand how
a company is going about creating value
or when they lack confidence in
managements ability to deliver it. To

Preempting hostile takeovers

address the former problem, executives

should ensure that the company has the
best possible investor communications,
issues candid earnings guidance, liaises
routinely with its more professional
shareholders, and manages expectations
adroitly. To a limited extent, companies
can also proactively manage the composition of their investor base by targeting
strategic long-term investors to create
stability during periods of transformation.
This approach may force a company to
rebuild its credibility through more aggressive steps, such as replacing senior management or recruiting new board members.
Each of these measures helps companies
anticipate and manage the forces that make
them most vulnerable, including consolidation and M&A frenzy in their industries,
the value that other owners might hope
to extract, and still more powerful enablers,
such as internal conflicts, failed attempts
at hostile takeovers, risk or accounting issues,
and bad press.

Do preemptive measures to unlock a

companys full value guarantee its longterm strategic independence? They
dontand shouldnt. In some cases, alternative owners may have intrinsic, unique
sources of value creation that stand-alone
companies cant match. In others, aggressive players may be deliberately willing to
overpay in their quest for size and for
leadership in an industry segment. The
rational choice for shareholders is then
to capture the highest net present value by
selling out and pursuing other investments.
In daily M&A activity, value creation isnt
always the key driver for acquisitions.
But one thing is certain: when a company
captures all available pockets of value
and systematically closes gaps (that is, opportunities for predators), it will fetch a
much higher price if it should ultimately be
acquiredand its shareholders should
be happy. MoF

The authors would like to thank Pedro Rodeia and Felix Wenger for their contribution to the development
of this article.
Jenny Askfelt Ruud ( is a consultant and Johan Ns (Johan_Nas@ is a partner in McKinseys Stockholm office; Vincenzo Tortorici (Vincenzo_Tortorici@ is a partner in the Milan office. Copyright 2007 McKinsey & Company. All rights reserved.

The state of the corporate

board, 2007: A McKinsey
Global Survey
Corporate directors want more information about their companies
and industries, and they say that investments by private-equity firms
improve governance.

1 Conducted from March 28 to April 11, 2007,

the survey reached 2,668 respondents from

around the world. Respondents represent
companies of all sizes, 42 percent with annual
revenues of less than $1 billion, 40 percent with
annual revenues of $1 billion to $30 billion,
and 18 percent with annual revenues of more
than $30 billion. They hail from a broad
spectrum of industries, including arts and
entertainment; business, legal, and financial
services; energy; health care; high tech;
manufacturing; mining and extraction; retail;
telecommunications; transportation; and
others. All data are weighted by GDP of constituent countries to adjust for differences in
response rates.
2 See What directors know about their
companies: A McKinsey Survey, The
McKinsey Quarterly, Web exclusive, March
2006; Robert F. Felton and Pamela Keenan
Fritz, The view from the boardroom, The
McKinsey Quarterly, 2005 special edition:
Value and performance, pp. 4861; and Robert
F. Felton and Mark Watson, Inside the
boardroom, The McKinsey Quarterly, 2002
Number 4, pp. 3242.

At a time of significant public debate about the role and performance of boards of directors,
a recent McKinsey Quarterly global survey of corporate directors and other executives
indicates that directors strongly desire more financial and operational information from
management about the companies they serve and want to see more sector specialists
and outside experts on company boards. They also regard the growing influence of private
equity on the value of public companies as generally positiveat least in the short
termand indicate that private-equity investors tend to strengthen many aspects of corporate governance. Few executives see hedge funds making any positive contributions.

These and other insights emerged from the

survey, in which 825 directors and more
than 1,800 other managers and executives
were invited to report on the roles and
perceptions of boards at public companies.1
Their responses complement the findings
of a series of surveys on governance conducted by McKinsey over the past several
years.2 Among the earlier findings are that
boards have generally become more active,
that directors want to devote more time to
developing talent and strategy, and that,
for all the forces encouraging companies to
rethink corporate governance, equally
strong forces hold them back.

What directors are doing . . .

Overall, in response to a question about

how their boards spend time, executives
identified three top activitiesreviewing
current company performance, risk exposure, and financials; approving strategy;
and tracking progress against strategy. They
agree that these priorities are generally
the right ones. Respondents whose boards
spend a majority of their time developing
talent and directly managing their companies
operations say the board should be spending time on strategic activities and reviewing
the companies performance. These
respondents generally believe the board

Survey 2007
Board survey
Exhibit 1 of 6
Glance: This article's exhibits display respondents' views on board governance.
Exhibit title: Degrees of satisfaction

Exhibit 1

% of respondents (n = 824)

Degrees of satisfaction

Internal board members

External board members

Board members who answered they were extremely

or very satisfied with their boards access to the following types of information . . .
Financial information


Strategic information
Operational information





Source: April 2007 McKinsey Quarterly corporate-governance survey

should focus on talent as well, but few

say it should continue to manage operations
Generally speaking, some seven out of ten
directors say they are satisfied with their
access to the financial information of the
companies they serve. But their satisfaction tails off noticeably when the subject
turns to strategic and operational information. About half of directors say they are
extremely or very satisfied with
their access to information in those two
respective areas. Not surprisingly, internal
board members (executives serving on
their own companies boards) are more satisfied than external ones (Exhibit 1).
. . . what they want . . .

Current board members express strong

interest in obtaining information from a
broader range of sources. They want
to gain more access to the workings of their
companies by developing relationships
beyond the CEO not just with C-suite executives, such as the chief financial and

operating officers, but with the heads of

divisions and business units as well
(Exhibit 2). Executives not on the board,
perhaps as expected, agree that these
are important goals. Regionally, North
American respondents are more likely than
others to want to develop relationships,
both within the C suite and with executive
vice presidents.
Across industries, a strong majority also
believes that sector specialists should serve
as members of the board, ostensibly to
help the board understand the information
that directors are seeking from within
their organizations. Interestingly, more
respondents support having sector
specialists sit on boards than favor giving
board seats to controlling or majority
Notably, more external directors than
internal ones express an interest in having
outside directors of all kinds, including
labor representatives, academics, and sector
specialists. Finally, although all directors

Exhibit 2

Survey 2007
Board survey
Exhibit 2 of 6
McKinsey on Finance
Exhibit title: Broadening input

Summer 2007

% of board member respondents

Broadening input

With which other executives

should board members form

Who should sit on

a board to maximize
its effectiveness?

n = 724

n = 824

Chief financial officer

Chief operating officer


Chief strategy officer


Minority shareholders


Other board members
Board survey
Exhibit 3 of 6
Source: April

Exhibit 3


Academic experts


Executive vice presidents


Retired executives


Other C-suite executives


Current executives


Heads of divisions or
business units


Sector specialists


Labor representatives


% of respondents (n = 2,668)

Roles financial
investors play

Do financial investors strengthen given aspect of corporate management?

Private equity
Hedge funds

Accountability to



Strategic focus



Financial structure






Overall, what effect do investment activities by financial investors

have on the value of public companies?
Create value

Destroy value


Dont know

Private equity



Short-term value
Long-term value1

Hedge funds





do not sum to 100%, because of rounding.

Source: April 2007 McKinsey Quarterly corporate-governance survey






The state of the corporate board, 2007: A McKinsey Global Survey

overwhelmingly support the roles of the

chair and executive board members in
setting the boards agenda, a strong majority
also believes that controlling shareholders
and nonexecutive directors should share that
role. Regionally, respondents from developing markets are more likely to support
minority shareholders as directorsand
less likely to support current executives
for that rolethan respondents from the
developed economies in Asia3 or from
Europe or North America.
. . . and what they face

As active and ubiquitous as private-equity

firms and hedge funds have been in recent
years, fully two-thirds of all respondents
believe the role of such investors will increase
over the next five years. Yet respondents
perceptions of these two types of financial
investors are markedly different. A plurality
believes that the activities of private-equity
firms strengthen a public companys accountability to shareholders, strategic focus,
and financial structure, but less than onethird believes the same of hedge funds
(Exhibit 3). Indeed, on most measures, more
respondents say hedge funds weaken
rather than strengthen the governance of
public companies. Furthermore, although
60 percent of respondents believe the activity
of private-equity firms creates short-term
value at public companies, few say the same
thing about hedge funds. For both types
of investors, the long-term view is decidedly
less rosy.

3 Australia, Hong Kong, Japan, New Zealand,

the Philippines, Singapore, South Korea,

and Taiwan.

These findings could lend credence to the

assertions of private-equity firms that
they create real value in the management of
their investments. Or they could reflect
a belief that the jury is still out on whether
the short-term gains tallied by the best
private-equity funds will produce long-term

value. Another possibility is that respondents see hedge funds as simply choosing
the right companies to invest in.
Governing boards

Boards adopt the high road when it comes

to articulating their missions. Fully
37 percent of board directors report that
creating shareholder value is their single
most important goal. When this response
is combined with an additional 22 percent who believe their most important goal
is providing oversight on behalf of shareholders, there is clear evidence of a strong
culture emphasizing shareholder value.
Surprisingly, barely 1 percent of respondents
identify ensuring leadership succession
as their most important goal.
Board members say the most powerful
motivator for them to act in the best
interests of shareholders is personal or ethical values (41 percent), followed by share
or equity ownership (24 percent) and personal reputation (15 percent). Only
12 percent of board members report legal
obligation as the most powerful motivator.
Furthermore, directors and executives
are ambivalent about time limits on board
membership. Slightly more than half do
not believe board members should have to
retire when reaching a given age. Similarly, a
third believes there should be no term
limits for board members, and another third
believes that if there are term limits, they
should be six years or longer. Most respondents say a board committeeeither alone
(29 percent) or in collaboration with the CEO
(27 percent)should have primary
responsibility for appointing new directors.
Few indicate that the CEO acting alone
(3 percent) or with only the board chairman
(5 percent) should have this role.

Exhibit 4 of 6
Exhibit title: Evaluating compensation

McKinsey on Finance

Exhibit 4

% of respondents (n = 2,668)

Evaluating compensation

Summer 2007

Relative to the value top executives create for

shareholders and the geographic region in which they
are located, how appropriately are these top executives compensated at your company?

Internal board member




Survey 2007External board member
Nonboard member
Board survey
Exhibit 5 of 6
Source: April
A McKinsey
voice inQuarterly

Exhibit 5

A voice in compensation


Dont know






% of respondents

What role should shareholders play in

setting executive compensation?

What elements of compensation should

shareholders be involved in setting?

n = 2,668

Share of respondents who believe shareholders should have

some role in setting executive compensation, n = 2,004

No role


advisory role

Metrics used to assess

executive performance


Structure of
compensation package


Exceptional and
one-off payments
Power to veto
executive pay deals

Total amount of
compensation package


Source: April 2007 McKinsey Quarterly corporate-governance survey


Given that one responsibility of most board

members is to set executive compensation,
it may come as no surprise that a large
majority of respondents perceive that executives are appropriately compensated or
even underpaid relative to the value they
create for shareholders and the regions
in which they are located. Executives who

are not board members are far more likely

than board members to perceive executives
as being overcompensated (Exhibit 4).
However, more than two-thirds of all respondents support giving shareholders some
input into setting executive compensation
whether in a nonbinding advisory role
or even in giving shareholders veto power

Survey 2007
Board survey
6 of 6
The state of the corporate board, 2007: A McKinsey Global Survey
Exhibit title: Regulation improves governance

Exhibit 6


% of respondents (n = 2,668)1

Regulation improves

How has each of the following recent reform

trends affected board governance?
Made governance
more effective

Made governance
less effective

Had no effect

Requiring more independent

board directors



Splitting roles of CEO and

board chair



More activism by shareholders


Limiting number of boards

directors can serve on


Sarbanes-Oxley accounting rules


SEC2 regulations



International guidelines for institutional

shareholders (eg, ICGN, OECD3)
Preventing former executives
from joining companys board








Dont know






may not sum to 100%, because of rounding.

Securities and Exchange Commission.
= International Corporate Governance Network; OECD = Organisation for Economic Co-operation and Development.


Source: April 2007 McKinsey Quarterly corporate-governance survey

over executive pay packages (Exhibit 5).

Interestingly, respondents are less likely
to say that shareholders should have input
into total compensation than into how
compensation is structured and calculated.
As for board members themselves, most are
at least somewhat satisfied with their
compensation. Moreover, a scant 5 percent
believe compensation is the most powerful
motivator in aligning board interests with
those of shareholders.

Regulation and reform

Past surveys have noted the difficulties

inherent in reform, and the media often
report on the costs associated with it.
However, most respondentsdirectors and
nondirectors alikesay many highly
visible reform efforts have made board governance more effective (Exhibit 6). These
perceptions are about the same whether
respondents serve companies with revenues
under $1 billion (for whom the costs
of reform might arguably be more onerous)
or companies with revenues of $1 billion
or more. MoF

Contributors to the development and analysis of this survey include Rainer Kiefer (,
an associate principal in McKinseys Munich office; Frank Mattern (, a
partner in the Frankfurt office; and Frank Scholz (, a partner in the Hamburg
office. Copyright 2007 McKinsey & Company. All rights reserved.


A longer version of this

interview is available

Investing in sustainability:
An interview with Al Gore and
David Blood
The former US vice president and his partner in an investment-management
firm argue that sustainability investing is essential to creating long-term
shareholder value.

Lenny T. Mendonca and

Jeremy Oppenheim

1 The research, summarized in The McKinsey

Global Survey of Business Executives: Business

and Society, January 2006 (The McKinsey
Quarterly, Web exclusive, January 2006),
indicates that 84 percent of executives think
business has a broader contract
with society.

As McKinsey research indicates, executives around the world increasingly recognize that
the creation of long-term shareholder value depends on a corporations ability to understand
and respond to increasingly intense demands from society.1 No surprise, then, that the
topic of socially responsible investing has been gaining ground as investors seek to incorporate concepts such as sustainability and responsible corporate behavior into their
assessments of a companys long-term value.
Three years ago, former US Vice President
Al Gore and David Blood, previously the
head of Goldman Sachs Asset Management,
set out to put sustainability investing firmly
in the mainstream of equity analysis. Their
firm, Generation Investment Management,
engages in primary research that integrates
sustainability with fundamental equity
analysis. Based in London and Washington,
DC , Generation has 23 employees, of whom
12 are investment professionals, and a single
portfolio invested, at any given time, in
30 to 50 publicly listed global companies.
The two partners recently sat down with
McKinseys Lenny Mendonca and
Jeremy Oppenheim to discuss reconciling

sustainability and socially responsible

investing with the creation of long-term
shareholder value.
McKinsey on Finance: What do you

mean by the term sustainability,

and how does it influence your investment
David Blood: Sustainability investing is

the explicit recognition that social, economic,

environmental, and ethical factors directly
affect business strategyfor example, how
companies attract and retain employees,
how they manage the risks and create opportunities from climate change, a companys
culture, corporate-governance standards,


stakeholder-engagement strategies, philanthropy, reputation, and brand management.

These factors are particularly important
today given the widening of societal expectations of corporate responsibility.
Al Gore: We dont think its acceptable to

force a choice between investing according

to our values or according to the ways
most likely to get us the best return on investment. Our objective in innovating with
this new model was to focus on the best
return for our clients, full stop. But we
wanted to do so in a way that fully integrates
sustainability into the model.
McKinsey on Finance: That sounds

David Blood: Yes, sustainability research

is complicated because it requires you to

think long term and to think about the firstand second-order effects of an issue. We
like to describe our approach to sustainability
research as taking a systems view. What
that means is, if youre thinking about
climate change you first need to understand
the physical, regulatory, and behavioral
impacts on business. But you also need to
understand what a changing climate means
for disease migration and public health,
what it means for poor populations in developing countries, what it means for
water scarcity or demographic and urbanization trends. The most important and
challenging research is trying to determine
how all these factors interact. Without that
understanding, you can miss a significant
part of the business implications.
McKinsey on Finance: What principles

drive your approach?

David Blood: The first principle, categori-

cally, is that it is best practice to take a

long-term approach to investing. We think

that the focus on short termism in
the marketplace is detrimental to economies,
detrimental to value creation, detrimental
to capital markets, and a bad investment
strategy. Its common corporate-finance
knowledge that something on the order of
60 to 80 percent of the value of a business
lies in its long-term cash flows. And if youre
investing with a short-term horizon youre
giving up the value creation of a business.
The second principle is that the context
of business is clearly changing. We are now
confronting the limits of our ecological
system, and at the same time societal expectations of business are widening. On top
of that, multinational businesses are
oftentimes better positioned than governments to deal with some of the most
complicated global challenges, such as
climate change, HIV/AIDS , water scarcity,
and poverty. Technology and communications have changed, and weve reached a
point where civil society is now demanding
a response from business.
McKinsey on Finance: Whats your

perspective on how that changes corporate

David Blood: In effect whats happening,

unbeknownst to many corporate leaders, is

that the goalposts for their businesses
license to operate have moved. There are
higher expectations and more serious
consequences, and the implications go way
beyond protecting your reputation or
managing costs. Rather, we see this changing
context for business as an opportunity for
companies to establish competitive
positioning, grow revenues, and drive
profitability. In the end, thats the holy grail
of sustainability investingto seize
the opportunities, not just avoid the risks.


McKinsey on Finance

Graduated in 1969 with BA in
government from Harvard College
Attended divinity school (197172)
and law school (197476) at
Vanderbilt University, Nashville,
Fast facts
Author of several books, including
An Inconvenient Truth (about the threat
of and solutions to global warming);
featured in the Academy Award
winning documentary film of the
same name

Summer 2007

Career highlights
Generation Investment Management
Cofounder and chairman
Current TV (2005present)
Cofounder and chairman

US government (19772001)
Vice president (19932001)
Senator (198593)
Member, House of Representatives (197784)

Served in US Army in Vietnam War (196971) and

worked as investigative reporter with Tennessean in

Serves on board of directors of Apple

and as senior adviser to Google

Al Gore

Visiting professor at Middle Tennessee

State University

McKinsey on Finance: What has

McKinsey on Finance: Why do you

been the reception from pension funds and

longer-term investors to this notion?

think that is?

David Blood: Its because people realize

David Blood: Very good. They recognize

that they have long-term liabilities, and it is

their fiduciary duty to match those
liabilities with assets. The recent adoption
of the UNs Principles for Responsible
Investment by asset owners and managers
representing over $8 trillion is a good
example of the institutional-investment
community beginning to commit to a
long-term time horizon and the explicit
recognition that environmental, social, and
governance factors drive value creation.
From Generations perspective, were
pleased with this awakening. If you go back
to when we founded this firm, we thought
that sustainability investing would
eventually be mainstream, but we never
would have guessed that the reception
and focus on sustainability would be as loud
and as urgent as it is today versus three
years ago.

that there are reputation issues related

to sustainability, but they also recognize
that, in the end, this is about driving
profitability and competitive position. Asset
owners are beginning to get this and they
are looking to invest in the companies that
understand it.
Al Gore: The market is long on short, and

short on long. Theres a widespread

recognition within the industry that what
has emerged over time doesnt really
make any sense. They know that it needs to
change and they are ready for change.
We are in a period of history, right now,
when the contextual changes are larger than
the ones weve been used to in the past.
Changes that weve associated with very
long cycles are now foreshortened and
are occurring much more rapidly. Positioning
a company to ride out these changes and

Investing in sustainability: An interview with Al Gore and David Blood


Graduated in 1981 with BA
from Hamilton College, Clinton,
New York

Career highlights
Generation Investment Management
Managing partner

Earned MBA in 1985 from Harvard

Business School

Co-CEO and CEO of Goldman Sachs Asset Management

Goldman Sachs (19852003)


Fast facts
Serves on board of trustees of
Acumen (nonprofit global venture fund)
and of SHINE (UK organization that
funds educational-support projects for
disadvantaged children and young

CEO of Goldman Sachs Asset Management, Europe

Served in various positions, including head of

international operations, technology, and finance;

treasurer of Goldman Sachs; head of global
private capital markets; investment banker (198597)

David Blood

profit from them often means making stretch

investments to change the infrastructure,
change the energy source, change the physical plant, and adapt to the new realities.
And if there is the tyranny of a three-month
cycle, then companies wont make those
investments. So focusing only on the quarter
can blind you to the most important
factors of all.
McKinsey on Finance: How many execu-

tives really understand the complexity and

interconnection of the trends you describe?
Al Gore: Its a rapidly growing number.

I recently spoke at a conference, in

Copenhagen, focused on carbon trading,
with thousands of companies represented.
As part of an internal survey, attendees were
asked how many of them had internalized
their carbon budget and begun to drive
down their internal emissions.
A year ago it was 15 percent. This year
it was 65 percent. That would correspond
with what weve found in multiple other

areasa kind of tipping point that we are

at right now. For example, I had a chance
to visit Wal-Mart in Bentonville, Arkansas,
around the time they launched their
commitment to green their supply chain.
And David and I spent time with [GE CEO]
Jeff Immelt, and we could give you lots
of other examples of CEOs who, a few years
ago, might not have talked this way and
yet are now not only knowledgeable but
highly sophisticated. They may have
started with concerns about brand protection and reputation and the like. But
once they got into it, it was as if a whole
new world of opportunity and markets
opened up.
McKinsey on Finance: What do

those executives and companies that are

doing this well see differently?
David Blood: The first is that they under-

stand their long-term strategy. Secondly,

they understand the drivers of their
businessboth financial and nonfinancial.
The leading CEOs are the ones who


McKinsey on Finance

Summer 2007

explicitly recognize that sustainability

factors drive business strategy.

goods there are issues around excessive

materialism, authenticity, and consumption.

In our minds, the best businesses have

always understood the importance of culture
and employees and ethics. And they get
it in their soul. But whats now becoming
trueparticularly for the industrials, the
retailers, the pharmaceuticals, the utilities,
and a broader array of industriesis
that managers are realizing that there are
broader factors affecting how they operate.
They can recognize that over the next
25 years their strategy will depend on leveraging new opportunities and must operate
within the changing context of business.

What Im describing here is what we call a

materiality-based approach to investing.
Rather than looking at 50 different tick-box
sustainability criteria, we think you need
to tackle the three or four long-term issues
that will really affect corporate profitability.
McKinsey on Finance: What examples

come to mind of companies that have

thought beyond managing sustainability
risks and moved on to creating revenue
David Blood: A company like Johnson

McKinsey on Finance: Is this approach

possible in all sectors? Can you get there in

tobacco? Fast food? Or are these just
sectors that are fundamentally, somehow,
no-go territory?
David Blood: There are material sustain-

ability challenges in all industries. In the

fast-food or food-manufacturing industry,
theres a very strong move toward healthy
living and eating, organic food, and
the implications for sustainable agriculture.
And how do food companies deal with
the upstream challenges of these trends,
challenges such as water use? While we
dont invest in it, the tobacco sector faces a
whole host of issues which are very
much sustainability drivennot just the
health impact of the product. But, again,
sustainable agriculture is a big story,
as is litigation risk. In another sector, like
financial services, the key sustainability
issue is how a company manages its human
capital. In the energy sector, climate change
is one of the most significant issues.
In the health care sector, we look at ethical
marketing practices between companies
and doctors. Even in industries like luxury

Controls, for example, is interesting

because of its focus on demand-side energy
efficiency. About 50 percent of its business
is batteries for hybrid cars and products to
run buildings efficiently, the other 50 percent is automotive interiors and controls. We
think its the former thats going to be
growing and driving that company. They
understand that their products will help
reduce their clients environmental
footprint. This strategy is completely revenue
driven. GEs Ecomagination is another
example. If you think about how GEs stock
price is going to trade, its going to trade
primarily on growth. Jeffrey Immelt knows
this. Hes betting his reputation and his
company on the notion that the businesses
related to the environment will enable
GE to grow faster than GDP. In Mexico we
cover two Mexican home builders that
are linked to demographic trends and to
the very strong demand and need for
affordable housing in Mexico.
These are just some examples of how companies can see sustainability trends
as growth opportunities or as new niches
for existing products and services.

Investing in sustainability: An interview with Al Gore and David Blood

McKinsey on Finance: One of the

McKinsey on Finance: Can we explore

important interfaces between the investing

world and management is the board.
What role do boards of directors play in
trying to ensure that this kind of mindset is embedded in corporate activity and
communicated to investors?

climate change a bit more deeply? How

do you think about that from an investing
standpoint and what do you think that
business should be doing that would help
not just with climate change but with
investment returns?

Al Gore: I think that the board of directors

Al Gore: There is a big story and oppor-

has a growing responsibility to address

these very topics. As stewards of shareholder
interests, boards should be focused on the
long-term sustainability of the firm rather
than on the market noise. If I were on
the board of a company doing business
primarily in the European Union, I would
ask questions about how long it will be
before my fiduciary responsibility required
attention to the aggressive management
of carbon. Because even though natural
resources are not depreciated and even
though pollution is treated as an externality
and a reputation risk, where regulations
and laws are involved, pollution now has an
economic cost. And that cost is increasing.

tunity around the supply side of cleaner

energy. We would look for companies to
recognize that carbon constraints will be
more aggressive in the future. So we would
expect to see opportunity in businesses
that are involved with lower-carbon energy,
including renewable-energy provision,
such as wind, solar, and cellulosic ethanol2
production. Or in businesses that are
involved in cleaning up traditional fossil
energy, which we see as a very big trend.
Or in companies that are involved in technologies like carbon capture and storage
(CSS) and sequestration-ready power plants.3

David Blood: Remuneration is one very

2 Cellulosic ethanol is produced using enzymes

to break down vegetation into cellulose (the

primary structural component of plants), which
is then converted into fuel.
3 Carbon capture and storage (CCS) is an approach
to eliminating carbon dioxide emissions from
sources such as power plants by capturing the
carbon dioxide and then storing it underground
in deep geologic formations instead of releasing
it into the atmosphere. Sequestration-ready
power plants have the appropriate technology,
equipment, and locations to perform CSS .


specific area that we look at. In line with all

the things weve already talked about,
perverse short-term incentives in the financial system obviously are manifested at a
corporate level by remuneration structures.

The demand side, we also think, is an underappreciated opportunity. The efficiency

of buildingsinsulation, specificallyis
low-hanging fruit in terms of economic
opportunity. The technology has existed for
some time; it just needs to be deployed
and implemented more effectively. There are
also demand-side opportunities around
sustainable mobility and transportation
for example, growth in hybrid vehicles
or lightweight materials in vehicles. MoF

The authors wish to acknowledge the contributions of Sheila Bonini; Colin le Duc, the head of research at
Generation; and Lila Preston, an associate at Generation.
Lenny Mendonca ( is a partner in McKinseys San Francisco
office, and Jeremy Oppenheim ( is a partner in the London office.
Copyright 2007 McKinsey & Company. All rights reserved.


A quiet revolution in Chinas

capital markets
Reforms that attracted little attention in the Western world mark a major
step forward in the modernization of Chinas capital markets.

James Ahn and

David Cogman

When China first began privatizing its state-owned enterprises in the 1990s, the intent
resembled that of other privatization programs around the world: to use capital market
pressures to improve the performance of a large number of state-owned companies, many
of which had weak balance sheets and were not as commercially focused as publicly held
companies elsewhere. However, the government wanted to retain substantial shareholdings
in and influence over these companies, which precluded the full privatization of state
assets. To allow such companies to raise capital in that context, a two-tier ownership
structure was put in place. Essentially, the original equity remained legally distinct
from the new equity and formed a separate class of shares held by the existing state-linked
owners. Although both classes had the same theoretical rights to profits and votes, the
nontradable shares could not be sold on the public markets.
As Chinese companies have grown in scale
and complexity, this system has faced
several challenges. With a two-tier equity
structure to manage, state-owned
enterprises understandably concentrated
on their most important stakeholders:
the government and one or two of their
largest holders of nontradable shares.
Smaller holders of nontradable shares and
public-market shareholders had very
limited influence either on the governance
of these companies or their investment
decisions. This arrangement had a

negative effect on the development of

the Shanghai stock market. After falling
from its peak in 2001, when the first wave
of IPOs was complete, it progressively
declined until mid-2005, losing more than
half of its value. Although the two-tier
share structure did not cause the slump, the
uncertainties it created prevented the
market from recovering over the following
five years, and it also affected the overall
credibility of Chinese stock markets, both
as a source of capital and as a vehicle
for investment.


Now a second-wave reform effort that does

away with the two-tier structure is showing signs that it could spark a revolution in
Chinas capital markets by affecting M&A
activity, the equity markets, and corporate
governance. Two years ago, the government instituted new policies requiring companies to merge the two classes of
shareholdingsin essence, making the
nontradable shares liquid. As of this spring,
more than 90 percent of state-owned
enterprises had already completed plans to
that effect; shareholders at the last few
companies are expected to finalize their
reform plans this year.

each company, over the next five years,

all shares in Chinas state-owned enterprises
will become fully tradable (Exhibit 1)
thousands of majority and large-minority
stakes, spread across the entire economy. In
several sectors, they account for up to twothirds of the equity of all listed companies
(Exhibit 2). These reforms will also
encourage the development of the countrys
M&A market by allowing industries
to consolidate, improving corporate governance at state-owned enterprises, and
expanding the capital markets.

Already, investors who lost significant

wealth in previous years have returned to
This seemingly technical reform received
the market en masse, sparking an 18-month
little attention outside China at the
rally that has already reversed the decline
time but will have a profound impact on
of the previous five yearsand continues at
the structure of its capital markets
the time of writing. Although the markets
24 2007
if implementation
proceeds as planned.
performance still attracts considerable
Depending on the specific agreements
attention from investors and the media, as
1 of 2between shareholder classes at
well as the interest and concern of policy
Glance: Depending on the reform plans approved by shareholders, all formerly nontradable
shares will become tradable over the next 5 to 10 years.
Exhibit title: A measured transition
Exhibit 1

Estimated tradable shares as % of total market capitalization1 in China

A measured transition


Depending on the reform plans approved by

shareholders, all formerly nontradable shares will
become tradable over the next 5 to 10 years.













on stratified sample of ~150 companies reform plans.

Source: Financial China Information & Technology (FinChina); Shanghai Stock Exchange; Shenzhen Stock Exchange;
McKinsey analysis


MoF 24 2007
China share reform
Exhibit 2 of 2
McKinsey on Finance
Summer 2007
Glance: Currently, the proportion of nontradable to tradable shares in total sector capitalization
varies across sectors depending on the strategic importance of that sector.
Exhibit title: How many are currently untradable?

Exhibit 2

Nontradable shares as % of total sector capitalization, for selected sectors in China

How many are currently



Coal mining
Food manufacturing

Today, the proportion of nontradable to

tradable shares in total sector capitalization
varies across sectors depending on
the strategic importance of that sector.


Nonferrous-metal processing




Clothing, textile manufacturing


Real estate


Printing, papermaking




Transportation, storage




Source: Financial China Information & Technology (FinChina); McKinsey analysis

makers, we believe that the longer-term

implications of the latest round of reforms
are potentially far more significant.
Setting the stage for reform

As the reforms of the 1990s ran into

challenges, the government put forward
several different plans for merging the two
kinds of shareholdings and making the
nontradable shares tradable. None of these
early trial runs won the support of
the companies and shareholders involved.
Public shareholdersin the minority
worried about what would happen to
them if the two-tier equity structure were
dismantled. Many feared that shareholder value would be massively diluted or
that the market would be flooded with
more new equity than it could absorb, thus
structurally depressing prices.

1 In most cases, the owners of the nontradable

shares are some combination of central-, state-,

and local-government departments; banks;
other state-owned enterprises; and investment
companies. SASAC s charge is extremely broad:
its ultimate responsibility is to advance the
governments overall reform agenda. In doing so,
it exercises a governance and control function
over state-owned enterprises, appoints directors,
approves business plans, and participates in
decisions allowing IPO s to proceed.

Owners of nontradable shares had their

own concerns. Deals involving nontradable
stakes achieved relatively low valuations
and faced considerable regulatory difficulty.
Transactions involving the nontradable
shares required approval from the StateOwned Assets Supervision and Administration Commission of the State Council1

(SASAC), a government department created

to oversee and supervise listed and unlisted
state-owned enterprises, and the valuations
for such deals were typically quite low
during 2003 and 2004, around a third of
the value of the traded shares, on average.
Moreover, approval requires an assessment
by SASAC that the valuation is faira
determination based on the implied
premium or discount to the estimated net
asset value in the deal rather than on
market-based notions of valuation. Because
this approach often created large disparities between the valuations offered by
strategic investors and the prices that
companies could accept, it prevented deals
from going through.
In 2005 Chinas State Council, the countrys
chief administrative authority, asked
SASAC and the China Securities Regulatory
Commission (CSRC), which regulates stock
markets, to come up with a def initive
scheme to end the two-tier equity structure.
The two entities put in place reforms
requiring all companies to implement plans
to merge shareholdings. Although the
companies themselves could determine the
specific form and implementation of the


A quiet revolution in Chinas capital markets

plans, every plan had to include two key

elements. First, no more than 5 percent of
the previously nontradable shares could
be sold in the first year following the shareholders approval of an integration plan
and no more than 10 percent in the next
year. Thereafter, companies could specify
longer, voluntary lockup periods, but
for most there would be no mandated restriction on the sale of shares in public
markets. This measure spreads the impact of
the reforms over several years: the first
wave of companies to pass a reform plan
will see their shares become tradable
only in late 2007 and early 2008.
Second, the plans had to involve some compensation paid by the holders of nontradable
shares to the owners of tradable ones.
A consensus quickly emerged that holders
of tradable shares should receive a bonus
worth 30 percent of their premerger stake.
Most plans approved bonuses to be paid
in equity, though many combined it with
cash and options. This compensation was a
high price for the holders of nontradable
shares to pay in order to make their shares
tradable. The reforms therefore represented
a gamble that eliminating the two-tier
structure would attract enough liquidity to
make the price worthwhile.
Negotiations over these plans involved
instances of shareholder activism that would
have been inconceivable in China when
state-owned enterprises were first privatized.
Under the reforms, each plan had to gain
the support of a two-thirds majority of the
nontradable shares in a vote and, separately,
a two-thirds majority of the tradable
shares. Almost all the public debate around
share reform centered on compensation
for the latter. In several high-profile cases,
when companies made offers that were
viewed as too low, public figures organized
to vote down the plans and forced the

companies to make more generous

M&A market development

These reforms are an important enabler

for the development of the domestic M&A
market. Many people suppose that the
state shareholding SASAC oversees is a single,
monolithic block. In fact it is a complex
web of different types of shareholders
different layers of government, other stateowned enterprises, banks, and investment
companiesoften with very different
intentions. Around 20 percent of the nontradable equity is in sectors viewed by
the government as strategic, where investment is closely controlled. Slightly more
than 55 percent is held by strategic investors
with a long-term interest in the companies:
for instance, those in an upstream or
downstream industry or local governments
that have invested because the companies
are major employers in the local economy.
The remaining 25 percent represents
shareholdings primarily by state-owned
financial investors. Of their holdings, more
than 75 percent of the equity (by value)
is in sectors open to foreign investment.
As the reform plans go into effect, these
financial investors in nontradable shares
will for the first time be able to rationalize
their noncore investmentsa development
that could create a wave of M&A activity.
That would provide a powerful stimulus
for the longer-term development of Chinas
domestic M&A market by forcing companies
to develop a sorely lacking experience and
confidence in doing deals. The domestic
M&A market and cross-border investment
in China may well grow too.
The biggest winners will be some of the
more aggressive domestic companies looking
to consolidate their sectors. Whats more,
many executives of state-owned enterprises


McKinsey on Finance

Summer 2007

weve spoken with view the reform as

an opportunity to manage their shareholder
base more actively by encouraging the
departure of passive, nonstrategic investors
and bringing in new strategic ones,
often foreign companies, that can help them
develop their capabilitiesfor instance,
in accessing new markets or technologies.
Astute foreign companies seeking to expand
their footprint in China will no doubt use
the unfreezing of ownership structures to
find strategic partners of their own.

into the domestic equity market could

grow even more. By the time the last of the
nontradable shares becomes fully tradable,
in 2012, current plans to reform the
pension system and social security, if implemented, will have generated new funds
for investment into the equity market. Those
funds will be worth two-thirds of the
value of all nontradable equity, or around
75 percent excluding sectors with investment restrictions.

Uncertainties remain. First, the government

also recently instituted a new policy to
create a transparent environment for M&A.
The policy extensively revises the framework for foreign companies investing in
China, specifying which industries are
considered strategic and thus not open to
100 percent ownership by private or foreign
investors. Many details on the policys
application are unclear, and the definition
of strategic is so flexible as to accommodate a number of interpretations. Second,
SASACs role will continue to be critical in
M&A activity involving state-owned enterprises. Historically, it has acted as custodian
of the state-linked portfolio. Although
the commission will still be responsible for
overseeing state-owned shares, it has
signaled interest in concentrating its efforts
on the subset of truly strategic companies
and progressively opening the rest to market
forces. However, it is hard to say how
quickly it will proceed down this path.
Capital market expansion

2 Diana Farrell and Susan Lund, Putting Chinas

Capital to Work: The Value of Financial

System Reform, McKinsey Global Institute, May
2006, available free of charge online at

By allowing formerly nontradable shares

to be sold, share reform creates a huge pool
of equity potentially seeking liquidity
nearly twice the capitalization of the market
today and far greater than the new liquidity
seen in recent years. The risk of a massive
inflow of new shares was a major concern
prior to reform. Yet the supply of liquidity

This increase will greatly enlarge the base

of domestic institutional investors,
which today account for only 10 percent of
all investors. That huge shift will create a
professional-investor segment with holdings
that exceed the capitalization of Chinas
domestic equity market today. Indeed,
McKinsey research suggests that from 2005
to 2015 the funds under management of
Chinas asset-management industry could
grow by as much as 24 percent a year. A
professional, organized investor base would
also be a powerful force in advancing bestpractice governance.
Furthermore, as Chinese middle-class
investors gain greater confidence in the
equity market, they could generate
enormous amounts of new liquidity by
shifting their assets to shares from
their present low-yielding bank deposits,
which now account for almost threequarters of Chinas financial assets,
compared with around 20 percent in the
United States.2 Because of exchange
controls on Chinas currency, the renminbi,
this capital is concentrated within the
country. The level of investment activity
in recent years in real estate, art, and
equities suggests a desire for viable domestic
investment opportunities. In that case,
domestic stock exchanges would become
much more attractive for listing. Already,
some high-profile Chinese companies


A quiet revolution in Chinas capital markets

that had scheduled IPOs in Hong Kong

have changed their plans, deciding instead
to pursue a Shanghai listing. Aside from
currently favorable pricing, this move has
considerable public-relations value.
Over time, a healthy, liquid equity market
will also take pressure off the banking
system, which today is the principal allocator
of capital. A gradual shift from bank debt
to equity as the primary source of funding
for companies would improve the allocation
of capital, make the ability to produce
profits more important, and reduce the
economys reliance on the banking system.
The development of domestic equity
markets might also make foreign companies
with significant operations in China consider the strategic merits of a Shanghai IPO
of minority stakes in their Chinese holding
companies. Indeed, a few joint ventures
have already started to explore this possibility. Although a Shanghai listing would
be complex, it has potential strategic benefits:
it could mitigate the implicit foreignexchange risk in funding and send a very
strong signal of commitment to China and
of success in localizing foreign businesses.

3 Dominic Barton and Richard He Huang,

Governing Chinas boards: An interview with
John Thornton, The McKinsey Quarterly,
2007 Number 1, pp. 98107.

One major uncertainty that remains

is how access to the equity markets will be
managed. Historically, a government
committee approved IPOs, and state-owned
enterprises found it far easier to gain
approval than did Chinas emerging privatesector companies. With the recent
explosive growth of the Shanghai stock
market, companies have become much more
interested in new IPOs. Greater access
to the capital markets would make privatesector companies less reliant on debt
financing, reducing the risks both for them
and for the banking system in the event of
an economic downturn. It would also allow
private enterprise to play a greater role

in accelerating the consolidation of many

The reform of Chinas capital markets still
faces significant obstacles. China must
further improve the accounting, legal, and
regulatory framework needed for equity
markets to reach their full potential.
Although the government implemented a
completely new set of accounting and
auditing standards earlier this year, there
are simply not enough Chinese-speaking
accountants to meet the needs of every listed
state-owned enterprise; accounting firms
cannot hire and train people fast enough.
Similarly, although the legal framework
is well designed, enforcement and support
courts, arbitration procedures, experienced
lawyersare still lacking or inconsistent.
Finally, effective market regulation typically
requires independence and objectivity, but
in todays China no government department
really enjoys them.
Corporate governance

Currently, China is sailing in uncharted

waters as it explores ways to develop
its own approach to improving corporate
governance.3 One of SASAC s most
heavily publicized initiatives is aimed at
encouraging the companies it supervises to
upgrade the quality and transparency of
their governance. Under the two-tier equity
structure, even companies that wanted
to implement corporate-governance systems
more inclusive of the holders of tradable
shares found it extremely difficult to do so.
The reforms facilitate a number of
important changes. Companies are now
allowed to implement share-incentive
schemes to align the interests of managers
and all groups of shareholders. With
the legal distinction between investor classes
removed, the importance of the publicmarket investors will increase and so will
the role of the equity markets in allocating


McKinsey on Finance

Summer 2007

capital. Companies will feel pressure

for greater transparency in their decisionmaking processes and will focus on
generating returns for all equity investors.

Implementing high-quality governance

will be a long, challenging process. China
will need to address a serious shortage
of executives in the mainland with the skill
and independence to be competent board
members. Because many state-owned
enterprises are at an early stage of installing
best-practice governance, executives and
potential board members will need time to
translate their academic understanding
of it into practice.

It may be too early to say how the development of corporate-governance standards

will affect overseas investors, but we are
cautiously optimistic. In recent years
many industries in China have seen intense
competition to build production capacity,
partly because mechanisms for allocating
capital rewarded companies for topline growth rather than generating returns
on capital. These problems were most
noticeable in commodity industries (such as
steel, cement, and paper), several of which
now have structural overcapacity in China
and are destabilizing export markets.
A greater role for equity shareholders and
better governance will increasingly push
management teams to run companies for
profitability and not just growth.

Over the past 25 years, Chinas market

reforms have delivered impressive results in
developing product and labor markets.
This latest round of privatization lays the
foundation for similarly dramatic changes
in the countrys capital markets and
the market for corporate control. MoF

James Ahn ( is a partner in McKinseys Hong Kong office, and David
Cogman ( is an associate principal in the Shanghai office. Copyright 2007
McKinsey & Company. All rights reserved.


A longer version of this

article is available on

The granularity of growth

A fine-grained approach to growth is essential for making the right
choices about where to compete.

Mehrdad Baghai,
Sven Smit, and
S. Patrick Viguerie

What are the sources of corporate growth? If, like many executives, you take an average
view of markets, the answers may surprise you: averaging out the different growth rates in
an industrys segments and subsegments can produce a misleading view of its growth
prospects. Most so-called growth industries, such as high tech, include subindustries or
segments that are not growing at all, while relatively mature industries, such as European
telecommunications, often have segments that are growing rapidly. Broad terms such as
growth industry and mature industry, while time honored and convenient, can
prove imprecise or even downright wrong upon closer analysis.
Our research on the revenue growth
of large companies suggests that executives
should de-average their view of markets
and develop a granular perspective on
trends, future growth rates, and market
structures. Insights into subindustries,
segments, categories, and micromarkets are
the building blocks of portfolio choice.
Companies will find this approach to
growth indispensable in making the right
decisions about where to compete.

1 Sven Smit, Caroline M. Thompson, and

S. Patrick Viguerie, The do-or-die struggle

for growth, The McKinsey Quarterly,
2005 Number 3, pp. 3445.

These decisions may be a matter of

corporate life and death. When we studied
the performance of 100 of the largest US
corporations in 17 sectors during the two

most recent business cycles, a pair of

unexpected findings emerged. The first was
that top-line growth is vital for survival.
A company whose revenue increased more
slowly than GDP was five times more
likely to succumb in the next cycle, usually
through acquisition, than a company
that expanded more rapidly. The second,
suggesting the importance of competing
in the right places at the right times, was
that many companies with strong
revenue growth and high shareholder
returns appeared to compete in favorable
growth environments. In addition,
many of these companies were active


McKinsey on Finance

Summer 2007

To probe deeper into the mysteries of what

really drives revenue growth, we have
since disaggregated, into three main components, the recent growth history of more
than 200 large companies around the world.
The results indicate that a companys
growth is driven largely by market growth
in the industry segments where it competes and by the revenues it gains through
mergers and acquisitions. These two
elements explain nearly 80 percent of the
growth differences among the companies we
studied. Whether a company gains or
loses market sharethe third element of
corporate growthexplains only some
20 percent of the differences.

apples basis with that of their peers,

and one that disaggregates growth at a
segment level.

At first blush, our findings seem counterintuitive. They demonstrate that although
good execution is essential for defending
market share in fiercely contested markets,
and thus for capitalizing on the corporate
portfolios full-market-growth potential, it
is usually not the key differentiator
between companies that are growing quickly
and those that are growing slowly. These
findings suggest that executives ought to
complement the traditional focus on execution and market share with more attention
to where a company isand should be
Going beyond averages to adopt a granular
perspective on the markets is essential
for any company as it shifts its portfolio in
search of strong growth, as this article
will explain. It will also argue that a finegrained knowledge of the drivers of the
companys past and present growth, and
of how these drivers perform relative to
competitors, is a useful basis for developing
growth strategies. To that end we will
present the findings of two diagnostic tools:
one that enables companies to benchmark
their growth performance on an apples-to-

Growth in a granular world

Telecommunications in Europe is often

described as a mature industry. But though
revenues at ten large European telcos
rose by an average of 9.5 percent a year from
1999 to 2005, we found that individual
companies expanded by 1 to 25 percent
annually. How could this be?
The most important reason is that
European telcos make different portfolio
choices so that they have varying
degrees of exposure to different segments
with different rates of growth. Wireless
grows faster than fixed line, for example,
and the growth rates of each vary widely
by country. In addition, these companies
have different levels of exposure to
fast-growing markets outside Europe.
In industries with higher overall growth,
the same kind of variation is apparent. The
annual growth rates of a representative
set of large high-tech companies, for
instance, ranged from 6 to 34 percent
from 1999 to 2005. In fact, the companies
in our 200-strong database that outperformed their peers on top-line growth and
shareholder value from 1999 to 2005
compete in industriesconstruction, consumer goods, energy, financial services,
high tech, retailing, and utilities
with different rates of overall growth. No
matter which industry they competed
in, however, the average market growth of
their portfolios outperformed that of
their peers. This fact suggests that they tend
to outposition their industry competitors
in high-growth segments. The portfolios of
outperforming utilities, for example,
enjoyed growth momentum that was two

The granularity of growth

percentage points higher than the overall

industry did. Indeed, when we compared the
growth rates of industries with the growth
rates of the companies in our database, we
could explain why some grew faster than
others only by zooming in and taking a
granular view of subindustries and product
categories by continent, region, and country.

2 Our analysis suggests that chasing revenue

growth for growths sake alone, at the

expense of profitability, generally destroys
shareholder value.


select acquisitions and divestments,

which affect the companys exposure to
underlying market growth. Another
is to create market growthfor instance,
by introducing a new product category.
Portfolio momentum (including currency
effects) is in a sense a measure of
strategic performance.

These findings should encourage com M&A is the inorganic growth a companies in industries with slow overall growth.
pany achieves when it buys or sells
Seeking growth is rarely about changing
revenues through acquisition or divestment.
industriesa risky proposition at best for
most companies. It is more about focusing
Market share performance is the organic
time and resources on faster-growing
growth a company records by gaining
segments where companies have the capaor losing a share of the market. We define
bilities, assets, and market insights needed
market share by the companys
for profitable growth.
weighted-average share of the segments
in which it competes.
To make granular choices when selecting
markets, management teams must have a
Beyond the averages
deep and similarly granular understanding
Our growth analysis of ten large
of what drives the growth of large
European telcos, for example, found that
companies and, in particular, of their own
individual companies can differ widely in
company and its peers. They can use
their performance on each driver.
the resulting growth benchmarks when they
plan their portfolio moves. One thing they
Portfolio momentum was by far the biggest
are likely to learn from the benchmarks is to
growth driver for the group as a whole,
avoid making unrealistic assumptions
followed by M&A . Market share perforabout a companys chances of consistently
mance made a negative contribution. When
gaining market share.
we looked beyond the averages, a more
nuanced picture emerged. Individually, these
Disaggregating growth
companies range of performance on the
The growth profiles of companies began to
three growth drivers was startling: from 2
emerge when we broke down their
to 18 percent annual growth for portfolio
growth into three main organic and inormomentum, from 2 to 13 percent for
ganic elements that measure positive
M&A , and from 6 to 5 percent for market
and negative growth.
share performance. Clearly, companies in
the same sector grow not only at different
Portfolio momentum is the organic
speeds but also in different ways (Exhibit 1).
revenue growth that a company achieves
through the market growth of the
To probe the sources of growth for the
segments represented in its portfolio. The
average company in any sector, we took the
company can influence the momentum
data on all of the companies in our
of its portfolio in several ways. One is to
database and broke down their average


McKinsey on Finance

Summer 2007

performance into the three growth drivers.

We found that of the overall 8.6 percent topline annual growth that the average large
company achieved from 1999 to 2005,
5.5 percentage points came from the market
growth of the segments in its portfolio,
3.0 from M&A activity, and a marginal 0.1
from market share performance.

tailwind of portfolio momentum requires

a company to maintain its position
in the segment, and this in turn hinges
on good or even great execution
particularly in fast-growing segments
that tend to attract innovative or low-cost
Linking growth

3 Our analysis covers a six-year period that we

used to compare detailed segment performance

year over year, so we couldnt look at the very
long term. However, we can compare revenue
growth with at least short- to medium-term
trajectories of total returns to shareholders.
4We define outperformance as the attainment of
a growth rate in the top quartile of the sample
for a particular growth driver. We define
underperformance as the opposite: performance
in the samples bottom quartile. Quartiles two
and three (the middle ones) are neutralneither
outperforming nor underperforming.

We found it more interesting to go beyond

and shareholder value
the averages. Our data show that portfolio
The detailed growth and value creation
momentum, at 43 percent, and M&A ,
histories in our database let us identify
at 35 percent, explain nearly four-fifths
correlations between the three growth
of the differences in the growth perdrivers and their roles for revenue growth
formance of large companies, while market
and value creation.3 Not surprisingly, comshare explains just 22 percent. Simply
panies that outperform on growth
put, a companys choice of markets and
increase their revenues faster than the
M&A is four times more important
underperformers do, 4 and the more
than outperforming in its markets. This
drivers they outperform on, the faster
finding comes as something of a surprise,
they grow.
since many management teams focus on
gaining share organically through superior
Its more intriguing that outperformance
2007 and often factor that goal into
on revenue growth is correlated with
their business plans.
the superior creation of shareholder value.
Exhibit 1 of 3 (including sidebar exhibit)
We defined four levels of performance
range of performance
three growth drivers
was startling. purposes: exceptional,
Not that
can affordonto
for benchmarking
execution. On the contrary, catching the

great, good, and poor. The threshold

exhibit 1

A wide range
Exhibit 1

Compound annual growth rate (CAGR) of revenues for 10 large European telcos,1 19992005, %

A wide range
The range or performance on the three growth
drivers was startling.



Growth by component
Portfolio momentum



2 to 18

Market share performance


1 Based



Total growth

2 to 13
6 to 5


1 to 25

on local currency; companies with headquarters in European Union.

impact of changes in revenue base caused by inorganic activity and share gain/loss.

2 Includes

Source: Analyst reports; company reports; Dealogic; Global Insight; Hoovers; McKinsey analysis




The granularity of growth

for differentiated performance appears to

be outperforming on one growth
driver while not underperforming on more
than one. Slightly more than half of
the companies in our sample did both and
achieved average annual total returns to
shareholders (TRS) of 8 percent and revenue
growth of 11 percent, which we define
as good performance. Companies that outperformed on two dimensions or that
outperformed on one at top-decile levels
without underperforming on more than
onenearly 15 percent of the sampledid
even better, achieving great performance.
Only four companies, which chalked up
exceptional revenue growth and shareholder
returns, outperformed on all three growth
drivers. Companies that did not outperform
on any driver or underperformed on
more than one did poorly, with TRS of only
0.3 percent.
Management would do well to assess
a companys performance, at the corporate
level, on each of these drivers, for they
are actionable, and the evidence shows that
the more of them companies outperform
on, the more those companies have
been rewarded. It might also be wise to
scrutinize a companys peers to find
out which growth drivers, if any, they
outperform on, and in which parts of their
businesses. Such knowledge can be the
starting point of a useful benchmarking
discussion about the companys growth
performance and potential.
Scanning for growth opportunities

Getting a detailed sense of the growth

performance of a company involves judging
how well it is performing on each of
the three growth drivers at the segment
level. By analyzing this information in the
context of the companys market
position and capabilities, its management

team can develop a perspective on

future opportunities for profitable growth.
Consider the disguised case of GoodsCo,
a multinational consumer goods
corporation. Our disaggregation of its
growth at the corporate level revealed that
it delivered stable, albeit slow, growth
from 1999 to 2005. M&A drove almost
all of the companys growth in the United
States, however; in Europe positive
exchange rates propelled modest growth.
Organic revenues rose strongly only
in emerging markets, such as Africa, Latin
America, and the Middle East. In fact,
the North American and European markets
that made the largest contribution to
the companys revenues were in the bottom
quartile for our full sample of companies.
The story gets more precise as we disaggregate the companys performance on
the three growth drivers in 12 product
categories for five geographic regions. No
fewer than 27 of the 47 segments the
company competes in register as poor in
terms of their performance on our
three growth drivers. Unfortunately, these
segments represent 87 percent of GoodsCos
sales. On the positive side, 20 segments
are good or great, but they make up only
the remaining 13 percent of sales. And
although a promising growth story
is developing in Latin America in most
segments, the business is performing
poorly in its core ones in Europe and North
America. It cannot claim exceptional
performance in any segment. GoodsCo has
a portfolio problem (Exhibit 2).
Once all the cards are on the table,
GoodsCos managers will be in a better
position to make well-informed portfolio
choices. The pros and cons of acquiring
businessesor expanding organically


Exhibit 2 of 3 (including sidebar exhibit)
Glance: Analysis of growth by segment or region can reveal
strengths and weaknesses in a
McKinsey on Finance
Summer 2007
companys portfolio.
exhibit 2

A detailed picture
Exhibit 2

Disguised example of growth for GoodsCo, a multinational consumer goods company, 19992005

A detailed picture


Analysis of growth by segment or region

can reveal strengths and weaknesses in a
companys portfolio.

Exceptional (not achieved

by any segment)

Revenue share
By region


North America







Latin America Africa, Middle East




By product
category,2 %







Total 100%


= outperforming on all 3 growth drivers; great = outperforming on 2 growth drivers or outperforming on 1

growth driver at top-decile level without underperforming on more than 1; good = outperforming on 1 growth driver without
underperforming on more than 1; poor = underperforming on 2 or more growth drivers or not outperforming on any.
2Figures do not sum to 100%, because of rounding.

by exploiting positive market share performancein segments where GoodsCo

enjoys strong portfolio momentum will
probably be high on the top teams agenda.
Another issue might be whether to seize
divestment opportunities in segments
where the companys portfolio momentum
is good, though the company is losing
market share. A third could be whether to
acquire a company (and so build portfolio
momentum) in lackluster segments where

GoodsCos management expects market

growth to improve significantly. The
growth of segments within industries
correlates closely with the differing profiles
that emerge when we disaggregate the
growth of large companies. This suggests
that executives should make granular
choices when they approach portfolio
decisions and allocate resources toward
businesses, countries, customers, and
products that have plenty of headroom
for growth. MoF

Mehrdad Baghai is an alumnus of McKinseys Toronto and Sydney offices, Sven Smit (Sven_Smit@ is a partner in the Amsterdam office, and Patrick Viguerie (
is a partner in the Atlanta office. Copyright 2007 McKinsey & Company. All rights reserved.



McKinsey on Finance

Summer 2007

Index of articles, 2006 to 2007

Previous issues can be downloaded at

Individual articles are available to McKinsey Quarterly subscribers at A limited number of past issues are available;
please send a request by e-mail to
Number 23, Spring 2007
The new dynamics of managing the corporate portfolio
Living with the limitations of success
Getting more out of offshoring the finance function
When Chinese companies go global: An interview with Lenovos Mary Ma
Preparing for the next downturn
Number 22, Winter 2007
What public companies can learn from private equity
Are companies getting better at M&A?
The truth about growth and value stocks
Governing Chinas boards: An interview with John Thornton
Why accounting rules shouldnt drive strategy
Number 21, Autumn 2006
Creating value: the debate over public vs. private ownership
Shaping strategy from the boardroom
Successful mergers start at the top
When should CFOs take the helm?
Number 20, Summer 2006
Learning to let go: Making better exit decisions
Habits of the busiest acquirers
Betas: Back to normal
The irrational component of your stock price
Number 19, Spring 2006
The misguided practice of earnings guidance
Inside a hedge fund: An interview with the managing partner of Maverick Capital
Balancing ROIC and growth to build value
Toward a leaner finance department
Number 18, Winter 2006
How to make M&A work in China
Capital discipline for Big Oil
Making capital structure support strategy
Negotiating better cross-border banking mergers in Europe
Data focus: A long-term look at ROIC

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articles using iTunes. Check back frequently for new content.
The truth about growth and value stocks
Investors and fund managers build entire portfolios around the premise
that growth stocks grow faster than value stocks. The problem is that they dont.

Bin Jiang and Timothy Koller

Why accounting rules shouldnt drive strategy
When changes in accounting rules provide no new information, they dont register
with investors. Nor should they lead managers to shift focus.

Timothy Koller and Werner Rehm

Preparing for the next downturn
In a buoyant economy, the next recession seems far off. But managers
who prepare during good times can improve their companies chances to endure
or thrive inthe eventual downturn.

Richard Dobbs, Tomas Karakolev, and Rishi Raj

The new dynamics of managing the corporate portfolio
As investors demand that companies actively manage their business portfolios,
executives must increasingly balance investment opportunities against the
capital thats available to finance them.

Lorenzo Carlesi, Braam Verster, and Felix Wenger

Living with the limitations of success
Once companies reach a certain size, setting realistic performance aspirations
gets a bit trickier.
Bin Jiang and Timothy Koller
Getting more out of offshoring the finance function
Companies arent getting the most out of their offshoring programs. Key design
changes would help.

Michael Bloch, Shankar Narayanan, and Ishaan Seth

A quiet revolution in Chinas capital markets
Reforms that attracted little attention in the Western world mark a major step
forward in the modernization of Chinas capital markets.

James Ahn and David Cogman

Preempting hostile takeovers
Companies that stick to valuation basics can preemptively capture any value that
would make them attractive for takeover bids.

Jenny Askfelt Ruud, Johan Ns, and Vincenzo Tortorici

Copyright 2007 McKinsey & Company