McKinsey comes up with three traits seen in successful diversification strategies M&A.
Although M&A has been light recently and most companies are choosing to deploy cash in other places – stock buybacks and dividends – companies flush with (growing) cash are still hungry to diversify through an acquisition. In this, according to a McKinsey report, “Testing the limits of diversification,” it is important that companies not stray too far outside their expertise, be disciplined, aggressive with capital and stay lean.
These are skills and traits good corporate treasurers usually have in spades. Having helped navigate their companies through the intense heat of the financial crisis, they’ve increasingly been called upon to act as advisors to management when it comes to M&A. This is a good thing, for companies still make mistakes in trying to force round acquisitions into square holes. According to McKinsey, “too many executives still believe that diversifying into unrelated industries reduces risks for investors or that diversified businesses can better allocate capital across businesses than the market does—without regard to the skills needed to achieve these goals.” And because few executives have the needed skills, diversification often works to cap the upside potential for shareholders while not limiting downside risk.
Deploying cash through M&A is likely most tempting to tech companies these days, many of whom have a high percentage of their excess cash overseas. This is because the US corporate tax code remains unfriendly to repatriating overseas profits, something tech companies have been complaining about for years. In the meantime, these companies are choosing to do M&A outside the US – witness, Microsoft’s 2011 purchased of Skype, PepsiCo’s foray into Russia with its purchase Wimm-Bill-Dann or GE’s many acquisitions.
But whatever the reason for the acquisition, McKinsey says the competence of the executives is key. “What matters in a diversification strategy is whether managers have the skills to add value to businesses in unrelated industries—by allocating capital to competing investments, managing their portfolios, or cutting costs,” wrote the authors.
McKinsey said there have been many high and low performers over the past two decades; and because companies have come and gone, the data is difficult to track statistically. However, it did find three characteristics that high performing companies shared:
- Discipline in investing. “High-performing conglomerates continually rebalance their portfolios by purchasing companies they believe are undervalued by the market— and whose performance they can improve.”
- Aggressive at managing capital. “Many large companies base a business’s capital allocation for a given year on its allocation the previous year or on the cash flow it generates. High-performing conglomerates, by contrast, aggressively manage capital allocation across units at the corporate level. All cash that exceeds what’s needed for operating requirements is transferred to the parent company, which decides how to allocate it across current and new business or investment opportunities, based on their potential for growth and returns on invested capital.”
- Lean corporate centers with rigor. “High-performing conglomerates operate much as better private-equity firms do: with a lean corporate center that restricts its involvement in the management of business units to selecting leaders, allocating capital, vetting strategy, setting performance targets, and monitoring performance. Just as important, these firms do not create extensive corporate-wide processes or large shared-service centers. (You won’t find corporate-wide programs to reduce working capital, say, because that may not be a priority for all parts of the company.)” McKinsey adds that in this case, taxes, auditing, investor relations, and some HR functions are done centrally.
While the first trait, discipline, could be seen as in a sense stock picking – something that should be left to professional money managers – the general premise remains valid; that is rigorous due diligence of a future acquisition is critical. But even before that due diligence, McKinsey suggests that before an acquisition, executives ask themselves whether they have the skills to be the best owners of businesses outside their core industries.