Actively reallocating corporate resources is important in the best of times, and even more so during economic downturns. Yet companies remain surprisingly slow to shuffle their resources, and even new CEOs have a tendency to maintain the status quo. In this video, McKinsey directors Stephen Hall and Conor Kehoe explain why changing allocation behavior is hard and advise new CEOs to take advantage of their opportunity to aggressively shift resources. What follows is an edited transcript of their remarks.
The problem of strategic inertia
Conor Kehoe: Making strategy happen is an important issue for CEOs. It really is. And they confront really two sets of barriers. One is internal barriers. And within the organization, there may be people who frankly do not want their best people reallocated to some new task in a promising market or alternatively, may want to hang onto the capital they have and not have it reallocated to a new market.
But there are also barriers coming in from the stock market. The stock market loves reallocation in the long term but actually doesn’t like it in the short term because it tends to depress profits for the first couple of years. The problem isn’t conceiving the strategy; the problem is implementing it—actually redeploying people and capital so that the strategy comes to life. And indeed, what we’ve been measuring in the research is this reallocation of capital and of people. And we’re finding companies do far too little of it.
Lessons from the downturn
Stephen Hall: The data is unambiguous on the point of the reward that comes from being a more activist reallocator. There’s something like a four percentage-point difference in the average return to shareholders year on year for those who are in the top third of reallocators versus those in the bottom third.
When we looked at the data through time, we expected that we would find that, in periods of economic turmoil, companies would be more activist in the way that they reallocated their resources. Those are the times when investors get nervous, when markets put pressure on CEOs, when performance starts to slip below the promises that have been made.
Interestingly, the results were the opposite of that. In other words, companies were no more active in periods of economic downturn, such as the last five years, than they were in the good times. And that tells us that despite the pressures on companies, there are a whole set of challenges that they face internally in doing what they know they need to do and what they’re being pressured to do.
Conor Kehoe: This was interesting because we know from other research that this is in contrast with private-equity-owned companies who try harder and produce better results relative to their quota peers in downturns than they do during good times.
We think what’s going on is that private equity is under less short-term pressure. They have about five years usually in which to make their companies work before they sell them on again, whereas the public company is under the scrutiny of quarterly-earnings reporting. And that may make CEOs hesitate—even when they’re under huge pressure—to invest in new areas which may depress profits in the short term.
What CEOs should do
Conor Kehoe: For new CEOs, this research says, “Get going quickly on redeploying people and capital towards growth opportunities.” So if you’re a new CEO, you have a golden opportunity. You’re in your honeymoon period. Do the reallocation, take the short-term hit, because you’ll benefit from the long term. And don’t worry about overdoing it. We haven’t found anybody who’s overdone reallocation. So go for it.
Stephen Hall: We looked at both how quickly new CEOs reallocated their capital and also how swiftly they made changes in their management teams. We think it’s probably very tempting for a new CEO to not want to make big changes immediately but to take time, understand the business, get to know people, and only then—in a more deliberate fashion—make changes. In practice, and based on the extensive data we looked at, CEOs are much better off being bold and making changes quickly.
Making it happen
Conor Kehoe: Since nobody seems to overdo reallocation, I quite like some of the crude instruments that are used to shake things up. One of them that we’ve come across, which is well known, is “We’ll be number one or number two in our market wherever we go.” Now, there’s no real evidence to suggest that in some markets being number three isn’t a very profitable position, thank you very much. But think about the reallocating tendency of that statement. If you’re not number one or number two, something’s going to happen. So that, for me, is a wonderful tool for reallocation. We came across another company where the CEO allocates 10 percent of capital, within his own discretion. That is a pretty arbitrary number. But it does mean that things get shaken up. And since this is not a fine-tuning exercise, our data shows that nobody really does enough reallocation. A crude instrument like this is a pretty good start. It begins to shake things up and overcome the internal inertia.