One of the perennial questions corporate leaders ask is which businesses their company should be in. Our recent article, “ Why you’ve got to put your portfolio on the move,” suggests that regularly changing the portfolio mix in response to market trends is the surest path to outperformance. During our European M&A conference in London earlier this year, two of the article’s authors discussed their research on portfolio transformation, which they based on an analysis of detailed financial results of more than 1,000 of the world’s largest public companies. Andy West is the global leader of our M&A practice and Sandra Andersen is an associate partner also in the M&A practice. This is an edited transcript of their discussion. You can listen to the episode on Apple Podcasts, Spotify, or Google Podcasts.
Sean Brown: Andy, your presentation today focused on research into portfolio transformations. Why did you decide to study this topic?
Andy West: About a year and a half ago, after some companies made major divestitures and acquisitions and were handsomely rewarded in the market, we asked ourselves what role the portfolio mix plays in corporate performance. How does market strategy—where and how to compete—translate into M&A moves and are there rules of thumb that people should apply to bringing strategy and M&A together?
So we took our ten years of Global 1000 research on programmatic M&A and the importance of systematic deal-making and combined it with the work featured in last year’s book
, which explores how companies create economic profit over long periods of time. We built a new data set that looks at portfolio performance. We asked, what if we had an apples-to-apples view of the businesses a company was in from 2007 to 2017? What would it tell us about the need to refresh the portfolio, where companies should invest, and how M&A can be a tool in driving that portfolio transformation? Strategy Beyond the Hockey Stick
Sean Brown: How did you define portfolio moves?
Andy West: We looked at portfolios in a few different ways. We looked at a measure called the refresh rate: how much of a company’s revenue moved from one industry classification to another over a ten-year period. We also looked at momentum, or how a company’s exposure to market tailwinds changed over the decade and what impact it had on its value. Those are largely strategy levers. Then we applied an M&A lens to say, given your refresh rate and market momentum, or your ability to move toward market momentum, how was M&A used as a tool to deliver value and did it accelerate or decelerate that journey? Lastly, we looked at context, because these elements are all very context-specific: where you started from in terms of your overall industry exposure and value creation, and the levers you pulled.
Sean Brown: How did the refresh rate factor into corporate performance?
Sandra Andersen: The refresh rate is a simple concept but an important one. It is the rate at which you change the sources of revenue in your company. One company we looked at switched from being exposed to three different industries to just two. In 2007, they were in logistics, e-commerce, parcel delivery, and retail banking. By 2017, they fully exited retail banking, which before accounted for 16 percent of their revenue. That means their refresh rate was 16 percent.
Andy West: The refresh rate results surprised me because all we looked at was revenue movement from A to B, not where or how it moved. First, we found that most companies don’t move: 53 percent of our sample shifted less than 10 percent of revenue over a ten-year period. We call these companies ponds, as a metaphor for stagnancy. Another category, which we call rivers, moved 10 to 30 percent of their revenues. Then there are the rapids—companies that moved more than 30 percent of their revenues from one industry to another.
Interestingly, we found that for the ponds, the average annual total return to shareholders (TRS) was relatively close to the global market average, at 7.7 percent. However, rivers, which made up 23 percent of the sample, had an average annual TRS of 11.7 percent—by far the highest of the three groups. The performance of rapids was only 5.1 percent—well below the global market average. So, there is a sweet spot in moving revenue from one point to another.
Sean Brown: Do you have any insights about why those categories achieved their respective performance?
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Andy West: When you talk to individual companies, it becomes clear that the 11.7 percent outcome for the rivers category is a function of focus. Moving that much revenue over a ten-year period requires a tremendous amount of fortitude, alignment, and perseverance in the boardroom, within the management team, and within the company. This conviction about where you are headed is probably the substrate from which a lot of these benefits come. But it is an interesting question: if you are not moving that much, why not? Can we learn anything from the things holding us back from that conviction?
Sean Brown: What role did M&A play in the results you saw?
Andy West: On the refresh rate, we looked not only at the TRS performance but the TRS performance applied to an M&A style. We asked, what kind of M&A did the rivers pursue to achieve those results? Were they programmatic, meaning they did a lot of deals over this ten-year period that accrued to a meaningful amount of market cap of around 15 percent? Were they selective kind of hobbyists in M&A? Were they organic? We saw significant differences. River companies that used a programmatic M&A strategy returned around 13 percent. Selective M&A produced much closer to the global market average of 9 percent. Companies that made organic shifts, meaning they moved 10 to 30 percent of their revenues without M&A, were at about the average of 11 percent. There is nothing wrong with being organic, but it is quite rare. For most companies that have to get in the river and start moving revenue, programmatic M&A seems to be the best strategy.
Sean Brown: Momentum is another element you said was a factor in separating the leaders and the laggards. Can you elaborate on its role?
Sandra Andersen: Momentum is an interesting concept. Investors tend to talk about tailwinds and headwinds in the industries they play in. Momentum is effectively the underlying energy behind the industries. In the case of the company in the refresh rate example, it had exposure to three industries: logistics, post, which is your run-of-the-mill sending of letters or paying bills, and banking. Logistics saw major tailwinds because of the rise of Amazon and other delivery services. That industry drove $67 million in incremental economic profit per firm that had exposure to it in our sample. Post stayed relatively flat. But banking took a major hit between 2007 and 2017. For companies exposed to banking, $590 million was at stake.
The power of changing your exposure to momentum was impressive. The example company that changed its refresh rate also shifted its industry exposure in a meaningful way, and so changed its momentum profile. In 2017, it increased its exposure to logistics. Its exposure to post was relatively flat, but the company fully exited banking. It ended up growing its economic profit by $99 million, and $94 million of that was due to exiting an industry that had headwinds instead of tailwinds.
Divestitures fundamentally change your exposure to areas facing headwinds. Sometimes, there are better owners for companies with a headwind, but it is a point that is often overlooked and rarely quantified.
Andy West: This is an interesting illustration of the value of divestitures. We struggle as advisors to describe the value of exiting a business. Usually we talk about managerial focus, the ability to change your strategy and better apply resources. All these things are absolutely true, but in some cases, divestitures fundamentally change your exposure to areas facing headwinds. Sometimes, there are better owners for companies with a headwind, but it is a point often overlooked and rarely quantified.
Sandra Andersen: The context around momentum is also important, because momentum changes over time. What used to be a tailwind may become a headwind and vice versa, and that is not entirely cyclical. The industries with tailwinds in 2007 changed materially by 2017. The most interesting thing about that is there is a major cost to standing still. If you were on the edge of a decision in 2007 and used the same framework in 2017 to think about where you get your tailwinds and headwinds, there is a good chance that you would be wrong. And when you look back from 2017, the industries that outperformed and underperformed relative to 2007 were very difficult to predict.
Sean Brown: So, keeping the business portfolio moving is more important than knowing where things are going?
Andy West: I think it means that staying still or assuming tomorrow will look like today is a fallacy, especially over a ten-year time horizon. Yet every single day managers need to make decisions that they hope will move them toward tailwinds. Another thing I would add around momentum is, there is a big difference between strategic buyers and private equity or other investors. When you do M&A, the amount of time on diligence in an asset is very high. The amount of diligence on a market you already operate in is typically very low. I think everyone would recognize that their markets will face some headwinds or challenges over a decade but very few focus on getting aligned on those assumptions. Private-equity firms have rigorous, healthy, regular debates about market exposure and that helps them manage this risk.
Strategic players are expected to know their industry inside and out, so it is difficult for those leaders to ask basic questions such as, do I still want to be in this space? By contrast, private-equity investors reinvent every single week.
Sandra Andersen: There are a couple of other things that distinguish the perspective of a strategic and a principal investor. One is that strategic players are expected to know their industry inside and out. They have been in it for a long time, they have created value in it, so it is difficult for those leaders to ask basic questions such as, do I still want to be in this space? By contrast, private-equity investors reinvent every single week. Learning from the principal investor perspective and applying it to the corporate lens, combined with the long-term focus corporates have, is a powerful tool.
The second difference is that corporate leaders have to rally many stakeholders to get alignment around a potential change. They have investors, day-to-day managers, the board—people with a lot of divergent views. Principle investors have it easier by comparison. But there is power in the conviction you must have as a corporate or strategic player that is worth exploring.
Sean Brown: What tactics should executives employ to analyze the headwinds and tailwinds their companies face?
Andy West: This is probably the most important part of being an effective portfolio manager or trader because numerous biases prevent management from acting. Whether it is the status quo bias—thinking that where you are today is going to be where you are tomorrow—or the short-term bias of solving for short-term gains at the expense of the long run. There are interest biases and misalignment on corporate goals or just placing more importance on available information: this is what I know so this is what I will act on as opposed to compelling information you are less comfortable with. You have to cut through this noise.
Companies that do portfolio transformations effectively really focus on alignment about market and momentum. They take the time to build the fact base around industry trends, growth themes, and how those things will affect their businesses. They can constantly evaluate their portfolios as opposed to doing a snapshot once a year or every three years as part of a strategic review. They are also very clear about boundary conditions, because if you need to move a meaningful amount of your capital, it is pretty easy to do the math on how much capital you have to redeploy. You put a number on it and see, is that in line with the amount of cash you have? Is that in line with investor expectations? Is that in line with what the board expects? Being honest about these boundary conditions and getting alignment are probably the most important things to drive both your refresh rate and focus on momentum.
Sean Brown: Let’s talk about the value of changing industries to gain momentum and how corporate leaders can do it most effectively.
Andy West: Just to anchor us in an interesting data point, companies that were in the fast lane of momentum and stayed there through the decade achieved excess TRS of almost 12 percent—double the global average. That shows the effect tailwinds can have, but the number of companies in that bucket is small: less than a third of the companies we looked at. The other two-thirds had some lane changing to do. The question is, what is the cost of doing nothing? Companies that remained stuck in the slow lane had TRS of about 4 percent, or quite a bit lower than the average globally, but those that changed lanes added 7.7 percent of TRS.
When you then look at how those companies that managed to change lanes approached it, programmatic M&A again comes out on top. Among companies that systematically pursued programmatic M&A, that 7.7 percent rose to 9.4 percent. If you did selective deals, you achieved only about 6 percent. If you changed lanes via a large deal, your TRS actually dropped to 5.5 percent, which reflects the risk and wider performance spread of large transactions. That is an important message if you are thinking about using M&A as an engine to change lanes.
Sean Brown: Speaking about programmatic M&A, how does a company develop a pipeline and capability to execute many small deals? Do you have to cast a wider net?
Sandra Andersen: It’s a question we hear a lot from executives: “How do I decide between doing one big deal or doing ten small ones?” Often, the smaller deals give you access to more growth than the big deal. Some companies are used to doing a big deal every two years, that is the rhythm that their shareholders expect. To shift to programmatic M&A, they have to change how they think about their markets and empower people in functions that traditionally don’t have a strong role in M&A to play a bigger role. Being successful here requires instilling a mindset in your organization that says, “There is a lot we can do organically, but what is possible if we also think inorganically?”
Andy West: Sean, you mentioned casting a wider net. I would say cast a deeper net. The reason why I make that distinction is precision drives a lot of creativity. You should unleash your organization’s power not on doing more deals, because that just adds a tremendous amount of noise to the system, but on doing deals that fit certain criteria and follow a very specific theme. “This is the industry trend that we are betting on. This is how we will add value to that industry trend. This is the type of deal that we are looking for in terms of size, geographic location, what we are able to do.” If you can get specific on those things, you can empower people to be creative and identify a privileged deal flow.
The other challenge is that the M&A value chain, the funnel, is broken in most companies. If you are doing project-based M&A, you can muscle anything through, but if you are talking about M&A as a function that will drive growth and outperformance—just like operations, R&D, sales—you need to treat it as such. The process, from strategy to deal making to integration and operations, needs to be optimized and resourced appropriately. Companies need to make some of those investments up front to ensure that process is effectively governed and managed.
Sean Brown: What are the most important messages leaders should take away from your research?
Andy West: I would focus on three things. One, take an apples-to-apples look at your portfolio over time. For most companies, this is a shock, but it helps people understand how mobile or immobile they have been. Linking strategy to M&A and having a granular M&A blueprint that enables the strategy is also important. At 90 percent of the companies we talk to, that link is broken. Finally, build your capabilities. You have to take it seriously and be methodical.
Sandra Andersen: I think we are at an interesting intersection. I had a very insightful conversation recently with a CEO. An executive at his company had said, “It’s really hard for me to create value. I’m competing with all these private-equity players who have a ton of dry powder to put to work.” The CEO reflected and said, “Why don’t you compare your returns to that private-equity player’s as well and think about what is possible?” That’s a great mindset. As corporate, strategic M&A players, we now compare ourselves to a broader peer set and can learn a lot from investors who are also in it for the long run. The comparison has to go through to the value creation that you can achieve over a longer period. That includes some bolder M&A moves and materially changing your exposure.
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