MoF Issue 28

McKinsey on Finance
Perspectives on How Chinese companies can succeed abroad 1

Corporate Finance As Chinese companies seek opportunities abroad, they will have to
and Strategy acclimate to new surroundings.
China’s track record in M&A 8

Number 28,
Summer 2008 China’s companies are expanding the focus of their outbound M&A , but so
far they have struggled to create value.
Managing capital projects: Lessons from Asia 14

Some Asian companies are better at executing capital projects than are
rivals elsewhere. What lessons can others learn from them?
Organizing for value 20

The division structure can mask big differences in the performance of smaller
units. A finer-grained approach can better show where value comes from.
A better way to understand TRS 26

Traditional methods of analyzing TRS are flawed. There’s a better way.
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1
How Chinese companies can

succeed abroad
As Chinese companies seek opportunities abroad, they will have to
acclimate to new surroundings.
Meagan C. Dietz, The wheel has turned: Chinese companies, like the multinationals that have come to
Gordon Orr, China over the past two decades, are reaching for opportunities in new markets abroad.
and Jane Xing Searching for raw materials, talented employees, technologies, brands, and customers,
these companies—many virtually unknown outside China—are themselves becoming multi-
nationals. In interviews with executives at 39 Chinese companies, nearly 80 percent
said that globalization is a strategic priority, and of these almost half said that they want
their companies to become true multinationals within ten years.
Some have found acquisitions the fastest more slowly—a reality that comes into
way to establish a global presence: in recent particularly high relief when you compare
years, for example, Lenovo acquired the globalization efforts of Chinese
IBM’s personal-computer unit for $1.35 bil- companies with those of their Indian, South
lion (9.45 billion renminbi), and the Korean, and Taiwanese counterparts.
China National Offshore Oil Corporation Our analysis, focusing on the top 100 com-
(CNOOC) unsuccessfully bid $18.5 billion panies in each country by market
for the US oil company Unocal. Earlier this capitalization, shows that Taiwanese, South
year, Huaneng Power International’s Korean, and Indian ones generate,
$3 billion purchase of Singapore’s Tuas respectively, four, three, and two times
Power and Sinosteel’s hostile $1.1 billion as much revenue from foreign sales
bid for the Australian mining concern as the Chinese do. Foreign asset ownership
Midwest further demonstrated the Chinese and the number of foreign workers
appetite for foreign acquisitions. employed paint a similar picture (exhibit).
Among the top 100 Chinese companies,
Behind these headlines, however, the true only 17 completed any outbound M&A
story of Chinese globalization is unfolding transactions between 1995 and 2007,
MoF28 2008
China global
2 Exhibit 1 of 2
McKinsey on Finance Summer 2008
Glance:
Exhibit title: A slower pace toward globalization
Top of sand background
Exhibit Baseline for unit of Top 100 companies by market capitalization, 2006, %
A slower pace towardmeasure/subtitle
globalization Proportion outside home country

Sales Assets Employees Shareholders Top management
Chinese companies are less
Least China 11 3 2 25 3
globalized than are Indian, South globalized
Korean, and Taiwanese ones. India 21 9 2 25 4
South Korea 28 11 11 31 4
Taiwan 48 24 32 29 2
Most Multinational
globalized corporations 44 38 39 31 11
and only 6 concluded more than three. build a better assessment of risk into their
By contrast, 31 of the top 100 Indian com- investment decisions. In particular,
panies have completed cross-border they should develop a fuller understanding
transactions since 1995, and 18 have done of how it might affect the future value
more than three deals. of their targets.
This inexperience puts most Chinese com- CNOOC ’s effort to acquire Unocal, which
panies on the back foot as they consider failed after politicians in the United
their international opportunities, whether States began attacking the takeover as
regional or further afield. To succeed a threat to US national interests, is
globally, these companies must not only one example of misunderstood risk. This
recognize and overcome their short- was not the only such case. In 2001,
falls but also change the way they are a Chinese utility considered an investment
managed. Traditional approaches in Southeast Asia but decided that the
that served them well when they focused political risks were too high and declined
on Chinese consumers, Chinese man- to move ahead. (Three years later, it
agers, and Chinese employees will no longer returned to the market. Leading an inter-
suffice as they grow into multinational, national consortium that helped it to
multicultural institutions. assess local risks and offering a significantly
higher price for the target, it won
Improving assessments of risk the acquisition.) And in recent years,
Chinese companies regularly seem to the Chinese consumer electronics
misjudge the political, labor, and environ- group TCL Multimedia Technology was
mental risks that the foreign business surprised to find that labor union
world presents. Many have missed invest- restrictions made it expensive and time
ment opportunities by being too cautious. consuming to close newly acquired
Others have unnecessarily suffered drastic loss-making operations in Europe.
consequences from their efforts to
make overseas acquisitions. To avoid such Training in-house experts and recruiting
problems, these companies must overseas employees who can assess risks
How Chinese companies can succeed abroad 3
will be necessary mid- and long-term steps of acquisition targets reflecting a company’s
in building better internal capabilities. strategic objectives. Companies should
But Chinese companies can do something also carefully consider possible markets to
right now: engage third-party experts enter, their policy makers and other
(such as law firms and public-relations agen- stakeholders, and their business and
cies) that have a deep knowledge of the economic environments. A factual catalog
target’s local environment early in the evalu- with this kind of information will make
ation process. Working with knowledgeable it easier to manage risk once active targets
advisers will also accelerate a company’s for acquisition have been identified.
efforts to understand how risk should To catch wind of suitable opportunities,
be managed. companies should create friendly
networks within their industries, the
Business partners and Chinese government investment community, and the home
officials, too, are valuable resources for and host governments.
companies weighing and addressing risk.
So are private-equity partners, which Companies that can act quickly on interest-
can provide not only funding, marketing ing opportunities use rigorous screening
expertise, and managerial insights but criteria to identify potential acquisitions
also access to foreign talent pools and net- worthy of serious consideration. For
works. Chinese embassies, as well as less experienced companies, the criteria
non-Chinese entities such as law firms could cover basic value drivers, such
specializing in government relations as market prospects, potential synergies,
and local development groups charged and operational and financial strengths.
with attracting foreign investment, Companies have also developed in-house
may be able to help Chinese companies M&A handbooks compiled from their
manage government and business own experience, that of other companies,
relationships in foreign countries. and global best practice. M&A guide-
lines typically cover governance and
Preparing for acquisitions decision making, valuation and pricing, the
Chinese companies should be ready to management of transaction processes,
seize international opportunities, which the capabilities required to complete deals,
can arise unexpectedly, especially and merger integration approaches,
in mergers and acquisitions. To expand including ways to address differing legal
effectively through M&A , companies systems, cultural norms, and values—
must have access to the right conversations generally, the most difficult areas for execu-
about which businesses may become tives. Preparing this kind of handbook
available. And they must have clear pro- in advance could allow Chinese companies
cesses for making speedy—but not to break through the endless consensus
hasty—decisions. building that now slows them down.
A company lacking experience in Developing global talent

acquisitions should start with the basic One of the greatest barriers to the
steps that today’s multinationals globalization efforts of Chinese companies
have already taken. One necessary move is a dearth of employees with the right
is building a comprehensive database know-how. As an executive at a high-tech
4 McKinsey on Finance Summer 2008
company told us, “We have a shortage of skills, Chinese managers must learn
global talent in every department— to delegate, to coach, and to have difficult
especially those who can negotiate with conversations with colleagues. These
partners and those who have a pro- soft skills, increasingly important as
found understanding of European and an organization expands across the globe,
American markets.” In our interviews, are generally underused and under-
88 percent of the Chinese executives appreciated in China’s business culture.
said that their globalization efforts were
hindered by the scarcity of people Some Chinese companies have filled the
with real cross-cultural knowledge or capability gap by looking for employees
experience managing foreign talent. outside China. TCL , for example, recruited
Ninety-three percent said that Chinese a Singaporean, Leong Yue Wing, a 28-year
companies would not achieve their Philips veteran, as vice president. Lenovo
global aspirations unless they developed lured an American from Dell, Bill Amelio,
suitable leaders more aggressively. to lead the company, banking on his
broad experience in both emerging and
These limitations reach into the executive developed markets and in many senior
suite. Of the Chinese executives we operational roles. Indeed, more than 70 per-
spoke with, 56 percent said that they had cent of the members of Lenovo’s top team
no cross-cultural training and half that are not Chinese nationals.
they wouldn’t accept a foreign assignment.
By contrast, multinationals based in In recruiting and retaining foreign man-
developed countries often make such post- agers, Chinese companies face a challenge
ings a prerequisite to career advancement. rooted in their global inexperience.
Unlike local employees, who regard com-
Many Chinese companies have started to pany loyalty as a given, foreign recruits
deal with this lack of global experience require more attention from senior man-
by sending their best managers to intensive agement to feel a similar level of
management-training programs—for commitment: if their local supervisors
instance, those of corporate universities and peers don’t allow them to com-
sponsored by multinationals and plete assignments with minimal supervision,
business schools. Others appoint human- for example, they will never be fully
resources leaders with experience integrated into the organization. Foreign
hiring international talent. The telecom- employees also want greater clarity than
munications-equipment maker Huawei local ones about issues such as career paths,
is among the companies that have corporate governance, and the expectations
undertaken pilot programs combining of management.
global recruitment, competitive
compensation, job rotation within an Creating a global brand
individual location, and mobility. For Chinese companies in the high-tech and
These programs include instruction in consumer goods industries, the push
giving presentations, communicating to globalize largely reflects the need to
with people (particularly foreigners), and find new markets for their products.
resolving conflicts. Along with these Brand building is one of the most important
considerations for such companies. Whether reduced our entry cost, before moving to
they buy established global brands or developed markets.” Lenovo’s high-profile
launch their own, they must build strong marketing efforts have included major
marketing capabilities—capabilities sports sponsorships—the Beijing Olympics,
that were less important in the captive the US National Basketball Association,
domestic market. and Formula One racing, for instance—as
well as prominent exposure in global
To reap value by investing in and acquiring mass-market business magazines.
brands, Chinese companies, broadly
speaking, must work on changing the way Redesigning the organization
the world market views their products— Many Chinese companies are organized
from low cost and quality to a level of qual- from the top down: headquarters is
ity equal to or better than that of their the nominal profit center where cross-
global competitors. No company has so functional decisions are made. This
far perfected a formula for turning structure worked so long as these com-
a Chinese brand into a well-perceived glo- panies offered one kind of product
bal one, but some have made strides. to one market. But global organizations
For many companies, part of the answer clearly require different structures
is better marketing, backed up by a and processes.
product-development strategy that stresses
value through quality as well as low costs. In the last decade, Huawei, for example,
has grown from a company with
As Huawei, for example, expanded beyond 800 employees and a single kind of product
China, it adopted a business model that (telephone switching equipment) sold
emphasized new technology, focused more only in China into a corporation with
sharply on the customer’s needs, and 61,000 employees and six product
carefully built a brand image. The company lines sold to customers in more than
also made a strategic choice to enter 100 countries. Along the way, it
developing markets first. “It takes time to created an organization in which product
build a brand,” one Huawei executive unit and geographic heads have profit-
offered. “To tackle that, we started with and-loss responsibility and make decisions
emerging markets, such as Eastern independently. Each product unit
Europe, with lower brand loyalty, which develops its own product and sales
strategies, which geographic subsidiaries cultural norms. For many, this will
implement. Both make their own human- be one of the greatest obstacles to global
resources decisions. integration and, by extension, to
performance in global settings. What’s
more, many Chinese managers
have limited fluency in English, which
Many executives in the leadership teams of Chinese is increasingly the language of global
companies lack international experience and are not well business. This problem undermines their
prepared to assume responsibility for global operations confidence when they speak outside
China. Coupled with a cultural distaste
for direct confrontation, it prevents
them from speaking directly and concisely
As one executive told us, “Managing to global audiences, the norm in
by people instead of by process is deeply Western business discourse.
rooted in Chinese culture.” Changing
gears will be difficult. Many Chinese com- In addition, Chinese culture typically places
panies struggle to frame, update, and few boundaries between work and personal
execute new organizational designs. Creat- life, while most Westerners consciously
ing strong regional organizations with try to separate the two. Chinese corporate
transparent financial-performance stan- culture tends to emphasize seniority and
dards is a good first step. This kind relationships more than responsibility and
of organization could be useful because it accountability—another stark contrast
is relatively straightforward to design, with the Western emphasis on personal
minimizes disruption, and creates a clear accountability and demonstrated
picture of profit and loss. Simplicity merit and ability.
is important: many executives in the leader-
ship teams of Chinese companies lack The right mix of Chinese and Western
international experience and, as a result, norms will vary from company to company
are not well prepared to assume respon- and is likely to evolve. To accelerate
sibility for global operations. Standardized the process of global acculturation, the top
systems throughout a global organization— teams of Chinese companies should
to evaluate performance, for example— hold meetings with open agendas at offsite
help ensure that employees work under the locations around the world so that
same quality yardstick and encourage managers from different backgrounds can
many of them to overcome their experience break the ice in a variety of settings.
gaps. As companies become more famil- Training in communications and external
iar with global operations, they can adopt programs for senior executives also
increasingly sophisticated organiza- help to bridge cultural differences.
tional models.
A message of common values and visions
Finding a balance of cultures must be central to this new approach
As Chinese companies globalize, they will to communications, particularly when
face the challenge of combining Chinese dissimilar companies integrate. Man-
and Western forms of communication and agers should work to establish a common
strategy and mission for the new organiza- China’s companies are on the cusp of
tion and to articulate a new culture, a major period of foreign expansion. They
including a clear delineation of roles and have a great potential to reach beyond
responsibilities. Communications their home market, but to succeed they
and cultural workshops ought to build must overcome their inexperience
an understanding of the different and change themselves boldly. MoF
core values and beliefs of people from
different countries. They should be
designed to encourage a shift in attitudes
about decision making and execution—
a shift from risk averse and nonconfron-
tational to proactive and inclusive.
Meagan Dietz is an alumnus of McKinsey’s New York office, Gordon Orr (Gordon_Orr@McKinsey.com)
is a partner in the Shanghai office, and Jane Xing (Jane_Xing@McKinsey.com) is an associate principal in the
Beijing office. Copyright © 2008 McKinsey & Company. All rights reserved.
8
China’s track record in M&A

China’s companies are expanding the focus of their outbound M&A,
but so far they have struggled to create value.
Thomas Luedi Chinese companies have been slower to expand abroad than many in the global business
community had expected, but some evidence suggests that the long-awaited expansion
is now under way: in the first quarter of 2008, they announced foreign direct investments
of almost $26 billion (182 billion renminbi)—nearly twice as much as during the same
period last year.
These companies are in a good position to of the capital and fears of political inter-
make an impact in the global M&A market. ference in strategically important industries
At the very moment when the valuations are generating significant opposition to
of their foreign counterparts are falling as otherwise solid business ventures. There is
a result of turmoil in the world economy also concern about whether some of these
and global capital markets, many of them overseas deals will create value for investors.
are sitting on large cash balances built
up over the past few years of quick and To develop a clearer understanding of
profitable growth. Others are respond- the globalization strategies of Chinese
ing to the convergence of high domestic companies, we assessed all of their cross-
liquidity levels (including the money border deals from 1995 to 2007 and
that Chinese banks have to lend and examined some of their more recent large-
the state’s foreign reserves), global exchange- scale M&A ventures in greater detail.
rate adjustments, political support for We found that these companies have diverse
overseas expansion, and the need for access motives for acquiring foreign ones and
to raw materials and new markets. that not all of the acquisitions are aimed
primarily at creating value for share-
That raises eyebrows in many Western holders. Indeed, few have actually done so,
countries, where uncertainty over the source at least in the short term.
MoF28 2008
China M&A
Exhibit 1 of 5 9
Glance:
Exhibit title: A recent phenomenon
Exhibit 1 Baseline for unit of Outbound deals as share of

Chinese outbound foreign direct investment (FDI), $ billion1 real GDP, 2007, %
A recent phenomenon measure/subtitle
Organic CAGR,3 % United Kingdom 15.5

Acquisitions by Chinese companies of M&A2 30.1 80 Hong Kong 9.3
assets outside their home country
3.3 24
is a relatively new phenomenon, but one France 8.8
21.2
that is growing quickly. 3.0 Germany 6.9
12.3
26.8 106 Malaysia 4.9
2.7 18.2
5.4
2.9 1.7 9.6 United States 2.2
1.4 3.7
1.5 China 0.8
2003 2004 2005 2006 20074
Japan 0.8
Number of Taiwan 0.7
40 51 48 82 89
deals
1$1 = 7 renminbi.
2For 2003–06, includes deals with final stake of >10%.
3Compound annual growth rate.
4Estimate based on M&A deal value ($26.8 billion) from Dealogic, plus organic outbound investments ($3.3 billion),
assuming 10% growth in organic investments over previous year; 2006 and 2007 data include financial investments; 2007
data include China Investment Corporation’s (CIC) $3 billion acquisition of 9.9% stake in Blackstone.
Source: Dealogic; Ministry of Commerce of People’s Republic of China; McKinsey analysis
An explosion of M&A More recently, leading Chinese companies

The acquisition of foreign assets by have pursued growth and a global presence
Chinese companies is a relatively new more actively, announcing deals across
phenomenon. As recently as 2003, all geographies and in many industry
their foreign direct investments, in both sectors. Most of these deals are the first of
organic growth and M&A, came to their kind for the companies involved,
only $2.9 billion. Since then, the level has and many of them are small and focused—
risen tenfold, to 0.8 percent of GDP in for example, aimed at gaining access
2007—still far below the levels of France, to a specific market—rather than large and
Germany, and the United Kingdom, for transformative. Many companies, lacking
example (Exhibit 1). Some megadeals (with the ability to conduct cross-border transac-
a combined capital market value of tions and the experience to maximize
more than $1 billion) have certainly caught the value from large ones, seem risk averse.
the world’s attention. Not coincidentally, China’s domestic
M&A and industry consolidation activity
Where the deals are are still often mandated by the govern-
In the past, Chinese outbound M&A deals ment and executed on a net-asset-valuation
were concentrated in Asia, except for basis rather than on market value (in
natural resources such as metals, oil, and particular, when assets of state-owned
gas, which Chinese companies have enterprises are involved). These deals tend
sought all over the world. This dual focus not to be very complex.
is understandable given the facts of
geography and China’s need to obtain Still, we expect the number and size of
access to minerals and energy resources cross-border deals to increase as Chinese
because of its own limited supply. companies build the capabilities they
MoF28 2008
China M&A
10 Exhibit 2 of 5
Glance:
Exhibit title: Looking for deals
Exhibit 2 Baseline for unit of Outbound Chinese M&A1 by destination and sector, 1995–2007
Looking for deals measure/subtitle
x.x = $ billion2 <$0.50 billion $1.0 billion–$5.0 billion
(x) = number of deals $0.5 billion–$0.9 billion >$5.0 billion
China’s companies are acquiring businesses
in many industries and geographies. North
2.0 (9) 4.3 (3) 0.1 (1) 0.1 (2) 1.4 (5) 0.3 (3) 0.2 (1) 0.2 (1)
America
Western
3.4 (4) 0.5 (1) 0.04 (2) 0.1 (1) 1.0 (2) 0.1 (1) 0.1 (2)
Europe
Asia 2.9 (20) 3.9 (36) 0.5 (7) 0.2 (2) 0.3 (5) 0.1 (3) 0.6 (5) 9.3 (16) 4.9 (12) 6.0 (11)
Latin
0.1 (3) 0.1 (1) 0.3 (2) 3.0 (5)
America
Africa 5.5 (1) 0.3 (2) 3.9 (5)
Others 2.5 (2) 0.4 (2) 1.4 (10) 4.7 (8)
High tech Financial Food and Health Machinery Metals and Mining Oil and gas Telecom Transpor-
services beverage care steel tation
1All deals with value >$10 million; major industries account for >80% of total outbound deal value in each country.
2$1 = 7 renminbi.
Source: Dealogic; McKinsey analysis
need to identify, capture, and conserve value Recent cross-border deals outside the
(Exhibit 2). natural-resource sector have been increas-
ingly strategic in nature. Some, such
The strategy behind the deals as Lenovo’s acquisition of IBM’s personal-
Chinese companies have many strategic computer business, aim to help Chinese
rationales for cross-border deals— companies globalize. Other companies do
and the rationales vary among industries cross-border deals to enhance their
(Exhibit 3). The first transactions aimed operating capabilities; Chinese auto com-
primarily to gain secure access to supplies panies, for example, have successfully
of critical raw materials. That strategy acquired brands and technology from ailing
remains an important driver for metals and UK companies and used them to launch
energy companies to make acquisitions brands in China—for instance, Shanghai
in resource-rich locations such as Central Automotive Industry Corporation’s
Asia and Africa. It does, however, raise (SAIC) Roewe brand, based on technology
some questions for investors in these com- from Rover. Many manufacturing com-
panies. Finance theory suggests that panies have acquired foreign businesses to
it may be good for the country of the gain access to new growth markets, to
acquirer to obtain natural resources, but lower the cost base by globalizing supply
not, perhaps, for its shareholders. At chains, and to consolidate manufactur-
this point, the size of the sample is too ing in large-scale facilities in China, thus
small to draw anything but the most benefiting from its lower capital and
general conclusions. Clearly, some of the operating costs. Chinese banks and insur-
resource deals create value for share- ance companies have used their invest-
holders; others clearly do not. ments in foreign financial institutions to
diversify their product portfolios and gain discount the value of the combined entities.
access to risk-management, credit-rating, Although the low number of deals—very
and other critical skills. few of which include two public companies—
makes comparisons with global POP and
Mixed performance DVA levels problematic, evidence suggests
At best, the outcome of outbound Chinese that the deals of Chinese companies from
M&A deals has been mixed. They have 1995 to 2007 performed less favorably than
underwhelmed the market by the standard those of Western ones did (Exhibit 4).
There is some indication that Chinese

companies do much better, in terms of both
Our analysis suggests that Chinese acquirers tend to
POP and DVA, in transformational deals
overpay in more than half of all deals and that capital markets
than in nontransformational ones. The rea-
on average discount the value of the combined entities son could be a more careful selection of
targets, a significant enhancement in the
overall operating and management capabili-
of value creation measured through share ties of the combined companies, or the
price movements around the time of availability of transformational synergies
announcement, namely, deal value added that improve overall operating efficien-
(DVA) and proportion overpaid (POP). cies rather than merely capturing
Although drawn from a relatively small cost synergies.
MoF28 2008
sample, our analysis suggests that
China M&A
Chinese acquirers tend to overpay in Where the capital comes from
aExhibit 3 of 5 than half of all deals
little more China has enjoyed strong economic growth
Glance:
and that the capital markets on average since the start of economic reforms and
Exhibit title: Strategic rationales
Exhibit 3 Baseline for unit of Chinese outbound deals1 by strategic rationale, 1995–2007 (n = 214)
Strategic rationales
measure/subtitle
Primary rationale Number of deals Total deal value, $ million2

Many deals are done for reasons other
than creating value for shareholders. Security, access to natural resources 68 27,083
Access to new markets 48 15,753
Financial investment/diversification 43 15,055
Access to capabilities 31 4,026
Gaining scale 10 1,448
Access to financing 5 184
Government influence 5 448
CEO’s personal ambition 3 577
Export of capabilities 1 14
1All deals with value >$10 million.

2$1 = 7 renminbi.
MoF28 2008
China M&A
12 Exhibit 4 of 5
Glance:
Exhibit title: Underwhelming the market
Exhibit 4 Baseline for unit of Chinese outbound deal1 performance, 1995–2007 (n = 56)
Underwhelming the market
measure/subtitle
Chinese companies overpay for most Average

DVA3 to acquirer Average deal Number of
acquisitions, only some of which create value. Type of deal POP,2 % (median), % size, $ million deals
Resource 56 –0.4 402 16

Nonresource 55 –2.2 274 40
Transformational 40 0.6 487 5
Nontransformational 57 –0.9 295 51
Global4 61 –3 4,700 1,229
1All deals with value >$10 million and final stake of >25%, 1995–2007; average deal size ~$500 million; $1 = 7 renminbi.
2POP = proportion overpaid; defined as proportion of transaction in which share price reaction, adjusted for market movements,
was negative for acquirer from 2 days prior to 2 days after announcement of deal.
3DVA = deal value added; defined as acquirer’s change in market capitalization, adjusted for market movements, from 2 days
prior to 2 days after announcement, as % of transaction value.
4Data from 1997 to 2007; average deal size ~$4 billion. Comparison with global data is useful and representative but not exact.
Because few deals in China involved two publicly listed companies, China’s DVA and POP indexes reflect movement only
MoF28
in 2008
acquiring company’s share price. Global DVA and POP numbers, by contrast, were calculated using only deals where both
China M&A
acquirer and target are public, and these numbers reflect share price movements for both companies.
Exhibit 5 of 5
Glance:
Exhibit title: Unusual suspects
Exhibit 5 Baseline for unit of 2005–07, $ billion1

Unusual suspects measure/subtitle
Total Chinese outbound M&A2 57.5

A majority of the Chinese companies
pursuing cross-border deals are
publicly traded state-owned enterprises Acquisitions by sovereign-wealth funds 3.0
that used to be wholly state owned.
Acquisitions by private-equity firms 0.5
3.1
Acquisitions by government-controlled entities3 40.3 43.4
Unlisted Public4
Corporate M&A 10.6
1$1 = 7 renminbi.
2All deals with value >$10 million.
3Listed or unlisted companies under direct supervision of either China’s State-owned Assets Supervision and Administration
Commission of the State Council (SASAC) or Central Huijin Investment Company.
4Includes listed and partially listed companies—ie, a group company with some of its subsidiaries listed (a common
phenomenon in China).
the transformation of state-owned enter- reduce fears that they might act on behalf of
prises into listed corporations. Unlisted the government. It will also make them
state-owned enterprises, listed ones, and obtain access to funds through conventional
privately held companies all enjoy channels, such as market-rate equity issu-
large cash balances that allow them to ance or debt (Exhibit 5).
acquire assets oveseas. For now, a
majority of the companies pursuing cross-
border deals are publicly traded state-
owned enterprises that used to be wholly The China Investment Corporation (CIC),
state owned. While at this point the a sovereign-wealth fund, has funds of
state is still a major shareholder in many some $200 billion, and it too is expected to
of these companies—often with as make selected cross-border forays. It is
much as 70 to 80 percent of their total more likely to do so, however, as a minority
equity—managers must operate them investor aiming for capital gains consistent
as corporate entities and follow the disclo- with its mandate and stated intentions
sure rules of the exchange on which they than as an active shareholder. Separately,
are listed. Because they rank among China’s China’s wide range of nascent private-
largest companies, it’s understandable equity funds tend to focus on domestic
that they have so far been in the forefront of investments, in view of the large number of
the country’s corporate globalization effort. opportunities and the greater ease of
executing these deals and managing the
Furthermore, the government’s stake in portfolios they create. MoF
these enterprises continues to fall; McKinsey
estimates that it will be almost entirely sold
off by 2012. Meanwhile, their shareholders
will increasingly hold them accountable
for the value created (or destroyed) by their
overseas acquisitions. That will further
Thomas Luedi (Thomas_Luedi@McKinsey.com) is a partner in McKinsey’s Shanghai office. Copyright © 2008

McKinsey & Company. All rights reserved.
14
Managing capital projects:

Lessons from Asia
Some Asian companies are better at executing capital projects than are
rivals elsewhere. What lessons can others learn from them?
Navtez Singh Bal, Around the world, the resources needed for big new capital projects are scarce. Shortages
Subbu Narayanswamy, of everything from commodities (such as steel plates and cement) to engineering,
and Anil Sikka procurement, and construction personnel are delaying projects significantly and generating
cost overruns for new factories, refineries, and mills.
Nowhere is the pressure greater than in such gains while meeting the developed
Asia, where more than 50 percent of world’s quality and safety standards. Such
the world’s capital investment is projected successes will strengthen the hand of
to take place over the next seven years.1 these companies as they branch out to com-
As many Western companies tap into the pete for capital projects in the West.
region’s rapid growth, they are finding
that the best Asian companies enjoy more To get a better idea of how some Asian com-
than just a home field advantage. Indeed, panies have completed projects so quickly
these formidable competitors have out- and inexpensively, we examined six green-
performed not only their Asian rivals but field and four brownfield projects in
also the global heavyweights both in a representative sector—oil refining—and
costs and in construction times for major compared Asian refineries with those
industrial facilities. Reliance Industries, built in the West and in the Middle East.
India’s largest private-sector enterprise, for We found that roughly half of the cost
example, built a world-class oil refinery and time difference was due to local Asian
and petrochemical complex in Jamnagar conditions, such as land costs, taxes,
with 20 percent less capital than similar and regulation, and to practices that were
plants elsewhere require, and its time to neither common nor transferable else-
1 Based on region-wide investment
commission was 30 percent lower. where. Other strengths of the Asian com-
figures projected by multiple analysts
and research agencies. Increasingly, Asian companies achieve panies are already global best practices
15
(such as using standard designs for a num- may seem reasonable, it also increases
ber of facilities and processing different costs and creates expectations of and
project components at the same time rather tolerance for delays.
than in sequence), though Asians may
push them further. The rest are innovative In contrast, best-in-class Asian CEOs
practices that break with the conventional typically set high, even unrealistic, targets
wisdom of many Western companies. for project teams, making explicit trade-
offs between time and cost (Exhibit 1). In
Set aggressive goals practice, that means overinvesting in
When most companies start projects, their equipment and labor, which form a rela-
in-house teams and consultants typically tively small part—typically, 2 to 3 percent
recommend safe and realistic targets for of overall project cost. This approach
costs, quality, and execution times. can greatly expedite construction by allow-
These2008
Web targets typically include a number ing companies to work on a number
of buffers
Asia capitalto offset potential delays in of projects simultaneously, preventing down-
the availability
Exhibit 1 of 3 of personnel, equipment, time when equipment breaks, and
and resources.
Glance: Investing While
up frontthat approach
can lead encouraging
to lower overall costs—and a fasterhealthy
route to competition among
generating revenues.
Exhibit title: Making trade-offs
Exhibit 1 Optimization criteria for 2 refinery projects of a leading Asian oil company Success factors
Making trade-offs A different global Higher prices, Overheated global t Cost and time targets for the
scenario . . . $ per barrel supply market, additional whole team
Investing up front can lead to lower refinery capacity, t Flat organizational structure and
overall costs—and a faster route to thousands of kbpd1 high CEO/leadership involvement

t Relentless focus on critical
generating revenues. 35–42
11.6 path items identified early from
basic design
×2.5 t Focus shifts from cost optimization
10–12 ×2.3
3.5 in precontract award phase to
on-time execution in postcontract
award phase
1999 2005 1995–2004 2005–102
. . . led to emphasis Cost, $ Time to completion,

on optimizing time. billion months
Project 1 (540 kbpd,
3.4 36
NCI3 of 9.93)4
Project 2 (580 kbpd,
6.0 30
NCI3 of 14)4
t Second refinery scheduled to be completed 6 months

before first one despite higher complexity
t Paid 2–3 times more for engineering in order to
expedite commission
Impact of decision t Early commissioning will result in ~$1.5 billion

additional margin5 (equal to 25% of expected cost of
entire refinery)
1Kbpd = thousand barrels per day.

2Estimated.
3NCI = Nelson Complexity Index, a measure of level of investment for and potential value created by a
petroleum refinery. Higher index number indicates higher costs but also higher value for a refinery's products.
4At time of commission.
5Assuming gross refining margin (GRM) of $15.4 per barrel.
Source: Company Web site, press clippings, interviews

teams. The value of completing projects address changing circumstances (such as

more quickly usually more than compen- regulations or market conditions) flexibly
sates for the incremental cost of the and to ascertain a project’s status.
additional workers needed to do so. In this
way, a leading Indian power company is By contrast, Asia’s best players regard
on track to complete its world-class thermal- project management as a core competence.
They may outsource various parts of
a project but retain an active role as its
overall integrator and manager.
Moreover, they rarely hand out lump-sum
turnkey contracts that award all
engineering, procurement, and construction
work for a whole project to a single
contractor. Instead, they adopt a hybrid
approach, managing the most critical
power plant in three and half years rather parts themselves and outsourcing only
than the five such projects usually take. standard equipment on a turnkey basis.
A top Asian metal company, which reduced
its production costs by about 20 percent The best Asian companies therefore invest
in four years, is now the world’s third-largest heavily to build in-house project-
base metal producer, moving steadily management capabilities. In one extreme
to create a capacity that will make it the example, an Asian oil company employs
second-largest base metal producer a massive team of 7,500 engineers
by 2010. who support day-to-day operations and
can also be drafted to work on future
Despite the pace of construction, the projects. Since experienced engineers are
Asian refineries we reviewed had adopted virtually impossible to find in such
health, safety, and environmental per- large numbers, the company has no choice
formance standards similar to those of but to hire many recent graduates and
refineries in the developed world and to develop their skills by giving them active
only marginally lower labor standards, with coaching from veteran managers.
few exceptions. The refinery design and
operational performance were also Not every company can go to such extremes
comparable, though their environmental in its home market; that depends on
performance was lower, a reflection of labor costs and the availability of the nec-
looser local regulations. essary expertise. Yet most companies
won’t need to do so. In our experience, for
Invest broadly a typical billion-dollar project, they
Many global companies outsource almost can extract most of this system’s benefits
everything related to the building of with only 15 to 30 skilled managers.
any large project, reducing their role to The investment is small compared with
awarding contracts and setting cost the value at stake.
and time targets. This approach lets them
maintain fewer in-house capabilities but The companies we studied not only build
also limits their control over the execution their internal capabilities but also take steps
of projects, as well as their ability to to prevent suppliers from falling behind
schedule. Less effective managers of low-cost countries like China and India,
capital projects typically rely on monthly they typically do so only for noncritical
status reports from contractors, high- items—for instance, low-pressure pumps
level communications between CEOs, and used in refineries; simple fabricated
occasional visits to sites; otherwise, structures, such as trusses for buildings;
the principals have little contact with the and peripheral items, such as elevators
process or the professionals working and fire protection systems. These com-
on projects. Best-in-class Asian companies, panies aim to avoid the risk of using
by contrast, spend significant time and unfamiliar vendors for critical equipment,
energy upfront, during the contracting stage, which they source from their existing
to minimize the cost of interaction networks of approved suppliers.
with vendors from contracting to execution.
A major Indian power company, for By contrast, Asia’s leading capital project
example, gives them only input, output, and managers obtain lower costs and faster
technology specifications, allowing them service by aggressively sourcing even critical
to develop the details of the design and to equipment from promising vendors that
suggest design options. Another player, have developed strong capabilities and repu-
after having done the negotiation ground tations in their home countries but that
work, managed to close the negotiation may lack extensive experience in global mar-
for all the bid bundles with selected vendors kets. A leading Asian metals company,
in three days flat. for instance, eliminated 40 percent of its
overall project cost by procuring more
Other best-practice Asian companies than 60 percent of its requirements, includ-
continually look ahead for potential diffi- ing the equipment for an entire power
culties, treat a vendor’s problems as plant, through low-cost Chinese engineers
their problems, and commit their own (Exhibit 2).
resources to achieve a resolution.
A top Asian metals company, for instance, To mitigate the risk that a vendor in a low-
has a large team of 30 to 40 procurement cost country might have limited knowledge
of the importing country’s regulations,
labor conditions, or safety standards, leading
Best-practice Asian companies look ahead for potential Asian companies deploy their own
experienced engineers and technicians to
difficulties, treat a vendor’s problems as their own,
oversee the erection and commissioning
and commit their own resources to achieve a resolution
activities that such vendors undertake. They
also invest in programs to strengthen the
technical and execution capabilities of these
expeditors working directly with many contractors and suppliers.
key vendors. This team, looking for ways
to improve their processes, monitors Avoid gold plating
their orders and the fabrication status of Less effective managers of capital projects
the equipment they build. seldom question the rationale for many
of the specifications and redundancies in
Reconsider low-cost suppliers the materials, supplies, and equipment
While many companies extol the they procure. As a result, overengineering
advantages of purchasing supplies from and excessive redundancies often add
considerably to a project’s cost. But Moreover, Western companies tend to

the Asian companies we studied believe have cumbersome and bureaucratic
in challenging all assumptions and in procedures and systems that reduce the
understanding the reasons for designs and speed of decision making.
specifications by subjecting them to
the rigorous and systematic tests of value But the companies we investigated for
engineering—the organized application this study think that the intense, fast-paced
of technical knowledge to find and elimi- nature of capital projects makes a flat
nate unnecessary costs. Using that organizational structure essential. Such
approach, a major Indian engineering, a project-management organization
procurement, and construction player typically has just two layers between the
aims to reduce the cost of developing and line staff and the project managers,
building the equipment it supplies by who report directly to the CEO or a board
10 to 15 percent. Similarly, a national oil member. While the CEO is involved in
company pushed the cost of its pipe- all critical discussions, project managers
lines 60 percent below global benchmarks have full authority to supervise support
by redesigning their specifications to functions and manage resources and as
eliminate overengineering (Exhibit 3). a result can make quick decisions
themselves—unless the budget is threatened.
Flatten the organization Decisions are reviewed as they are made,
Web 2008
While the concept of flat organizational so the review doesn’t delay decision making.
Asia capital
structures is not unfamiliar, in practice its
Exhibit 2 of 3managerial preferences or
use reflects Clear processes and strong incentives
Glance: Sourcing critical equipment from global suppliers
organizational history rather than necessity. that canencourage
unlock substantial value. teams to meet
construction
Exhibit title: Low-cost suppliers
Exhibit 2 Characteristics Example Impact, project cost; index: typical project cost = 100
Low-cost suppliers t Provide significant A leading Asian metals company 100
top-down push to leverage t Sourced 60%+ parts from China, including t Construction
global sourcing entire captive power plant 40% time also
Sourcing critical equipment from global suppliers t Ensure global sourcing for t Contracted project to a Chinese project-
60 reduced by 4
can unlock substantial value. cost and time advantage management contractor keen to develop months
t Look for engineering business outside China
activities besides t Executed with low-cost Chinese
commodity equipment engineers—hundreds working in remote
sourcing location; no intellectual-property/legal
t Consider new but issues
promising vendors Typical Achieved
t Make it worthwhile for
vendor to succeed A leading Asian national oil company 100
t Sourced 40%+ of equipment from China,
including an entire reactor 80–75 20–25%
t First state-owned company to hire Chinese
vendors for reactor purchase
t Created a specialized sourcing operation
in China to source low- and medium-
technology items; used landed-cost approach
to optimize supplier base
Typical Achieved
Source: Press clippings, interviews

Web 2008
Asia capital
Exhibit 3 of 3
Glance: Companies challenge all design specifications to eliminate unnecessary waste and ensure
optimal performance.
Exhibit title: Trust but verify
Exhibit 3 Pipeline system for a leading Asian national oil company

Trust but verify Aim Analyze Achieve
t Base business case on actual t Studied fluid flow equation to t Optimal diameter found to be
Companies challenge all design speciﬁcations throughput build crude pipeline model smaller than initial specifications
to eliminate unnecessary waste and ensure t Optimize across length, thickness, t Estimated lowest-cost pipeline t Reduced amount of materials
optimal performance. diameter, and pump pressure diameter through analysis needed
of maximum fluid pressure, t Led to 15–20% reduction in
potential pump locations capital expenditures
project deadlines support this structure— Employees are evaluated on clear and
a necessity given the aggressive performance simple performance metrics, of which the
expectations and stretch targets of these most common is spending per day at
companies and their intense scrutiny of the the project level, which is then broken down
process. To ensure success, they use to individual managers. Project man-
detailed planning and motivational tactics: agers are assessed by several criteria, each
activities are planned down to the micro- weighted by its importance at different
level (for example, day-to-day delivery plan stages of a project, including speed and
for each vendor), and the planning func- energy (20 percent), willingness to
tion ensures that all project teams stick to learn (20 percent), and openness (10 percent).
the plan and report any deviations from Employees may be fired or moved to
it. Detailed instructions cascade down to noncritical positions for failing to meet
specific individuals, who have clear tar- targets, but those who do meet them
gets and responsibilities. Project managers, receive significant benefits. A leading oil
for example, must take charge of a project company, for example, offers a
from start to finish, coordinate their 15 to 20 percent increase in the annual
work with the line functions, and minimize compensation of the members of
capital expenditures. Less effective project teams for every month gained
managers of capital projects prepare only during project execution.
high-level schedules, and though proj-
ect managers are responsible for end-to-end
project delivery, they are not responsible
for minimizing capital expenditures. Leading Asian companies are creating
a significant competitive advantage
To motivate people, the companies we for themselves by using these best practices.
studied use carrots and sticks. The CEO A company that carefully adapts them
conducts weekly reviews with all func- can improve the return on capital for its
tional heads to monitor costs and adherence own new projects—and compete
to timelines. Managers conduct weekly more successfully against the top
or even daily reviews of their subordinates. Asian performers. MoF
Navtez Bal (Navtez_Bal@McKinsey.com) is an associate principal in McKinsey’s Delhi office, where Anil Sikka
(Anil_Sikka@McKinsey.com) is a consultant; Subbu Narayanswamy (Subbu_Narayanswamy@McKinsey.com)
is a partner in the Mumbai office. Copyright © 2008 McKinsey & Company. All rights reserved.
20
Organizing for value

The division structure can mask big differences in the performance
of smaller units. A finer-grained approach can better show where value
comes from.
Massimo Giordano and Organizing large corporations along a few divisional lines has long been an effective
Felix Wenger way to groom managers for top jobs and to limit the number of direct reports the CEO has
to keep track of. But for value-minded executives, those bulky divisions can obscure the
performance of smaller units where value is actually created. In a big, complex division, the
division and function heads often become the de facto decision makers about whether
and where to invest and how to make trade-offs between long-term growth opportunities
and short-term demands. A head of research and development might spy a promising
new technology investment, but just as quickly look away when the broader demands of
complying with the budget of that function come into view.
This organizational blind spot, often creating strategies—such as investment in

combined with an excessive focus on short- high-growth niches, entries into new
term earnings, can produce unfortunate markets, or new R&D projects—that don’t
results, in our experience. Managers end up fit into their short-term planning horizon.
optimizing earnings goals at the expense Many treat all units within a division as if
of long-term growth and value creation. “We they were creating value equally. A large
typically spend 80 percent of our time European bank, for example, reduced staff
figuring out how to squeeze the economics, after the subprime crisis hit its US
and only 20 percent on actual strategy, operations. The uniform freeze across
without numbers to back our decisions,” business units meant that even an
says one executive. Some readily admit alternative-investment unit delivering
to cutting back on value-creating projects in 60 percent earnings growth had to
order to meet short-term earnings targets. cut back its resources, negatively impacting
Others overlook or underfund value- future growth.
21
One way companies can compensate for different economics. One large health care
the blunt tools of traditional planning company, for instance, analyzed one of
is to take a finer-grained perspective on its divisions by the type of disease to be
businesses within large divisions. By treated, rather than by the classic functional
identifying and defining smaller units built structure of research, development, sales,
around activities that create value by and production. This meant adding up all
serving related customer needs, executives the products used to treat each disease,
can better assess and manage perfor- the specialized sales forces serving specialist
mance by focusing on growth and value professionals around the globe, and
creation. These units, which we call the development teams working on new
“value cells,” offer managers a more detailed, medical devices. Additionally, parts of
more tangible way of gauging business the production, supply chain, and overhead
value and economic activity, allow CEOs to needed to be allocated.
spend more time on in-depth strategy
discussions, and make possible more finely As a rule of thumb, value cells have stand-
tuned responses to the demands of alone economics and must be relatively
balancing growth and short-term earnings. “homogenous” in regard to their target mar-
There is no guarantee that companies ket, business model, and peers—that is,
taking this approach will make the right they must have one target segment, one
investment decisions, of course. But in country or region, or one group of products.
a number of companies across industries, The trick is to create financial analyses,
we have found that it fosters trans- such as P&L statements, as if a value cell
parency and a more strategic and longer- were a stand-alone business. This is
term perspective. normally not done in a classic divisional
structure, where each division’s finan-
Simply recasting a company’s view of cials are an amalgam of different products,
its assets in this way is a largely no-regrets markets, and costs relating to shared
move, we believe. However, executives assets. A useful litmus test is determining
looking to make strategic decisions and whether a value cell could be sold and
measure performance using a value whether there would be a clear market price
cells approach will face the challenges of for it. Defining cells in this way also
rewriting metrics, redefining the implies a value-minded bias for managerial
performance-management process, action: some may need investment,
and changing the mind-sets of some may need to increase their profits,
top managers. and others should be wound down.
What are value cells? In our experience, a company of above

Value cells are actually smaller business $10 billion market capitalization should
units, typically segments or geographical probably be managed at the level of
markets, along with their backbone 20 to 50 value cells, rather than the more
functions, such as central production or typical three to five divisions.1 Another
1 In our study of 400 very large companies, we operations. We think of them as “cells” European bank, with above €50 billion2 in
found that, on average, they have three to because they stand apart from the tradi- market cap, for example, identified more
five divisions, with the largest division making
tional organizational-unit structure of than 50 value cells, where it had once had
up 55 percent of revenues.
2 About $80 billion.
most companies and often have surprisingly nine divisions. Each cell was built around
related products, segments, or geographical folio systematically. The report also served
boundaries. Examples of cells were as a basis for longer-term growth and
consumer finance, asset management investment plans, something that was not
for institutional clients such as possible using the traditional three-year-
pension funds, or wealth management earnings approach to planning.
for wealthy individuals.
While managing so many value cells might
Value cells can easily coexist with the appear to increase the CEO’s workload,
organizational structure of a division, which the reverse is often true. Focusing more on
might need to take other factors into single cells actually reduces complexity
account, such as geographic proximity or because managers find it much easier to
economies of scale in common functions identify and monitor the two or three
such as production plants, supply chain, or operational metrics that truly drive perfor-
sales networks. As an overlay on an existing mance, as well as to make decisions
structure or a lens through which to in a more straightforward way. In essence,
view existing businesses, however, the cells the CEO can use value cells to take out
facilitate strategic decision making. Their a “disintermediation layer” between actual
primary benefit is to improve reports to the business decisions and the corporate
corporate center by increasing the level planning process. Instead of aggregating
of detail in data and differentiating between strategies and economics into complex
the performance of units previously buried divisions and then spending lots of time
in larger divisions—and the opportunities understanding the overall strategy
these units pose. The mere process of and performance, the CEO can take a larger
identifying value cells and discussing the number of more rapid, more specific,
strategic options around them creates and more radical decisions at the value
transparency about the sources of value cell level.
within divisions, making it clear
whether, say, high-performing businesses A secondary benefit of a value cells
have been cross-subsidizing weaker sib- approach is its emphasis on a company’s
lings. What typically emerges is a better performance and longer-term pros-
baseline for portfolio decisions regard- pects. In today’s typical command-and-
ing which value cells managers should keep, control, budget-driven organization,
which require more investment, and most managers focus on ensuring that their
which they should divest altogether. Senior units meet short-term earnings targets.
executives—the CEO and the CFO — With value cells, CEOs and CFOs have
will need to insist on detailed economic and better information for taking a more active
strategic data from business managers in role in managing a company’s long-term
each value cell before allocating the com- development rather than the shorter-term
pany’s resources. In the case of the bank focus of the divisions. The more detailed
described previously, the CEO did so by information they get from value cells, the
requiring a 50-page “value report” on less likely they will be to tolerate
all cells before making investment decisions continual underperformance or to forgo
The CEO used the report, which included investment opportunities.
business drivers, economic profit, and
valuation data, to monitor and challenge At a global technology company, for
the businesses in the company’s port- example, R&D was managed broadly as a
percentage of divisional revenues. When implementation challenges—creating better

the CEO exerted pressure to meet short- data, exerting pressure to collaborate,
term earnings targets, R&D spending was adopting incentives that reflect the value
squeezed. One of the divisions did make created per cell. The real change of
investments in a breakthrough renewable- culture and mind-set requires even more:
energy technology—but did not want to instilling business managers with
commit more than a certain percentage of the feeling that the new process gives them
its R&D budget. Once the company rede- more freedom and more resources for
fined the technology and its application as a good ideas.
value cell, its R&D costs were linked to its
long-term revenue potential. The investment Overcoming resistance
Some managers have a certain antipathy
toward greater transparency, often because
they have typically been rewarded for
a division’s overall short-term performance.
A value cells approach is meaningful only if a company has the
As long as that performance depends
courage to follow up on decisions to invest or divest
on a few aggregated numbers, they have
enough flexibility to let the strong
performance of one unit make up for
the weak performance of another,
returns were risky, but potentially very or to favor a unit that generates more
high. Strategically, the company found it revenues today over one that promises
was already losing ground to competi- more growth for tomorrow.
tors and spending significantly less on R&D
than they were. As a result, the com- In order to overcome that resistance, CEOs
pany decided to increase R&D spending and CFOs will need to explain the bene-
and accelerate the commercialization fits of the value cells approach clearly, and
of the technology, even though this meant the rewards of managing for higher
sacrificing some short-term profit margins. growth. On the one hand, this means
adapting reward programs, so that
It’s worth noting that a value cells approach managers will be rewarded for creating
is meaningful only if a company has the long-term value, even if this means
courage to follow up on decisions to invest investing, or riding out market cycles—
or divest. Managers must regularly scruti- things that can’t be done if every-
nize cells that destroy value and divest them thing is melded into the usual division-level
if turnaround plans don’t materialize. reports. One appropriate model for this
They must nurture high-potential businesses can be found in many private-equity firms
aggressively and continuously. If com- and hedge funds, which compensate
petitors devote far more resources to a managers according to their return on
given business, for example, the real investment, offering them a share of
choice is exiting it or doubling down on the returns as they materialize. As a first
the investment—not adapting marginally. step, many companies are moving
away from absolute profit as the key
Getting started metric towards return on invested
Using value cells to emphasize value capital (ROIC), or economic profit after
management requires some obvious cost of capital invested.
On the other hand, it also means stressing (such as product market share, client churn
the greater opportunities for personal rates, and productivity per sales point)
growth. The value cell approach requires and to establish an “educated” dialogue
business leaders at all levels to be entre- with business units. In our view, this
preneurs as well as managers. Instead of requires that CEOs and CFOs first ask
just delivering short-term earnings, the corporate finance and strategy
business managers have more incentive to staffs to define value cells and to calcu-
become opportunity scouts; business- late their economics and value using
development strategists; and investment consistent assumptions, for example, on
managers who are expected to discover allocations of overhead or valuation
profitable opportunities in high-growth parameters such as cost of capital. Then
niches, entry into new markets, or they must test these analyses with the
R&D above and beyond current projects. business managers (divisional and below),
As strategists, they need to weigh oppor- inviting them to comment on the key
tunities to drive long-term value. As metrics that drive the value of cells and
managers of value, they constantly need to present investment cases on how
to optimize all elements of the value they could increase the value of cells—for
equation, such as short-term earnings, long- example by investing in distribution
term growth, and capital requirements. or reducing capital absorbed. Once the best
A practical first step here can be to devote cases have been approved, there must
more time in the corporate-planning also be an ongoing process of challenging
process to discussing strategic options, the performance of cells relative to the
and ask business managers to come initial plans and external benchmarks.
up with investment cases that can be con-
sidered and challenged. This approach To meet these challenges, most CEOs will
can require changing performance metrics need to train and develop—or hire—a staff
and the incentives linked to them. that can conduct such analyses, brief
them on the findings, and coach them dur-
Beefing up the corporate staff ing discussions with business managers.
CEOs and CFOs face new challenges The number of these employees can be mod-
when managing with a value cells approach. est, however. Companies should bear in
Those who have made the transition have mind that many comparably sized private-
often found it difficult to strike a balance equity firms, which operate in a similar
between tangible short-term earnings fashion, need only a handful of analysts to
and accounting metrics and much less monitor the value of their portfolio
tangible long-term-investment and companies and to brief their executives
value ones. Ensuring that measures of value effectively on what questions to ask
and returns are correct and consistent and what to challenge.
and that projections and investment cases
are comparable, some have found, Beefing up the managerial bench
requires substantial valuation skills and Many business managers are not immedi-
a fairly detailed knowledge of the ately up to their new role when
economics of various businesses. Many the value cell approach is adopted. One
have found it useful to benchmark large European financial institution
performance against external indicators found it hard to fulfill one of the primary
tasks of this approach: identifying profitable investment plans than they had before and
and creative ways to invest more money— distinguished more clearly between growth
other than, in some cases, buying a competi- and mature businesses.
tor. It turned out that the existing man-
agement bench was much more oriented
towards fine-tuning short term revenues
and costs, often at the expense of growth. Focusing corporate and divisional decision
processes on value and growth isn’t
In some cases, companies will be able to simple, particularly when the activities
train and develop existing talent. In the that create value are embedded in
institution just mentioned, it took business large divisions. Companies that adopt
managers one to two years to build the a finer-grained, granular approach
skills they needed to generate high-quality can better identify and manage their value-
investment ideas above and beyond creating assets. MoF
their current scope. Once that change was
in place, their role became much more
entrepreneurial and strategic, and they
proposed more and better-developed
Massimo Giordano (Massimo_Giordano@McKinsey.com) is a partner in McKinsey’s Milan office, and

Felix Wenger (Felix_Wenger@McKinsey.com) is a partner in the Zurich office. Copyright © 2008 McKinsey &
Company. All rights reserved.
26
A better way to
understand TRS
Traditional methods of analyzing TRS are flawed. There’s a better way.
Bas Deelder, Executives, board members, the press, and investors regularly look at total returns to
Marc H. Goedhart, and shareholders (TRS) as an important metric of value creation. Yet TRS , like any performance
Ankur Agrawal metric, is instructive only when users understand its components. Actual corporate
performance, for example, is only part of the mix, as TRS is also heavily influenced by
changes in investors’ expectations of future performance. Sophisticated managers
know that a failure to grasp how the various components work together can generate
unrealistic expectations among companies or their investors and even steer companies to
pursue more growth or take on more risk—without any value creation.
Sadly, most traditional ways of under- many acquisitions when the goodwill paid
standing TRS are flawed. Many of them, is taken into account.
for example, define TRS as the sum
of the percentage change in earnings plus Traditional approaches also err when they
the percentage change in market relate TRS to dividend payments. Dividends
expectations—as measured by the price- do not create value. For example, if
earnings ratio (P/E)—plus the dividend a company pays a higher dividend today
yield. This simplistically connects TRS with by taking on more debt, that simply
changes in earnings, as if all forms of means that future dividends must be lower.
earnings growth created value equally. Not If a company pays a higher dividend by
so. Earnings growth creates more value forgoing attractive investment opportunities,
when it is rooted in activities that generate that also reduces future dividends. Finally,
high returns on capital—such as the the usual approaches fail to account for the
discovery of new customer segments for impact of financial leverage: two com-
a company’s products—than in activi- panies that created underlying value equally
ties with low returns on capital, such as well could generate very different TRS,
simply because of the difference in debt- achieve the 7 percent earnings growth con-
equity ratio and the resulting differences sumed most of the earnings growth;
in risk. the TRS stemming from it is actually only
1.4 percent.1 With 3 percent coming
A better approach to understanding TRS from a change in expectations, the remain-
breaks up the metric into four fundamental ing 10 percent is the TRS that results
parts: a company’s operating performance, from the company’s value at the start of
its stock market valuation at the beginning the period—its “zero growth” return,
of the measurement period, changes in which represents the company’s TRS if it
stock market expectations about its perfor- had no earnings growth and investors
mance, and its financial leverage. The had no change in expectations.2
analysis can further divide a company’s
operating performance into the value Let’s now consider Company B, which
from revenue growth net of the capital is identical to Company A except for its
required to grow, from margin debt financing (Exhibit 2). As a result,
improvements, and from improved Company B generated higher TRS but did
capital productivity. not create more value after adjusting
for higher financial risk. The traditional
Consider a hypothetical example using decomposition approach fails to reflect
a traditional approach to gauging this and suggests that Company B’s share-
TRS (Exhibit 1). Company A has a 14.4 per- holders benefited from a higher dividend
cent TRS based on 7 percent earnings yield and a stronger increase in expectations.
growth, a 3 percent change in the com- The fundamental decomposition clearly
pany’s P/E (as a proxy for changed shows that at the business level, companies
expectations), and a 4.4 percent dividend A and B have an identical TRS from
1 Required investments = 5.6 percent Web
yield.2008
When we apply a more funda- zero-growth returns, growth, and changed
total returns to shareholders ( TRS), ie,
(107–100)/125.
TRS
mental breakdown of the elements of TRS expectations, when measured by the
2 More precisely, the “zero growth” return
Exhibit
into the1 parts
of 4 described above, however, we unlevered P/E multiple (enterprise value/
equals the earnings yield—that is, the inverse
of the earnings multiple.
Glance:
see that thetraditional
Most ways of
reinvestment understanding
required to TRS areearnings).
flawed. The additional 3.6 percent
Exhibit title: The old versus the new TRS decomposition
Exhibit 1 Company A financials Decomposition of TRS, %

The old versus the new
TRS decomposition
Base year 1 year later Traditional Enhanced
Most traditional ways of understanding Invested capital, $ million 100.0 107.0 ‘Zero growth’ return 10.0
total returns to shareholders (TRS) Earnings, $ million 12.5 13.4 Growth 7.0 7.0
are flawed. Dividends, $ million 5.5 Required investments –5.6
P/E multiple 10.0 10.3 Net growth 7.0 1.4
Equity value, $ million 125.0 137.5 Change in multiple 3.0 3.0
Capital structure impact 0
Dividend yield 4.4
TRS 14.4% TRS 14.4% 14.4%

TRS for Company B now shows up under Over the subsequent five years, revenue
TRS from capital structure, indicating that growth was not an important factor
it is leverage-induced and not value creating. for shareholder returns: InBev’s top-line
annual growth of almost 24 percent
Examples from various industries show how did not create positive shareholder returns
a more detailed, fundamental analysis once capital expenditures and good-
can be illuminating. Let’s compare the TRS will paid were taken into consideration.
performance of the Dutch brewer Heineken Heineken actually generated higher
and its Belgian–Brazilian competitor shareholder returns from much lower
InBev. A traditional TRS decomposition revenue growth.4
suggests that InBev generated signifi-
cantly higher annual shareholder returns InBev’s outperformance of Heineken
over five years mainly because of its in terms of TRS was driven by its superior
superior earnings growth (Exhibit 3). improvements in return on capital
A deeper look with the new approach reveals over the period. It generated an impressive
more accurately where InBev made 34.6 percent shareholder return per
the difference. annum by pushing its return on invested
capital5 (ROIC) from 14 percent in
Compared to Heineken, Interbrew 2002 to an industry-leading 47 percent
3 We call this the treadmill effect; see Richard F. (now InBev) was facing a bigger challenge in 2007. Heineken, by contrast, saw
C. Dobbs and Timothy M. Koller, “The in 2002 to generate strong TRS. Its its ROIC decline over the same period to
expectations treadmill,” The McKinsey
Quarterly, 1998 Number 3, pp. 32–43.
Web 2008 multiple already reflected higher
valuation 17 percent, from 24 percent, thereby
4 Keeping all other factors constant, such as
TRS
investor expectations for future value losing around 5 percent in TRS.6
returns on capital, investor expectations, and
capital structure. Exhibit
creation,2 ofresulting
4 in a zero-growth return
5 Return on invested capital (ROIC) adjusted for
Glance: For a company
three percentage partlybelow
points financed by debt, the traditional
that decomposition
Finally, InBev’s TRS approach suggests a higher
was negatively
operating leases and excluding goodwill.
6 Again, keeping all other factors constant. dividend yield
of Heineken. and
3 a stronger increase in expectations, ignoring the impact of total returns
impacted by 14.4 percent as its to valuation
shareholders
(TRS) from leverage.
Exhibit title: Illusory growth
Exhibit 2 Company B financials Decomposition of TRS, %

Illusory growth
Base year 1 year later Traditional Enhanced
For a company partly financed by debt, the
Enterprise value, $ million 125.0 137.5 ‘Zero growth’ return 10.0
traditional decomposition approach suggests
a higher dividend yield and a stronger Cash (debt),1 $ million –25.0 –25.0 Growth 7.0 7.0
increase in expectations, ignoring the impact Equity value, $ million 100.0 112.5 Required investments –5.6
of total returns to shareholders (TRS) P/E multiple 8.0 8.4 Net growth 7.0 1.4
from leverage. Change in multiple2 5.5 3.0
Capital structure impact 3.6
Dividend yield 5.5
TRS 18.0% TRS 18.0% 18.0%
1Assumes cash (debt) carries no interest (for illustrative purposes).

2Change in P/E multiple for traditional approach vs change in unlevered P/E multiple in enhanced approach
(enterprise value/earnings).
Web 2008
TRS
A better way to understand TRS 29
Exhibit 3 of 4
Glance: TRS performance of the Dutch brewer Heineken and its Belgian–Brazilian competitor InBev
provides a case in point for a more nuanced TRS decomposition.
Exhibit title: A closer look
Exhibit 3 Decomposition of TRS for Heineken and InBev, Dec 31, 2002 to Dec 31, 2007, annualized, %
A closer look Heineken InBev
Total returns to shareholders (TRS) Traditional TRS decomposition misreads Enhanced TRS decomposition shows underlying
underlying drivers. differences in growth and returns.
performance of the Dutch brewer Heineken
and its Belgian–Brazilian competitor
EPS growth 0.8 27.0 ‘Zero growth’ return 7.7 4.7
InBev provides a case in point for a more
nuanced TRS decomposition. Revenue
P/E change 7.4 –6.6 8.4 23.7
growth
Required
Dividend yield 1.9 1.7 –7.5 –27.6
investments
Total TRS 10.2 22.1 Net revenue growth 0.8 –3.9
Change in return on
–4.9 34.6
invested capital
Change in multiple 5.3 –14.4
Capital structure impact 1.3 1.1
Total TRS 10.2 22.1
Source: Annual reports; Datastream
multiple declined from 2002 to 2007, to 2007 (Exhibit 4). These institutions
reflecting lower stock market expectations are a good proxy for the entire European
that InBev would further improve its banking sector, as they represent around
value creation. By contrast, the market 80 percent of its assets. In aggregate,
increased its expectations for Heineken to they have delivered a 15 percent TRS per
improve its performance and growth after annum over the last five years. A traditional
2007, driving up TRS by 5.3 percent. TRS decomposition indicates that these
returns largely reflect growth, suggesting
The analysis shows that InBev generated that it is critical and that banks should
its shareholder returns through very strong focus on growth strategies.
operating improvements, not top-line
growth. In contrast, most of Heineken’s Once the analysis takes investment
TRS was due to a high zero-growth requirements and acquisition goodwill into
return and increased investor expectations. account, however, it turns out that for
The company’s business growth and the sample as a whole, growth didn’t drive
operating performance had little impact. shareholder returns. In reality, since
2002 better returns on capital have driven
A more detailed decomposition of TRS can the creation of value in European banks,
also offer insights into the drivers of whose aggregate return on equity (ROE)
shareholder returns in a sector as a whole. increased to 23 percent, from 16 per-
Take, for example, the stock market cent. This insight has several implications
performance of the largest 25 European for managers. Going forward, value
banks by market capitalization from 2002 creation in the sector probably won’t come
Web 2008
TRS
Exhibit 4 of 4
Glance: An improvement in the return on equity of the largest European banks has been the key
driver of their TRS—not growth, as the traditional approach implies.
Exhibit title: Insight into a sector’s TRS
Exhibit 4 Decomposition of TRS, top 25 EU banks, Dec 31, 2002, to Dec 31, 2007, annualized,1 %
Insight into a sector’s TRS
Traditional TRS decomposition, % Enhanced TRS decomposition, %
An improvement in the return on equity
of the largest European banks has ‘Zero growth’ return 7
been the key driver of their total returns to
shareholders (TRS)—not growth, Equity growth 13 Net revenue growth 1
as the traditional approach implies. Change in return Change in return
7 15
on equity on equity
EPS growth 20
P/E change –8 P/E change –8
Capital structure
Dividend yield 3 0
impact
Total TRS 15 Total TRS 15
1Based on market weighted TRS and aggregate balance sheet and income statement data.
Source: Annual reports; DataStream
again from performance improvements, set 15 percent as the aspiration for the next
given the record profit levels of recent years. five. But decomposing this TRS might
In fact, falling expectations show that show why it will be very difficult to con-
investors believe that profitability will tinue to achieve that level of returns.
decline. Yet finding value-creating growth
might be as big a challenge, since banks Suppose that the 15 percent TRS of the last
on average did not manage to generate TRS five years comprised 3 percent from oper-
from growth in the recent past, when ating performance, a zero-growth return of
profitability was peaking. This leaves banks 8 percent (reflecting an initial P/E of 12),
with a difficult problem: where to find and 4 percent from the change in P/E (from
attractive returns for their shareholders in 12 to 15 over five years). The challenge for
the future. Company X is that its zero-growth return is
now 7 percent (because it has a higher
Finally, executives can also use a finer- P/E), and its current P/E is top quartile for
grained, fundamental TRS decomposition its industry. Since the P/E isn’t likely to
to evaluate potential performance tar- rise, there will probably be no contribution
gets for shareholder returns. Too often, from that quarter. To reach a 15 percent
we see companies setting aspirations TRS over the next five years, Company X
blindly—basing them, for example, on past will need to get 8 percent from oper-
TRS performance. If Company X earned ating performance—over twice its level
15 percent TRS annually over the last five during the last five years. MoF
years, you might think it reasonable to
Bas Deelder (Bas_Deelder@McKinsey.com) and Marc Goedhart (Marc_Goedhart@McKinsey.com) are

consultants in McKinsey’s Amsterdam office; Ankur Agrawal (Ankur_Agrawal@McKinsey.com) is a consultant
in the New York office. Copyright © 2008 McKinsey & Company. All rights reserved.
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China’s track record in M&A

China’s companies are expanding the focus of their outbound M&A, but so far
they have struggled to create value.
Thomas Luedi
Communicating with the right investors

Executives spend too much time talking with investors who don’t matter.
Here’s how to identify those who do.
Robert N. Palter, Werner Rehm, and Jonathan Shih
Preparing for a slump in earnings

Historic trends suggest earnings may fall more than most executives expect.
Companies should prepare for steeper declines and take steps to strengthen their
positions when times improve.
Richard Dobbs, Bin Jiang, and Timothy Koller
Running a winning M&A shop

Picking up the pace of M&A requires big changes in a company’s processes
and organization—even if the deals are smaller.
Robert T. Uhlaner and Andrew S. West
Taking stock: Ten years after the Asian financial crisis

The Asian financial system could become a full-fledged partner in the global
triad of economic powerhouses, alongside Europe and the United States—
but only if its regulatory systems, economic ministries, and financial institutions
improve dramatically.
Dominic Barton
Deal making in 2007: Is the M&A boom over?

Reports of the demise of the M&A boom may be greatly exaggerated. But to
keep it going, companies must work even harder to ensure that deals create value.
Antonio Capaldo, Richard Dobbs, and Hannu Suonio
The new role of oil wealth in the world economy

Regulators may worry when Arab investors acquire stakes in Western
companies, yet vast reserves of petrodollars have kept down interest rates and
buoyed financial assets. What’s the broader effect of the surge in petrodollars?
Diana Farrell and Susan Lund
How to improve strategic planning

It can be a frustrating exercise, but there are ways to increase its value.
Renée Dye and Olivier Sibony
Copyright © 2008 McKinsey & Company

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McKinsey on Finance

Perspectives on How Chinese companies can succeed abroad 1

China’s track record in M&A 8

Managing capital projects: Lessons from Asia 14

Organizing for value 20

A better way to understand TRS 26

Editorial Contact: McKinsey_on_Finance@McKinsey.com

To request permission to republish an article, send an e-mail to

Copyright © 2008 McKinsey & Company. All rights reserved.

How Chinese companies can

Top of sand background

globalization Proportion outside home country

A company lacking experience in Developing global talent

China’s track record in M&A

Top of sand background

Exhibit 1 Baseline for unit of Outbound deals as share of

Organic CAGR,3 % United Kingdom 15.5

An explosion of M&A More recently, leading Chinese companies

Top of sand background

Africa 5.5 (1) 0.3 (2) 3.9 (5)

Others 2.5 (2) 0.4 (2) 1.4 (10) 4.7 (8)

There is some indication that Chinese

Top of sand background

Primary rationale Number of deals Total deal value, $ million2

1All deals with value >$10 million.

Top of sand background

Chinese companies overpay for most Average

Resource 56 –0.4 402 16

Top of sand background

Exhibit 5 Baseline for unit of 2005–07, $ billion1

Total Chinese outbound M&A2 57.5

Acquisitions by private-equity firms 0.5

Corporate M&A 10.6

Thomas Luedi (Thomas_Luedi@McKinsey.com) is a partner in McKinsey’s Shanghai office. Copyright © 2008

Managing capital projects:

overall costs—and a faster route to thousands of kbpd1 high CEO/leadership involvement

. . . led to emphasis Cost, $ Time to completion,

t Second refinery scheduled to be completed 6 months

Impact of decision t Early commissioning will result in ~$1.5 billion

1Kbpd = thousand barrels per day.

Source: Company Web site, press clippings, interviews

teams. The value of completing projects address changing circumstances (such as

considerably to a project’s cost. But Moreover, Western companies tend to

Source: Press clippings, interviews

Exhibit 3 Pipeline system for a leading Asian national oil company

Organizing for value

This organizational blind spot, often creating strategies—such as investment in

What are value cells? In our experience, a company of above

percentage of divisional revenues. When implementation challenges—creating better

Massimo Giordano (Massimo_Giordano@McKinsey.com) is a partner in McKinsey’s Milan office, and

Exhibit 1 Company A financials Decomposition of TRS, %

TRS 14.4% TRS 14.4% 14.4%

Exhibit 2 Company B financials Decomposition of TRS, %

TRS 18.0% TRS 18.0% 18.0%

1Assumes cash (debt) carries no interest (for illustrative purposes).

Total TRS 10.2 22.1 Net revenue growth 0.8 –3.9

Change in multiple 5.3 –14.4

Capital structure impact 1.3 1.1

Total TRS 10.2 22.1

Source: Annual reports; Datastream

P/E change –8 P/E change –8

Total TRS 15 Total TRS 15

Bas Deelder (Bas_Deelder@McKinsey.com) and Marc Goedhart (Marc_Goedhart@McKinsey.com) are