The portfolio management imperative and its M&A implications

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While portfolio management has always been high on many executive agendas, companies could achieve solid returns without rigorous portfolio management when capital was readily available, and the economy was booming. But now, as capital becomes more constrained, many companies need to sharpen their portfolio management capabilities and rethink their approach to M&A accordingly.

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Thinking like a portfolio manager

The pandemic brought record levels of M&A activity and freed companies to explore diverse opportunities. Today, four trends are creating a new imperative to manage the portfolio of businesses more tightly.

Trend 1. Central banks’ battles against inflation raise the cost and limit the availability of capital. Especially in the US and Europe, inflation hit levels not seen for years, increasing uncertainty and volatility and leading central banks to tighten their policies. While those policies are beginning to curb inflation, the average global cost of capital across industries nevertheless jumped 2.5 percentage points—from 5.7 percent in 2021 to 8.2 percent in 2023, only slightly below its recent peak of 9.5 percent in 2022.1

Trend 2. Challenging macroeconomic conditions demand local responsiveness by globally integrated multinational companies. The center of economic gravity has been shifting for more than a decade. Over the last 15 years, China and India have accounted for almost two-thirds of global GDP growth and more than half of new consumption. The pandemic and rising tensions among nations have created some of the most challenging macroeconomic conditions in recent memory.

Trend 3. New technologies disrupt business models more rapidly. The pace of digital disruption has been increasing for decades. Two life-changing inventions—the telephone and the mobile phone—required 75 years and 16 years, respectively, to reach 100 million users worldwide. TikTok hit that milestone in nine months, and ChatGPT in just two months. The pace of AI disruption remains to be seen but seems likely to set a new record.

Trend 4. Investors increasingly prefer pure players and differentiated portfolios. In recent years, investors have pushed companies hard to focus on a single industry or business to enhance the creation and crystallization of value. Many corporations with portfolio businesses that are much more homogeneous than earlier conglomerates have streamlined their portfolios through splits or sales. But they still have to set clear synergy aspirations across the portfolio, and that requires portfolio management skills and experience that can handle a cross-enterprise perspective.

Acting like a portfolio manager

These trends put a high premium on having the right capabilities to build and manage a company’s portfolio of businesses. Empirical evidence and our experience in advising companies suggest six core capabilities that portfolio managers need to succeed in today’s challenging environment.

Capability 1: Reviewing the portfolio with brutal honesty. Effective portfolio management starts with understanding the current portfolio. Developing a holistic, unbiased perspective requires reviewing the portfolio from the perspective of an external investor or capital markets analyst. The review should challenge the company’s current industry selection and exposure and analyze the strategy and performance of each portfolio company.

Peer insights can enrich this review. Benchmarking the strategy, performance, and recent moves of each portfolio company against selected peers can deepen understanding of the current state, show what great means, and locate white spots and opportunities to improve.

This understanding can then inform decisions on how aggressive a portfolio strategy should be.

Portfolio managers need six core capabilities to succeed in today’s challenging environment.

Research has found that companies in the lowest quintile of performance improved significantly by making faster, broader portfolio adjustments. Global packaging company Amcor, for example, did just that—turning its performance around by acquiring Alcan’s packaging businesses during the financial crisis.

But, often impeded by political factors or legacy thinking, brutal honesty can be challenging. Tough discussions can be especially difficult for companies that enjoyed easy growth in the recently favorable macroenvironment, which often reduced the need to make tough decisions.

Capability 2: Locating the most promising playing fields to create value. Headwinds and tailwinds matter in selecting the right playing fields. Portfolio managers should leverage the insights gleaned from the portfolio review, consider how the winds are shifting, and predict where the greatest opportunities for value creation lie.

Because growth rates and momentum vary across industries, the portfolio momentum of a company (the sum of its moves for each business unit) looms large in TSR. We see companies that start the analysis period strong and sustain positive industry momentum doing very well. Riding the right tailwinds, they achieve annual excess TSR of 4.4 percent.2Why you’ve got to put your portfolio on the move,” McKinsey Quarterly, July 22, 2020.

But a slow start does not preclude success. Some companies whose portfolio momentum starts slowly succeed—to a reasonable extent—by moving into higher-momentum industries. They achieve excess TSR growth of 1.7 percent. Consider Apple shifting from the negative momentum of desktop computing into mobile phones or global investment holding company SoftBank reducing its telco exposure while building its software footprint.

Other companies stay in their industry, still exposed to its headwinds. Without corrective action, these companies struggle, and their average excess TSR remains negative.

Predicting wind shifts is not easy. It requires deep market understanding to spot trends, openness to both emerging opportunities and potential disruptions, willingness to communicate often uncomfortable truths, and the courage to act on those truths expeditiously, whatever action is required. But making predictions is essential to selecting the right playing fields, and that is especially important as fewer playing fields still enjoy the growth rates of the recent past.

Portfolio managers must also manage uncertainties and potential risks. Scenarios can help. Defining scenarios that employ different critical drivers supports making fact-based decisions on the right playing fields, despite uncertainty.

Capability 3: Defining the right portfolio composition to maximize value. The effort to define the right portfolio composition builds on the assessment of the current portfolio and the selection of the playing field.

The target composition should maximize the value of the overall portfolio. Every business included should have a clear rationale, such as creating synergies, gaining access to an attractive adjacent profit pool, ensuring a supply of critical inputs, or reducing risk across the portfolio. The rationale should focus on tangible and proven value creation, not intangibles and promises.

Every business should also sit at the right distance from the company’s core. Statistically speaking, acquisitions at the outer edge of the portfolio (for example, to shore up existing secondary businesses) achieve the best results. They average excess TSR of 1.6 percent.

Defining the right composition requires willingness to let a business go when it loses its rationale or the prevailing winds shift, making the business less attractive. Just securing consensus on plans to let a business go (never mind actually letting it go) can prove difficult.

While we offer no single blueprint for composing a winning portfolio, we have identified five approaches to creating value that can help companies build a strong portfolio (Exhibit 1).

We have identified five approaches to value creation.

Core centricity. Core-centric companies build and manage a portfolio anchored in their core business or operations. They gravitate toward businesses with similar value propositions, key success factors, customers, and suppliers. This similarity supports creating and then capitalizing on the scale of the portfolio and its synergies by tapping dimensions that have financial impact, such as procurement, and less tangible dimensions, such as industry and competitive insights. Think Unilever’s evolving portfolio of consumer products.

Vertical integration. Companies that have a vertically integrated portfolio move up and down the industry value chain, often to acquire attractive profit pools they already know as a customer or supplier. Upward moves typically seek to secure the supply of critical inputs, while downward moves seek to gain or protect direct access to end-customers.

A vertically integrated portfolio positions a company to capture synergies along the value chain. Some large corporations have moved so far vertically that they developed a new business that proved more attractive than their core business and evolved into a stand-alone business. Think Amazon Web Services, Amazon’s subsidiary that provides on-demand cloud computing services.

Diversification. A diversified portfolio consists of only loosely connected businesses. The typical goal is to leverage the company’s financial firepower in order to win attractive markets outside its core or to mitigate the cyclicality of its core business.

Many conglomerates attempt to manage each different business directly. Their success varies. Because investors increasingly expect synergies within a portfolio and prefer pure players focused on a single industry, more companies work to position their central organizations as “holdings” focused on selected, overarching synergy drivers and let each individual business operate independently. Capital allocation can become a major bone of contention, but success is possible. While failures are more widely known, Siemens, Virgin, and Google offer success stories.

Transformation. Most companies bring new businesses into the portfolio on top of their core operations. Even if the additions become more attractive than the core, the core usually remains.

But a few companies have boldly built a portfolio distinct from their core, planning to divest the core over time to strategically refocus or turn around the business. Perceiving the core as unattractive or even headed for extinction, they pursue profit pools with greater long-term promise, as dsm-firmenich (formerly Dutch State Mines) refocused from mining to nutrition and well-being.

Venture capital investment. Unlike typical corporate venture capital activities, this approach plays a central role in a company’s strategy. Companies make (equity) investments to develop a portfolio of (often minority) investments in and beyond the core. These companies are betting on and gaining insights into potential targets for acquisition in the medium to long term, or they are finding ways to support strategic interests, such as new customers or new capabilities.

This remains an emerging portfolio management approach, used primarily by tech players like Palantir, UiPath, and Coinbase. Its broader, long-term potential remains to be seen.

Capability 4: Rotating the portfolio toward its target composition. Evolving a portfolio from its current state to its target state requires adding and subtracting businesses, either organically or inorganically. Both approaches require making changes to overcome obstacles, such as the inertia that often perpetuates the status quo.

Research, based on prepandemic data (to exclude the impact of pandemic-related factors), found an optimal rate for rotating industries and companies. Portfolio managers should aim for a rotation that is balanced—neither too low nor too high. In a ten-year review, companies with static portfolios (having a refresh rate—also known as changing the revenue mix of the company—below ten percentage points) did not achieve meaningful excess TSR. Companies with significantly refreshed portfolios (more than 30 percentage points) achieved slightly negative excess TSR. Companies that hit the sweet spot between ten and 30 percentage points outperformed peers, with excess TSR of 5.2 percent (Exhibit 2).

Refreshing a company’s portfolio at a rate of 10 to 30 percent will create the best outcomes.

M&A transactions provide a powerful tool for rotating the portfolio rapidly. Research has shown that companies focused primarily on organic strategies and related portfolio moves, on average, underperform their peers.

But just doing deals to refresh the portfolio is inadequate. Different approaches to dealmaking produce different results. In our research, programmatic acquirers outperformed their peers who also hit the refresh sweet spot (Exhibit 3). Programmatic acquirers do at least two small and midsize deals a year and secure meaningful total market capitalization over a ten-year period. The research companies that coupled a portfolio refresh rate of ten to 30 percentage points with a programmatic approach to M&A achieved, on average, excess TSR of 6.2 percent (Exhibit 3).

Taking a programmatic approach to M&A will create the best outcomes.

During the analysis period, Boeing led the pack (excess TSR of 7.4 percent), thanks to several technology-related acquisitions (such as n2d3 Sensing, AerData, and Miro). Luxury goods company LVMH followed closely (excess TSR of 6.9 percent), thanks to its acquisitions of Loro Piana, Rimowa, and Bulgari, among others.

The research further found that companies taking a programmatic approach to M&A when moving into industries blessed with favorable tailwinds outperformed peers, with excess TSR of 3.7 percent. Their steady cadence of transactions offers continuous opportunities to strengthen their transaction and integration capabilities and update their market insights.

Rotating the portfolio to maximize its value requires looking beyond acquisitions to consider other ownership models, like partnerships that reduce financial commitments, while maintaining some control and exposure to a playing field, or divestments for those able to meet the challenges of letting go.

Telecom and energy companies, for example, sell shares in their infrastructure subsidiaries to financial investors in order to free up capital for higher-growth opportunities while maintaining control. German utility EnBW recently sold a 24.95 percent share in its high-voltage transmission grid, TransnetBW, to a consortium led by a savings bank and an additional 24.95 percent share to the German government via the KfW bank.

Divestments demand deep understanding of each business’s operations to determine the right time to trigger the divestment process. This requires looking beyond changes in general market trends to consider such triggers as a natural inflection point in the lifecycle of an asset or a looming need to make significant investments.

Capability 5: Steering the portfolio based on rigorous return logic and tailored KPIs. Effective resource allocation assigns resources to the highest-value opportunities across the portfolio, ensuring that the portfolio achieves maximum return on invested capital (ROIC), while supporting current business objectives and future growth. But many companies rely on profit instead—often because that is common practice in their industry and much simpler to calculate. They need to see that ROIC represents value added more accurately and is more relevant to valuation. Admittedly, calculating ROIC, especially below the Group level, can be challenging because it requires knowledge of each segment’s asset base, which companies do not always track. But the effort adds significant value.

Consider Microsoft. Despite entering cloud computing late, Microsoft built a cloud business worth $35 billion in 2018 that boasted market share of 17 percent (versus less than 1 percent in 2012). How did Microsoft do it? By committing significant resources—unlike IBM, which enjoyed market share of 5 percent in 2012 but grew that share to only 7 percent in 2018. Failure to commit sufficient resources likely played a large role in limiting IBM’s growth.

Effective financial steering helps every portfolio company reach its full potential by setting appropriate, ambitious KPIs and using them to measure and monitor performance. Success requires understanding the true value drivers of each company and the company’s potential (defining what good means as a basis for setting targets).

Automotive manufacturer Stellantis is a poster child for rigorous, KPI-based financial management. Its KPIs focus on net cash flow—the guiding metric for a holistic efficiency program across cost categories and a key factor in management and executive compensation decisions.

Financial steering may use KPIs like ROIC across the portfolio but should complement those metrics with KPIs tailored to each business. High-growth businesses often require metrics that reflect their value drivers and maturity, such as user/subscriber growth.

Capability 6: Deploying the operational steering model that best fits the portfolio. Effective operational steering does not require portfolio managers to participate directly in day-to-day operations. Instead, they set a framework that both captures synergies and scale across portfolio companies and maintains speed and accountability in each business.

Too much attention to either half of the equation can undermine value creation. Excessive focus on synergies can reduce the speed and agility of decision making, leaving the company more vulnerable to fast-moving competitors. Excessive freedom in managing each business can put scale benefits at risk.

Holding companies can play a key role in effective operational management. Some companies, including Samsung and Unilever, treat holding companies as active “operators” deeply involved in technology, M&A, and the strategy of each portfolio business. This model works best for setting up similar or almost identical businesses, where synergies drive significant value.

Toward the other end of the spectrum, companies like TATA and A.P.M Møller treat holding companies as a “strategic holding.” They play a coordinating role while each business retains significant autonomy. This model best fits portfolios that have moderate synergy potential as their more diverse businesses benefit from autonomy.

Getting started

Now, more than ever in the last decade, companies must get serious about portfolio management. Leaders need to understand the trends that are stoking a more volatile environment and the new imperative these trends create. Leaders can then ensure that their company has the capabilities required to manage the portfolio holistically.

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