In business, breaking up is hard to do. While divesting businesses in a timely manner is an essential aspect of effective portfolio management, companies tend to struggle with separation decisions. In this episode of the Inside the Strategy Room podcast, three experts discuss how to determine which businesses to strengthen and which to divest and explain how to make your M&A strategy nimble enough to keep up with increasingly dynamic markets. Obi Ezekoye, a leader in the Strategy and Corporate Finance practice, and Anthony Luu, an expert in M&A and strategy transformations, are coauthors of a recent article, “Divesting with agility.” They are joined by Andy West, the global coleader of McKinsey’s M&A practice. This is an edited transcript of the discussion. For more conversations on the strategy issues that matter, subscribe to the series on Apple Podcasts or Google Play.
Sean Brown: Obi, your article reaffirms something McKinsey has talked about for some time; namely, that efficient reallocation of resources creates better returns than standing pat does. Mergers, acquisitions, and divestitures are at the core of resource reallocation. Are companies using those levers enough?
Obi Ezekoye: Given that the COVID-19 crisis has accelerated performance gaps both across industries and within industries, it is more important than ever to be an active portfolio manager so you can benefit from new industry dynamics. But we find that companies struggle to make portfolio decisions, especially on the divestment side, and often make them far too late.
Sean Brown: You mentioned that the pandemic has accelerated performance differences. How did the crisis cause these gaps to grow?
Obi Ezekoye: When you look at the average economic profit, industries such as semiconductors and pharmaceuticals have gained huge value during the pandemic, while others, including banks and energy, have been negatively affected. The gap between the top- and the bottom-quintile companies within the same sector is also growing, with 83 percent of industries seeing that pattern. Clearly, it matters what industry you are in and what end markets you are exposed to, but it also matters how you perform within your industry. Now is the time to think about whether you are the best owner of an asset or whether other assets should be part of your portfolio.
Sean Brown: What does it mean to be the best owner of an asset?
Obi Ezekoye: It means there are valuable linkages to your other businesses. You may have distinctive skills that add value to the business or you have access to and insights about the markets, capital, or industry relationships. One element that is often ignored is talent. If you are the go-to place for chemical engineers or a specific type of software developer, that talent linkage can be powerful.
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Sean Brown: Andy, what kind of factors play a role in how companies should manage their portfolios?
Andy West: Portfolio questions are typically entangled with operating actions and market risks, so we tried to look at the power of portfolio moves while controlling for other variables. We published an article last year that summarizes lessons from the research. One is around what we call the refresh rate, which relates to changing the revenue mix of your business. We also looked at the industry impact and found that whether you place bets on industries with headwinds or ones with tailwinds has a huge impact in corporate performance.
M&A and divestitures are tools to fuel this process, and how you use them makes a big difference. Are you a hobbyist doing occasional M&A, or are you more programmatic about how you buy and divest businesses? We also assessed how to think about where to buy. Should you buy assets close to your core business or expand your radius of operation? We found a bit of a sweet spot in terms of the M&A radius, where you need to be close enough to your core business to reap the benefits of competitive advantage. Our last point is that you have to be thoughtful about where you are starting from. If you are in the middle of the pack and trying to accelerate, a different approach is needed than if you start in the bottom quintile of performance.
Sean Brown: How do you determine if you are in the right businesses and how big an influence do these “where you play” decisions have on overall corporate performance?
Andy West: Industry tailwinds matter when you control for everything else. We looked at two metrics: economic profit change for industries over a ten-year period and the correlation between that and excess total return to shareholders (TRS), meaning your ability to outperform your peers from a share value perspective. We divided companies into three categories. One was companies that started with high momentum and stayed there. If you were in a sector that performed well over a decade, you would have realized 4.4 percent better annual share-price returns, so if you were in the fast lane and doubled down in that space, that yielded significant returns. If you started out in a slow lane because your sector was struggling and you moved your business mix toward a higher-performing sector, your returns outperformed peers by 1.7 percent. If you stayed in the slow lane and did not migrate your business mix toward higher-performing sectors, you underperformed by 0.8 percent per year. That shows how important it is to play in areas with momentum, and buy and sell assets to maximize your exposure to tailwinds. The great acceleration of trends makes that extremely important.
Sean Brown: Can you elaborate on the concept of refresh rate?
Andy West: The refresh rate is how much your company’s revenue mix changed over a ten-year period, or what percentage of revenue moved from one business to another. We asked ourselves a provocative question: Is it just inherently good to move revenue around? As I mentioned, migrating your business toward tailwinds is important, but is simply moving your portfolio beneficial? We broke the company sample into three categories again [Exhibit 1]. One, where the refresh rate was below 10 percent, we called “ponds” because they largely stayed stagnant. The next group is “rivers”: companies that refreshed between 10 percent and 30 percent of their business mix. Finally, companies that moved more than 30 percent of revenue really changing their business profile, and we called these “rapids.” And what we found is that companies in the river category significantly outperformed.
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So is changing the revenue mix inherently good? Probably not. But companies that migrate a lot of revenue need to have strong governance, alignment, and conviction around industry trends, so it stands to reason that they might perform better.
Sean Brown: What role do divestitures play in these M&A migrations of revenue? If your core business is in the slow lane, do you need to make acquisitions to shift it into the fast lane or is just exiting sectors with headwinds enough?
Andy West: When you change your overall mix toward high-performance sectors, that does not necessarily mean entering new industries. Divesting out of slow-lane businesses and increasing your exposure to fast-lane businesses counts as migrating your portfolio to higher momentum. We saw several companies that limited their exposure to those slow lanes and gained big benefits. One of the biases management often gets stuck in is presuming that the status quo is static. It’s not. With divestitures, management usually knows well before the market and competitors whether they are the best owner for the asset and whether the fundamentals are worth betting on. Unfortunately, most people wait until everybody knows that and that destroys value.
Sean Brown: Even if an organization adopts that active portfolio mindset, what are some of the barriers that may keep executives from making deals?
Andy West: I mentioned the status quo bias, whether it is how you evaluate assets or allocate risk, but there are 12 biases in social science that inhibit management decision making and all of them affect portfolio moves. To manage them, one important thing is alignment. Senior executive teams are rarely aligned on what needs to be divested or where they want to double down. The second thing is getting the facts. You need conviction around the data and where you want to place your bets to overcome biases, because somebody is bound to say, “I built this business. It is my legacy. The price is too high or we don’t have enough cash.” You do not want to litigate divestitures and acquisitions based on these biases and lack of alignment.
Sean Brown: You mentioned programmatic M&A earlier, Andy. What role does it play in the context of industry momentum and refresh rates?
Andy West: When you apply programmatic M&A—which means placing several bets on a theme that you believe in—to what I just described, that becomes a further accelerant. Companies that are programmatic about deal making are very purposeful. They have the alignment, they have a clear strategy, they are generating enough capital to drive deal making, they have the discipline to execute deals. Your deal making represents investment in your strategy, I want to reinforce that. If you are going to deploy $1 billion against a particular strategy such as going into services or expanding our footprint in Asia, you can spend that money on deals. Programmatic M&A is a tool but using it effectively requires skill and resources.
Sean Brown: Obi, for your article on divestitures you did an executive survey, looking at why companies are often slow to divest. Did the responses yield any surprises?
Obi Ezekoye: Nearly half the respondents told us they had held onto noncore assets for too long, so either they wished they had divested them or they had divested them too late. A very small number thought they divested too early. It’s interesting how portfolio inertia dominates the boardroom on divestitures.
There is a fear of making big moves. I find that divestitures are very hard to greenlight but very easy to stop. Almost everyone seems to have veto power.
We then asked the people who waited too long to divest what reasons they had for holding off and we saw some of the cognitive biases that Andy mentioned coming out. “We were waiting for the business to improve,” for example. We have all been in meetings where we see those magical hockey-stick graphs, where the industry or revenue is declining but in 18 months they turn around. Lack of management focus or incentive was another reason. Management is too busy running a multi-business company or a business unit leader has an incentive for maintaining a larger portfolio. Some worry about replacing the lost earnings, but if you take a shareholder’s perspective, if you had divested assets, those earnings potentially could be put to better use under a different ownership structure. Disentanglement complexity, another reason cited, can be quite real, but we have found that many barriers to disentanglement can be overcome with careful planning. Losing the benefits of scale was another reason. Some executives see the benefits of a divestiture but they don’t want their business to get smaller. There are psychological benefits of leading a big company or a big business inside a company.
Finally there is just a fear of making big moves. I have found that divestitures are very hard to greenlight but very easy to stop. Almost everyone seems to have veto power.
Sean Brown: So how do business leaders overcome this tendency to inertia?
Obi Ezekoye: One issue often is a lack of a clear strategy. M&A and divestiture decisions must be clearly anchored in corporate strategy and not the other way around. Another challenge is that the world of potential options is large, which links to the first point: business development teams need to be anchored in a corporate strategy that clearly states where M&A and divestitures fit, which narrows down the portfolio options.
Sean Brown: You have alluded to two different dynamics that delay divestments. One is around delaying decisions and the other is around the timing to executing the sale. Which one is the bigger challenge?
I could create a list of 50 reasons why this day should not be the day when we talk about divesting a business. But you have to be clear-minded because if that adds up to ten years of inaction, you are looking at inherent underperformance.
Obi Ezekoye: Sometimes those two questions get comingled, and that delays decision making across both. Once you have made the decision to divest, there is a benefit to moving with speed but there are no hard rules of thumb about how fast that should be. I mostly work in heavy industrials and process industries where there are significant physical entanglements. In other industries, you can go from announcing a divestiture to separating very quickly. What delays the decision to divest goes back to clarity around the strategy, because if you do not have that, it is hard to know whether the assets fit into the strategy or not.
Andy West: It is about that conviction, and it is hard for management teams to have those honest, hard discussions. That is why you so often see deal-related discussions becoming a backdoor to strategy discussions. But you are not really debating a specific deal; you are debating whether you ever should have gotten into or out of a particular business. Then you lay that on top of the inertia associated with exiting an industry, especially for companies that may have been in a particular business for a long time. I could create a list of 50 reasons why this day should not be the day when we talk about divesting a business. But you have to be clear-minded because if that adds up to ten years of inaction, you are looking at inherent underperformance.
Sean Brown: Why does the speed of the separation affect its success?
Obi Ezekoye: We are not suggesting to rush into these decisions. The language I use is, “Move slowly to move fast.” Measure twice, cut once. You should do most of the work of separating the companies before the announcement, because once you announce, it’s like the gun goes off and you have to move quite quickly.
Delays in separations have a dramatic effect on returns. . . . The markets can be quite unforgiving when it comes to poor execution of M&A or divestitures.
Anthony Luu: Our research shows that delays in separation have a dramatic effect on returns [Exhibit 2]. Significant delays create shocks to the business that are hard for it to recover from, ranging from organizational disruption, such as attrition and loss of focus, to investor nervousness. The markets can be quite unforgiving when it comes to delays and poor execution of M&A or divestitures. We are not advocating separating quickly or haphazardly but doing it in under 12 months. Successful divestors take the time to fully prepare both before the announcement and before closing the transaction. Some of the most successful and complex spinouts I worked on were completed in 12 months but the preparation began months before.
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Sean Brown: Anthony, what are some of the tactical considerations in getting divestitures right?
Anthony Luu: Performance of divestitures varies widely but we found that the most successful ones got four things right. They aligned their separation strategy with their core strategy, ensuring that their actions were consistent with the long-term aspirations. They also had a win–win mindset, grounded in a firm understanding of how value can be unlocked through the separation. They moved with urgency and empirical evidence shows that divestitures that take long to complete destroy value. Finally, they made sure to address entanglement and risk implications up front.
Sean Brown: What makes those deals win–win?
Anthony Luu: These cases often focus on separating fundamentally different businesses with different capital needs or distinct advantages as standalone entities. We see this in specific sector trends, such as divestments in the pharma industry between capital- or R&D-intensive therapeutic areas and less intensive segments such as consumer health. Management needs to recognize that it has fundamentally different businesses with distinct value drivers that more often than not have few synergies between them. By separating them, each entity can focus on its core and better allocate capital based on its own growth and risk/return profile, while also providing the opening to reinvent the business with new leadership and operating models. I am seeing this in the technology sector, where companies are separating lower-growth, capital-intensive but cash-flow-healthy businesses from smaller, more nimble enterprises that probably need the space to grow in the form of smaller, leaner infrastructure.
Sean Brown: Once you have decided to divest and everyone is aligned, what should be the next step?
Anthony Luu: First, you have to identify any potential deal killers. One of my clients in a hypercompetitive technology segment recognized a significant risk of competitors poaching accounts while the client was separating one of its largest business units. The team spent considerable resources prior to public announcement on ensuring that account teams had what they need to respond to competitive moves.
You also have to define the perimeter in terms of where people and assets will go. And you have to fully understand the universe of options. Is it a spinoff or a sale to corporate or private equity? Each option entails different preparation and value levers. More often than not, perimeter decisions are made in a vacuum without fully thinking about how to package assets for divestments. Finally, you have to understand the separation issues and have a plan in place to address them. Unlike acquisitions where you can sometimes wait until closing before kicking off integration planning, on separations the clock starts when you announce. By closing date, you have to have everything in place to transition the asset to the buyer.
Sean Brown: Where in the organization should responsibility for agile portfolio management lie?
Andy West: First, you have to build the facts, and that usually falls to the corporate development team. What are the perimeters? How much do you have to invest behind M&A? How much in proceeds will come from divestitures? From a strategy point of view, obviously the top team is setting those guardrails. What are we willing to do? What will our investors let us do? What will our legacy allow us do? But do not let that overwhelm the specificity of the actions. Just start checking things off. It’s not rocket science, but bringing them all together is hard.