McKinsey on Finance

Perspectives on The crisis: Timing strategic moves  1

Corporate Finance Timing is key as companies weigh whether to make strategic investments now or
and Strategy wait for clear signs of recovery. Scenario analysis can expose the risks of moving too
quickly or slowly.
Number 31, Just-in-time budgeting for a volatile economy  6
Spring 2009 A volatile economy makes traditional budgets obsolete before they’re even completed.
Here’s how companies can adapt more quickly.

The future of private equity  11

These funds face a credit-constrained world; they must adapt to thrive.

The voice of experience: Public versus private equity  16

Few directors have served on the boards of both private and public companies.
Those who have give their views here about which model works best.

The economic impact of increased US savings 22

US consumers are spending less and saving more. The economic impact of that
combination will depend upon how fast incomes grow.

Opening up to investors  26
Executives need to embrace transparency if they want to help investors make
investment decisions. But what should be disclosed?
McKinsey on Finance is a quarterly publication written by experts and practitioners in
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 1

The crisis: Timing

strategic moves
Timing is key as companies weigh whether to make strategic
investments now or wait for clear signs of recovery. Scenario analysis
can expose the risks of moving too quickly or slowly.

Richard Dobbs and It may be a nice problem to have, but even companies with healthy finances face a quandary:
Timothy M. Koller should they pursue acquisitions and invest in new projects now or wait for clear signs
of a lasting recovery? On the one hand, the growing range of attractive—even once-in-a-
lifetime—acquisitions and other investment opportunities not only seems hard to pass
up but also includes some that weren’t possible just a few years ago. Back then, buyers faced
competition from private-equity firms flush with cash, governments applied antitrust
regulations more strictly, and owners were less willing to sell. What’s more, investments in
capital projects, R&D, talent, or marketing are now tantalizingly cheaper than they have
been, on average, over the economic cycle. On the other hand, many indicators suggest that
the economy has yet to hit bottom. Companies that move too soon risk catching the
proverbial falling knife, in the form of share prices that continue to plummet, or spending
the cash they’ll need to weather a long downturn.

1  As of the end of March 2009, the present
downturn has seen five so-called bear market
rallies, which were followed by subsequent
declines. This downturn could be different
from past ones, so there could be more than
the earlier maximum of six such rallies.
As of March 2009, the market was about 18
months past its peak. The time to trough
was 32 months in the 2000 recession, 21 months
in the recession of the 1980s, 21 months in
the recession of the 1970s, and 35 months in the
Great Depression.
Timing such moves is bound to be difficult.
How quickly the world economy returns
to normal—and indeed, what “normal” is
going to be—will depend on hard-to-
predict factors such as the fluctuations of
consumer and business confidence, the
actions of governments, and the volatility of
global capital markets. Identifying mar-
ket troughs will be particularly hard because
stock indexes can rally and decline several
times before the general direction becomes
clear. In previous recessions, as many as
six rallies were followed by market declines
before the eventual troughs were reached.1
During the current downturn, market indexes
fluctuated by an average of 20 percent
each month from November 2008 to
March 2009.
Given the uncertainty, executives may easily
give up in frustration, hunker down, and
await irrefutable evidence that the economy
is turning around. But this approach could
be a recklessly cautious one. Instead,

2 McKinsey on Finance Spring 2009
Exhibit 1
Profits revert to the mean
Corporate profits fluctuate around a
stable percentage of GDP over the long term.
2  Managers using this approach for actual
strategic decisions would need to refine it by
country, economic sector, or both, or to
reflect the peculiarities of investments such as
capital, R&D, or marketing expenditures,
as well as competitors’ moves and possible
changes to regulators’ policies.
3  We’ve excluded financial institutions from
this analysis because their recent profits have
been highly volatile—way above average
in 2005–06 and way below average in 2007–08.
The inclusion of these companies would not
change the results but would make it harder to
interpret the long-term trends.
MoF 2009
Market discount
Exhibit 1 of 5
Glance: Corporate profits fluctuate around a stable percentage of GDP over the long term.
Exhibit title: Profits revert to the mean
Ratio of nonfinancial corporate profits to GDP,1 %
7
6
5
4
3
0
1968 1971 1974 1977 1980
1Includes all US-based nonfinancial companies with real revenues greater than $100 million. Profits are earnings before
interest, taxes, and amortization (EBITA), less estimated taxes.
executives must make educated decisions
now by weighing the risks of waiting or
of moving too early. And while better timing
of acquisitions, and therefore the prices
paid for them, can make a big difference in
their ability to create value, the best way
to minimize risk is to ensure that invest-
ments have a strong strategic rationale.
Analyzing scenarios
Executives considering whether to jump
back into M&A or to make other strategic
investments now must understand what
lies behind earnings and valuations. To illus-
trate the risks, we conducted an analysis
of a hypothetical acquisition. Real US market
and economic data allowed us to build
a range of scenarios embodying different
assumptions about future US economic
performance.2 We found that even scenarios
assuming conservative levels of market
performance (as indicated by the experience
of past recessions) suggest that many
industries may be reaching the point when
acting sooner would be as appropriate
Median = 4.9
1983 1986 1989 1992 1995 1998 2001 2004 2007 2008
as—if not better than—acting later. Managers
who wait may be failing to maximize the
creation of value.
The primary drivers of capital markets are
levels of long-term profits and growth,
so we define our scenarios in those terms.
Long-term profits are tightly linked to
the economy’s overall performance: over
the past 40 years, they have fluctuated
around a stable 5 percent of GDP3 (Exhibit 1).
It’s therefore reasonable to assume
that a return to normal for corporate profits
would mean a return to their long-term
level relative to GDP and that long-term
growth in corporate earnings will
also be in line with long-term GDP. For our
scenarios, we assume that US corporate
profits will revert to some 5 percent of US
GDP, although that estimate could be
a conservative one if the trend to higher
profits in the years leading up to the
crisis resulted from a structural change in
the economy. One can tailor this analysis
to the circumstances of individual industries
 The crisis: Timing strategic moves 3

4  See Charles Atkins and Susan Lund, “The
economic impact of increased US savings,” in
this issue.
5  For more on our model of market valuation, see
Marc H. Goedhart, Bin Jiang, and Timothy
Koller, “The irrational component of your stock
price,” mckinseyquarterly.com, July 2006.
by developing a more detailed understand- conditions the market as a whole has a price-
ing of the linkages among GDP, revenue, to-earnings ratio ranging from 15 to 17.
and earnings. We used that multiple in our 2.5–3.0 percent
growth scenario and a lower one (14 to 16)
Growth in the labor force and productivity in our 2.0–2.5 percent growth scenario. Both
drive the long-term growth of real GDP. multiples are consistent with a discounted
Since it has historically grown in the range cash flow valuation of companies.5
of 2.5 to 3.0 percent a year and returned
to its former trend line in all US downturns Under the scenario that most resembles the
from the Great Depression onward, with course of previous recessions (no permanent
no permanent loss in GDP once the economy loss of GDP and 2.5 to 3.0 percent long-
recovered, our base scenario assumes that term real growth), the stock market’s normal
both of those trends will continue. (We also value in early 2009 (as measured by the
examined scenarios reflecting the possibility S&P 500) would have been about 1,200 to
that long-term GDP growth might be 1,350. This implies that the stock market
lower as a result of changing demographics or was trading, as of the end of March, at a dis-
MoF 2009 productivity growth; or that GDP
declining count of about 30 to 40 percent from
Market discount
might fall permanently by as much as 5 or its normal value (Exhibit 2). The discount
Exhibit
10 2 ofas
percent 5 a result of a permanent increase is much lower under the more negative
Glance:
in The marketsavings.
US household today is 4trading at aindiscount
) Finally, normalusing scenarios,
even conservative scenarios
but even in theofworst
GDP of them—
loss and growth.
Exhibit title: Estimating stock market value

Exhibit 2 Scenario, % Normal level, Market discount,

S&P 500 index from normal level, %
Estimating stock Assuming this level of . . . plus this level of equivalent
market value permanent GDP loss . . . long-term real growth

0 2.5–3.0 1,200–1,350 30–40

The market today is trading at a discount
using even conservative scenarios of GDP loss 0 2.0–2.5 1,100–1,250 25–35
MoF 2009
and growth. 5 2.5–3.0 1,100–1,250 25–35
Market discount
1,050–1,200 20–30
Exhibit 35 of 5 2.0–2.5

Glance: 10 the market is consistent1,000–1,150

The current discount of2.0–2.5 with those during past recessions. 15–25

Exhibit title: Discounts in earlier recessions

Exhibit 3 Discount from stock market trough to normal value, %

Discounts in earlier
Recession Range of discounts
recessions
1929–32 59–68
The current discount of the market is consistent
with those during past recessions. 1973–74 28–30

1980–82 39–51

1990–91 21–25

2000–02 20–25
 4 McKinsey on Finance Spring 2009

an unprecedented 10 percent decline and downturn, the old relationships among

6  This analysis looks at share prices relative
to the trough. In the 2000–01 recession, it
took longer for the stock market index to
return to its prior peak because that peak was
based on unsustainably high stock prices
in the technology sector.
a limited recovery—the market is still valued
at a small discount. You would have to
expect a permanent GDP reduction of around
20 percent to see the March S&P 500 index
level (around 800) as normal. A similar
analysis for the performance of the stock
market in previous recessions finds that
at the trough of deeper recessions, it typically
trades at a discount greater than 30 percent
from its normal value (Exhibit 3).
Current stock prices can be interpreted in
several ways. Perhaps the market is
experiencing levels of pessimism typical of
previous downturns, with the same
opportunities for investors and acquirers.
Or it may assign a reasonably high
probability to a large, permanent GDP
MoF 2009which can’t be ruled out even
decline,
Market
though discount
it didn’t happen in past downturns
Exhibit 4 of 5
since, and including, the Great Depression.
Glance:
Finally,Historically, the marketnature
given the different returns of
from its trough very
this
Exhibit title: Speedy recovery
GDP, profits, and stock prices may no longer
hold, or in the future investors will demand
higher returns from the market.
Timing the recovery
Strong companies deciding whether to move
forward now with acquisitions or major
capital projects should weigh further data
on the timing of a stock market recovery.
One common analysis calculates how many
years must pass before the market will
return to normal, assuming growth at the
historical long-term average rate (10 per-
cent a year). In past recessions, however, the
stock market returned from the trough
much more quickly, with cumulative returns,
over the two years that followed it, of
50 percent to 130 percent (Exhibit 4).6 If this
pattern holds in the current downturn,
there’s a real danger that companies wait-
ing too long will miss the upside of
the quickly.
rebound.

Exhibit 4 Pace of recovery, cumulative total

Speedy recovery returns to shareholders (TRS), %

Recession 1 year 2 years 3 years

Historically, the market returns from its
1929–32 129 123 176
trough very quickly.
1973–74 46 85 79
MoF 2009
1980–82 66 79 113
Market discount
1990–91 34 48 72
Exhibit 5 of 5
Glance: Compared with2000–02 36
investing now, a company would 50
earn a higher net 63
present value from a "wait and see" strategy only if it got the timing just right.
Exhibit title: Now, or later?

Exhibit 5 Net present value (NPV) of alternative investment decisions

Now, or later?
Invest Invest in Invest in
Compared with investing now, a company now 6 months 12 months
would earn a higher net present value Market at trough now 100 55 38
from a ‘wait and see’ strategy only if it got
the timing just right. Market declines by further 100 122 104
20% over next 6 months
The crisis: Timing strategic moves
Such an analysis of earnings and stock mar-
kets can help companies evaluate the pros
and cons of waiting or acting now. Assume,
for ease of analysis, just two scenarios:
either the market is currently at its trough,
or it will decline by an additional 20 per-
cent, reaching its trough in six months, so
that the S&P 500 falls from its current
level to around 640. A company attempting
to time the market for a planned acquisi-
tion could make its move at any point, but
let’s assume three: it invests now, in six
months, or in a year. For the purposes of our
analysis, we assume that the market and
the economy will return to normal in three
years under either scenario, though clearly
these are not the only possibilities.
In this simplified example, only timing
an investment perfectly (in six months under
scenario two) would produce a net present
value (NPV) meaningfully better than the one
resulting from investing now (Exhibit 5).
If a company didn’t hit the timing precisely,
it could easily end up with a much lower
NPV. This type of approach can also establish
what you’d have to believe for “wait and
see” to be the right strategy, but the analysis
must be tailored to a specific industry or
The authors would like to thank Bing Cao, Ezra Greenberg, John Horn, and Bin Jiang for their
contributions to this article.
Richard Dobbs (Richard_Dobbs@McKinsey.com) is a partner in McKinsey’s Seoul office, and Tim Koller
(Tim_Koller@McKinsey.com) is a partner in the New York office. Copyright © 2009 McKinsey & Company.
All rights reserved.
5
country and to the type of investment,
such as M&A , capital expenditures, R&D,
or marketing. The approach can also be
tailored to analyze other risks, such as the
possibility that competitors could preempt
strategic moves, that regulators could
become less accommodating, that companies
could run out of capital, or that other,
more favorable, investment opportunities
might become available should the
downturn deepen.
Much uncertainty surrounds the timing of
the downturn’s end, but companies waiting
for clear evidence of a turnaround may
find that they have been recklessly cautious
and missed once-in-a-generation opportuni-
ties to acquire or invest. Executives con-
sidering when to make their next strategic
moves can learn much by examining the
course of previous downturns—particularly
how valuation levels were related to
corporate earnings and how valuations and
earnings were related to the economy
as a whole—and by weighing the risks of
moving too early or too late. MoF
6

Just-in-time budgeting
for a volatile economy
A volatile economy makes traditional budgets obsolete before they’re
even completed. Here’s how companies can adapt more quickly.

Mahmut Akten, Most companies find budgeting a formidable challenge even under stable conditions.
Massimo Giordano, and Managers often spend significant amounts of time on it, only to be dismayed by how little
Mari A. Scheiffele value comes from four to six months’ effort. Under volatile conditions, when economic
forecasts change from week to week, developing one reliable budget to coordinate business
units and track performance for an entire fiscal year is very difficult. Following the
traditional budget process may even be unproductive.

There’s no easy fix, particularly for very large
corporations, and companies that have
tried to solve the problem don’t have much
of a track record. Executives can, however,
take several measures to make the process
more effective: for instance, scenario
planning, zero-based budgeting, rolling
forecasts, and quarterly budgeting.
Central to all of them is a substantial increase
in the CFO’s role and a radical speeding up
of the budgeting process.
New approaches
For many companies, allocating or with-
holding resources quickly and efficiently may
be the only way to navigate today’s
very tough environment. A completely new
approach to the budget process is often
needed. The list that follows isn’t exhaustive,
nor are the activities on it mutually
exclusive. In some combination—depending
on the business, size, complexity, and
culture of the organization involved—they
can help companies improve the budget
process.
1. Scenario planning with trigger events
In more stable times, the budget process is
typically an exercise in consensus build-
ing—a lengthy and difficult effort to generate
a single view of the future to guide a com-
pany’s investments and rewards over the
coming year. While many management
teams speculate informally on how their busi-
nesses will evolve, few actively debate a
number of scenarios or undertake the con-

1  See Richard Dobbs, Massimo Giordano,
and Felix Wenger, “The CFO’s role in
navigating the downturn,” mckinseyquarterly
.com, February 2009.
2  Zero-based budgeting, first named by Peter
Pyhrr in the Harvard Business Review (1970),
gained prominence during the 1970s,
particularly when President Carter introduced
zero-based budgeting into the federal budget
process, in 1977. See Peter A. Pyhrr, “Zero-base
budgeting,” Harvard Business Review, 1970,
Volume 48, Number 6, pp. 111–21.
crete short- and long-term financial
analyses that would make such a debate
meaningful. The process therefore isn’t
agile enough to respond to sudden, dramatic
changes in the economy. Any revisions to
the budget as the year unfolds are reactive
and backward focused rather than
reflecting an informed view of alternative
future scenarios.
Executives at some forward-thinking com-
panies, however, have not only formally
developed concrete macroeconomic and
business scenarios, including some
considered extreme,1 but also modeled the
implications of each scenario for their
own businesses and customers, as well as for
competitors. At the end of the process,
these companies adopted a single budget,
but they supplemented it with concrete
alternative financial statements and business
plans based on plausible future scenarios.
This approach lets companies build flexibility
into their cost structures—for instance,
through the outsourcing of services or the
use of contingent purchasing contracts—
so they can more easily shift from the primary
budget if necessary.
Furthermore, these companies have also
identified the handful of events—say,
a change in the availability of short-term
funding, the bankruptcy of major cus-
tomers or suppliers, or a specific market share
decline—that would trigger a shift from
the primary scenario to an alternative. CFOs
and the finance function monitor these
trigger points and stand ready to alert the
executive team if risk levels breach well-
defined thresholds. The entire executive team
would then immediately implement the
predetermined contingency plans.
At one global health care products company,
for example, executives monitor sales of
specific premium product lines, a key indi-
7
cator of the future course of revenues
and profitability. When the executives saw
that customers were buying fewer pre-
mium products and greater numbers of basic
ones—or none at all—they shifted to a
different budget and withheld part of the
company’s planned second-half 2009
spending until the first-quarter numbers were
clear. This company is actually growing
and doing quite well, but when its trigger
points suggested weakness in a key indica-
tor, executives quickly adapted their approach
to resources and investments for the rest
of the year.
It’s important to note that the CFO need
not apply contingency plans to the whole
organization; changes can be limited to
specific business units, while others continue
to implement the current budget. Managers
of the affected units must then develop and
apply new budgets and incentives and
reconsider hedging strategies, capital allo-
cations, and funding.
2. Zero-based budgeting
Amid today’s extreme uncertainty, most
companies are cutting discretionary expendi-
tures. The typical budget process is not,
however, designed to make managers rethink
their business models if the recession
persists or shifts the economy in a fundamen-
tal way. On the contrary, many current
budgets are anchored in past ones, with incre-
mental changes to adjust for inflation or
specific product trends.
Zero-based budgeting was developed during
the inflationary environment of the mid-
1970s to avoid precisely this trap.2 It starts
the process wholly from scratch, assuming
different end points for different industries
and businesses, such as a 30 percent smaller
overall market or a modified organization or
portfolio. Operating and capital expendi-
tures are then prioritized according to their
8 McKinsey on Finance Spring 2009
alignment with the company’s strategy
and their expected returns on investment.
Breaking down the budget into such
discrete funding decisions makes it easier
for the CFO and other senior executives
to choose among competing claims on scarce
resources.
Consider, for example the telecom industry,
which has changed significantly in the past
decade. Most incumbent operators project
lower revenues in the near future but must
still invest significantly in next-generation net-
works to be viable in the long term. To
balance these competing demands, a Euro-
pean telecom player recently started a
zero-based budgeting process by disaggre-
gating its expenditures into logical decision
units addressing different types of expenses,
such as new capital expenditures (say,
building a third-generation network) or main-
tenance. Each decision unit’s capital
expenditures (such as those for meeting
license requirements or growth in a
targeted city) were then classified as “keep,”
“discuss,” or “cut.” Finally, executives
based the priority of each capital expendi-
ture on its financial returns and alignment
with the company’s strategy. After only a few
iterations, the company reached its target
capital expenditure level—a 20 percent reduc-
tion, which nonetheless supported invest-
ment in future growth.
Clearly, this approach can add a couple of
months to an already long process. We
therefore recommend zero-based budgeting
only for areas promising the highest
potential savings—for instance, capital expen-
ditures, certain operating expenditures,
and very focused costs, such as procurement.
It’s useful to identify a company’s biggest
expenses and which of them can realistically
be cut. Some costs, such as those for employ-
ees or a branch network’s real estate,
are relatively inflexible and hard to change.
Others, such as advertising or most capital
expenditures, could be reset from scratch
every year.
3. Rolling forecasts
Most companies prepare informal earnings
forecasts on a monthly or quarterly basis,
usually in a planning group within the finance
department. These forecasts, seldom tied
to active decisions about the budget’s man-
agement, almost always involve nothing
more than updated projections of year-end
values. As a result, the company-wide
process is opaque, no one is accountable for
the outcome, and projections for the rest
of the year are less and less valuable as it
progresses. At one global Internet provider,
this haphazard approach meant that some
business units projected meeting their
full-year earnings targets despite growing
gaps between the forecasts and the
actual numbers. The finance department,
trying to explain the actual numbers
and to propose ways of closing the gaps,
found itself caught between the CEO
and the chief operating officer (COO) on
the one hand and the heads of business
units on the other. By the time the business
units acknowledged that they would
miss their targets, it was too late to take
compensatory action.
Some leading companies have formalized a
process that involves rolling 12- to 18-month
forecasts for the most important financial
variables. This approach increases the visi-
bility of the process and accountability
for it so that CFOs can act when forecasts
start to diverge from actual performance.
In companies we’ve observed, the CFO man-
ages the process, convening business leaders,
the CEO, and the COO each month or
quarter to identify gaps and discuss how to
close them. Typically, a good, hard debate
among business units examines their
performance and generates a way forward.

3  For a perspective on how to reorganize
performance cells by implementing a value
creation approach, see Massimo Giordano and
Felix Wenger, “Organizing for value,”
mckinseyquarterly.com, July 2008.
Just-in-time budgeting for a volatile economy
For companies that aren’t accustomed to
this kind of collaboration on their budgets, it
represents a big cultural change: managers
are accountable for their promises and must
collectively adapt to the fast-changing
macroeconomic climate. At the global Internet
provider, simply getting everyone into
the same room to discuss the growing gaps
between forecasts and performance was
a challenge. The CFO had to orchestrate a
mind-set shift so that the managers of
different units rallied around one another
to solve the problem.
4. Quarterly budgeting
In periods of extreme uncertainty, some
companies may need to set aside their long-
term goals and concentrate on the next
three months. Companies under that much
stress, especially those attempting a turn-
around, ought to abandon annual budgeting
and switch to a more tactical quarter-by-
quarter process. These companies should
focus on cutting costs and on managing their
working capital and short-term financial
needs, not on developing annual revenue or
profit guidance. The quarterly approach
allows companies to allocate their resources
in real time, to make better forecasts, and
to review their performance at the end of each
quarter and therefore identify and address
problems more quickly.
In the longer run, quarter-by-quarter
budgeting can stunt growth by overempha-
sizing the short term. CFOs and their
companies should return to focusing on the
long term, with annual budgets, as soon
as possible.
General improvements
Whether a company sticks to its traditional
approach, implements one of the new
ones described above, or combines them
to meet its own needs, it should also improve
the budgeting process as a whole. These
9
improvements take time to implement, but
when carried out from the top down,
by the CFO and other senior executives, they
can limit the amount of cumbersome work
an organization must undertake at the end
of each quarter.
Key metrics
At a time when priorities and, indeed, the
very business environment itself are
changing rapidly, companies must review
their key performance indicators (KPIs).
Today’s focus on cash and risk management
requires a reevaluation of metrics relevant
to the quality, liquidity, and returns of assets
and a shift away from the revenue and
growth indicators emphasized in recent years.
Often, the new focus just means reprior-
itizing performance metrics when budgets
are prepared or incentive systems linked.
Executives must also constantly assess the
quality and health of all performance
cells3 in order to detect any deterioration in
key metrics—such as the number of
orders or customers or the churn rate—
more quickly.
A shorter process
The time the budget process consumes
must fall dramatically: it can no longer start
in September and go on until February or
March, as it does at many companies. They
can speed up the pace sufficiently only
by substantially increasing the amount of
top-down guidance from the CFO, syn-
thesizing tracked KPIs, and eliminating formal
bureaucracy. In the usual approach,
for example, top management introduces a
budget that descends to the front line for
fleshing out in detail and then returns to the
top for finalizing. One way CFOs could
accelerate the process would be to conduct
negotiations between top managers and
the divisions during the first iteration and
leave the divisions to manage the budget’s
implementation by the front line.
10 McKinsey on Finance Spring 2009
Level of detail
If an existing budget needs updating rather
than rewriting, a company doesn’t have
to update it at the original level of detail.
Business unit managers in many companies
imagine that deep specifics and full
financial statements reflect greater accuracy.
At the level of individual units, for any
given year, it’s hard to disprove that idea.
Many business unit leaders produce a
conservative budget, however, so that they
are sure to meet or exceed expectations at
the year’s end. When such unit-level numbers
are aggregated, the resulting company-wide
numbers are wildly off the mark. Knowing
that business unit managers are typically
too conservative, executives may pad their
forecasts, making the end product all
the more unreliable. On occasion, however,
individual business units are too aggressive,
and that’s why one global construction
company, for example, missed its aggregate
production targets for more than a decade.
Less data can actually be more meaningful
data if executives restrict the projections
of business units to top-line estimates.
Incentives
Any time a budget is modified, changes to
forecasts and expectations can affect manage-
ment’s compensation levels and bonuses.
Such incentives are typically aligned with
specific levels of budget line items, such
as volume forecasts, that companies may have
to change so they can adapt to volatile
Mahmut Akten (Mahmut_Akten@McKinsey.com) is a consultant in McKinsey’s Istanbul office, Massimo
Giordano (Massimo_Giordano@McKinsey.com) is a partner in the Milan office, and Mari Scheiffele
(Mari_Scheiffele@McKinsey.com) is a partner in the Zurich office. Copyright © 2009 McKinsey & Company.
All rights reserved.
economic conditions. Those conditions can
render bonuses null as a performance
incentive anyway. Why strive to meet a
volume target, for example, if the
downturn makes it unlikely that you will?
Updating incentives when budgets change
appeals to some people but may create great
complexity in practice. Negotiating new
targets and resetting incentives can politicize
the budget process as managers maneuver
to impose their own mind-sets: lowering
targets to beat them comfortably. New
targets and incentives also distract attention
from the need to review the business plan
and the allocation of resources.
A more appropriate way of structuring
incentives is to start using relative targets—
such as market share, cost metrics, or health
indicators (say, customer satisfaction)—
excluding uncontrollable variables. Such
targets (for instance, the cost of an
airline seat exclusive of expenses for fuel)
are relatively insensitive to macro-
conditions and thus motivate managers to
build the business no matter which
scenario comes to pass.
These times of economic volatility
call for a faster budget process more closely
connected to strategy through the CFO’s
active intervention. Despite the special
challenges, companies can greatly improve
their chances of coping with the uncertainty
they now confront. MoF

Conor Kehoe and
Robert N. Palter
1 Even the venerable 2 percent management
fee and 20 percent carry structure may be
vulnerable as limited partners respond to the
current crisis and the weakening perfor-
mance of buyout funds.
2 Earnings before interest, taxes, depreciation,
and amortization.
11
The future of private equity
These funds face a credit-constrained world; they must adapt to thrive.
Is there life after leverage for private equity? The global financial system is struggling to
work its way out of disaster: banks are flat on their backs, equity markets have plummeted,
and a business culture built on leveraged portfolios has come unhinged. The future of
private equity is one of the more intriguing questions for corporate finance and corporate
governance alike.
It may seem hard to be sanguine about Yet the prognosis isn’t entirely bleak. In
the sector’s long-term prospects. With returns our experience, the sector’s strengths have
under pressure, private-equity firms come not from its use of leverage but
will struggle to perform.1 The megabuyouts from its ability to marshal resources, both
(deals valued at more than €5 billion) human and financial; its strong incentives
that absorbed so much of the sector’s capital to adapt quickly; and its active ownership.
since 2004 are nowhere to be found. Some Opportunities do exist: megadeals may
limited partners—in particular, sovereign- have vanished, but not medium-sized or all-
wealth funds—have shown a willingness to equity deals. Moreover, private-equity firms
bypass private-equity firms and strike out are well poised to stand in as a new class of
on their own. With an estimated $470 billion shareholder in the overturned public-
in committed but unused funds, the sector equity market, in developing economies, and
faces an enormous challenge just finding in financial institutions. Despite the current
ways to invest. Finally, its portfolio companies, difficulties, it bears remembering that the best
with their high debt levels, may become private-equity firms have persistently
financially distressed and default in the event outperformed both their private-equity
of only small downturns in sales and counterparts and the public-equity markets,
EBITDA.2 Recent bankruptcies of several in good times and bad, over the past two
private equity–backed companies hint decades. The winners will be firms with the
at how dark the future may be. wits to adapt to a much harsher environment.
 12
Contrary to common perceptions, the challenges
portfolio companies face do not result from levered risky
investments
3  See Alexander Groh and Oliver Gottschlag,
“The risk-adjusted performance of US buyouts,”
Groupe HEC , Les Cahiers de Recherche,
Number 834, January 2006; and Viral V. Acharya,
Moritz Hahn, and Conor Kehoe, “Corporate
governance and value creation: Evidence from
private equity,” working paper, January 2009.
4  See Gregor Andrade and Steven N, Kaplan,
“How costly is financial (not economic) distress?
Evidence from highly leveraged transactions
that became distressed,” Journal of Finance,
1998, Volume 53, Number 5, pp. 1443–93.
McKinsey on Finance Spring 2009
Managing the downturn through external support networks—than
Right now, the first priority for the vast they had in previous downturns. In the
majority of private-equity firms is mitigating short term, all the committed but unused
the recession’s impact on portfolio capital could be turned to advantage
companies and, to some extent, on cash- if it were deployed in overstretched portfolio
strapped limited partners. companies. And the lessons of the 1990
downturn, when the debt levels of private
equity–owned companies were much
higher, suggest that even if such companies
go into bankruptcy, they are more
valuable than they would have been without
private-equity ownership,4 despite the
costly process of managing the reorganiza-
Yet contrary to common perceptions, the tion. That’s good news for employees
challenges portfolio companies face do not and customers, if not equity investors.
result from levered risky investments.
The average private equity–owned company, There will of course be failures, even in
despite its higher initial leverage, is only the short term, and each private-equity firm
slightly riskier than an average public-market should move aggressively to reduce the
company. Indeed, although the typical threats in its portfolio’s cash, cost, and risk
leveraged buyout starts with more than twice position and to mitigate their effects.
the leverage of its public-market counter- What’s more, since exits are now very difficult,
part, its leverage is often lower on exit.3 In it will be necessary to learn how to manage
addition, research shows that private- portfolio companies beyond the normal
equity firms tend to buy steady companies three- to four-year cycle, without letting
whose volatility, before the extra leverage, returns slip. Some private-equity firms
is about two-thirds that of companies listed are already addressing this problem by
on public markets. Portfolios tend to be simulating an internal sale when the initial
concentrated in companies and sectors less value creation plan runs its three-year
susceptible to the effects of booms and course—in other words, forcing themselves
busts—a critical condition for supporting the to take an outsider’s perspective to identify
higher initial leverage the private-equity missed opportunities. These firms review such
model has typically deployed. Not surprising, companies and their industries and
private-equity portfolios, though spread appoint new internal teams, if necessary,
across most industries, are underrepresented to develop another value creation plan,
in the battered construction, automobile, to change management, or to conduct a due-
and financial-services sectors. We expect the diligence process as if the firm were buying
revenues and before-interest earnings the business anew.
of private equity–owned companies will fall
less than those of companies listed in Finally, many private-equity firms that
public markets. expanded their staffs and opened new offices
during the recent investment surge must
Moreover, private-equity firms also enter now make do with less. Even the top
this downturn with much stronger performers can expect smaller funds and
operational capabilities—either in house or lower fee income in the next few years.

5  Private equity–owned companies aren’t always
marked to market, yet the investors’ public
securities are—so the value of the latter appears
to have declined much more.
6  See Viral Acharya, Conor Kehoe, and Michael
Reyner, “The voice of experience: Public versus
private equity,” in this issue.
The future of private equity
Managing investors
Private-equity firms will need to manage
their relationships with investors carefully.
Limited partners are not protected from the
general downturn. Some are having difficulty
meeting their commitments to provide
funds—in particular, because reduction in the
value of quoted equities has mechanically
increased the percentage of assets allocated to
private equity.5 Further, the difficulty of
exiting from portfolio companies means that
money from private-equity funds is flowing
back much more slowly than might have
been expected. Some supposedly liquid assets,
which limited partners could otherwise
have sold to finance private-equity cash calls,
aren’t nearly as liquid as had been assumed.
Except in extreme circumstances, limited
partners probably won’t default—they’d risk
losing the cash they have already subscribed
and access to top funds—but they may
pressure private-equity firms to reduce fees,
commitments, or both if investment
opportunities don’t open up soon. In the
near future, limited partners may also
demand improved terms before subscribing
to new funds and invest lower amounts in
them. Private-equity firms should act strate-
gically in these situations by giving some
limited partners more flexible terms if they
experience short-term difficulties. This
approach could play an important role in
maintaining relationships with attractive
long-term funding sources.
A relatively new class of private-equity
investor—sovereign wealth funds—needs
particularly careful nurturing. These long-
term investors constitute a very large group
in the aggregate, with $3 trillion in total
assets in 2007 and a projected $8 trillion in
the next decade. By the end of 2007,
they had committed about $300 billion to the
private-equity sector, but they can bypass it
13
entirely if they wish by investing their cash
directly. Their recent direct investments
already include the stakes that the govern-
ment of Singapore and the Kuwaiti
Investment Authority took in Western banks
last year, as well as the holdings of direct-
investment arms such as Mubadala Develop-
ment (Abu Dhabi) and Temasek Holdings
(Singapore). It can be tricky for sovereign-
wealth funds to be assertive and active
owners, though, especially in Western com-
panies. Investing through private-equity firms
raises fewer political hackles, but the firms
will need to sharpen their value proposition.
By and large, the sector is well prepared
for these challenges. Active ownership is its
biggest competitive advantage over
companies in the quoted market: the best
private-equity firms are more effective
because of their stronger strategic leadership
and performance oversight, as well as their
ability to manage key stakeholders.6 Firms
must continue to hone these skills and
to ensure that they are applied consistently.
Even the better firms have a great deal of
opportunity for improvement—particularly
in attracting partners with the right operating
skills, getting a better balance between
financiers and active owners, adding people
who have experience in downturns, and
reviewing the current portfolio with the rigor
traditionally devoted to new investments.
Finding new ways to invest
In the long term, the math of deploying the
industry’s $470 billion in committed but
uninvested capital looks challenging. Forty
percent (about $240 billion) of the equity
capital that private-equity firms invested
from 2004 to 2007 financed 55 megadeals
(2 percent of all private-equity deals).
It could take a long time for megadeals to
reemerge if recently completed ones
perform less well than quoted companies
 14
7  After the late-1980s collapse of the junk-
bond market, the $25 billion (enterprise value)
RJR Nabisco deal of 1998, at more than
90 percent leverage, wasn’t topped until 2006.
8  The purchase of stock, at a discount to the
current market value per share, by a private-
investment firm, mutual fund, or other
qualified investor for the purpose of raising
capital for the issuing company. The
discount is needed when companies seek to
raise significant capital or when there
is an illiquidity provision in the agreement.
McKinsey on Finance Spring 2009
do.7 And even if the core midmarket leveraged
buyout comes back quickly, it probably
won’t absorb all the available capital, so the
sector must look for new investment
opportunities. Given its current market
share—the value of the capital that private
equity controls equals only some 2 to 3 per-
cent of the total value of all the equity
quoted on public markets—more opportu-
nities for active owners exist, though
few are proven.
Private investment in public equity
One way for private-equity firms to use their
ownership expertise would be to channel
some of the capital under their control into
public companies through private investment
in public equity (PIPE)8 and to assert
themselves, even without complete control,
on the boards of those companies. The
benefit to a public company’s executives—
besides quick access to capital—would
be the commitment of a shareholder that will
be stable in the medium term and perhaps
provide them with private equity–style
incentives to ensure that the company acts in
the interest of shareholders. Private-equity
firms will need to learn how to operate in
public companies, however. Private-equity
board members can help a public company
focus on shareholder value, as well as offer
their own time and the resources of their
firms and networks. But they have much to
learn from their public-market colleagues
about communicating with a dispersed body
of stakeholders and compliance with
public-market regulation.
Developing markets
Companies in developing markets enjoy
favorable demographics and are opening
up to the global economy. Nonetheless,
immature regulatory and legal systems, along
with a lack of transparency, can bedevil
outside investors who lack connections to
the companies in which they invest.
Although those companies may have local
sources of new money, they often lack
the value-adding capital that experienced
private-equity firms can offer. In particular,
family-controlled companies that aim to excel
internationally see them as a way to
gain expertise previously available only from
multinationals. Private-equity firms can
deploy their managerial and sectoral know-
how to help such companies, family
owned or otherwise, and to provide close
local supervision on behalf of the firms’
international investors. These companies are
a very important long-term outlet for
private-equity firms, though from 2003 to
2007 their investments outside Europe
and North America accounted for only
around 5 percent of their $630 billion of
invested equity.
Financial institutions
In the past, private-equity firms seldom
invested in financial institutions, like banks
and insurance companies, which are
already leveraged to very high levels set by
regulators, as the current banking crisis
has clearly demonstrated. Yet today such
institutions provide a fascinating oppor-
tunity: they may be cheap, their productivity
varies widely, and recent events show that
they clearly need more intense governance
and will face demands that they obtain it.
The board of an average bank, for example,
could add considerable value by resolving
to use a private equity–like approach
to improve the bank’s operational and risk-
management practices. Measuring the
value of so-called toxic assets presents real

9  Allocations to newcomers in emerging
markets may offset this concentration in the
developed world.
The future of private equity
difficulties to a private-equity transaction,
however, and these risks may be too
great unless the authorities hive off such
assets to a “bad” bank. Private-equity
firms might then be tempted to infuse the
“good” institutions with much-needed
private capital—and $470 billion of it gives
the authorities a strong incentive to
explore this route.
The alternative
If the private-equity sector can’t identify
new channels for investment, it may have to
contract. In any event, it will probably
concentrate. The top ten firms controlled
30 percent of the sector’s capital in 2008,
just as they did in 1998. Since then, the idea
Conor Kehoe (Conor_Kehoe@McKinsey.com) is a partner in McKinsey’s London office, and Robert Palter
(Robert_Palter@McKinsey.com) is a partner in the Toronto office. Copyright © 2009 McKinsey & Company.
All rights reserved.
15
that private equity has persistent outperfor-
mers and underperformers has been
analytically substantiated and taken root.
We therefore expect that the more dis-
criminating limited partners will concen-
trate European and US investments in
fewer private-equity firms and that many
firms will disappear when they can’t
raise their next round of funds.9
Private equity’s core value proposition—
superior representation to maximize returns
for the long-term investor—remains sound.
But private-equity firms that hope to survive
must adapt to a new world. MoF
 16

The voice of experience:

Public versus private equity
Few directors have served on the boards of both private and public
companies. Those who have give their views here about which model
works best.

Viral Acharya, Conor Kehoe, Advocates of the private-equity model have long argued that the better private-equity
and Michael Reyner firms perform better than public companies do. This advantage, these advocates say, stems
not only from financial engineering but also from stronger operational performance.

1  We interviewed directors who had, over the
past five years, served on the boards both
of FTSE 100 or FTSE 250 businesses and private
equity–owned companies with a typical value
of more than £500 million. While the number of
interviewees may seem small, it is probably
a large proportion of the limited population
of such directors.
Directors who have served on the boards
of both public and private companies
agree—and add that the behavior of the
board is one key element in driving
superior operational performance. Among
the 20 chairmen or CEOs we recently
interviewed as part of a study in the United
Kingdom,1 most said that private-equity
boards were significantly more effective than
were those of their public counterparts. The
results are not comprehensive, nor do they
fully reflect the wide diversity of public- and
private-company boards. Nevertheless,
our findings raise some important issues for
public boards and their chairmen.
When asked to compare the overall effective-
ness of private-equity and public boards,
15 of the 20 respondents said that private-
equity boards clearly added more value;
none said that their public counterparts
were better. This sentiment was reflected in
the scores the respondents gave each
type of board, on a five-point scale (where 1
was poor and 5 was world class): private-
equity boards averaged 4.6, public boards 3.5.
Clearly, public boards cannot (and should
not) seek to replicate all elements of the
private-equity model: the public-company
one offers superior access to capital
and liquidity but in return requires a more
extensive and transparent approach to
governance and a more explicit balancing of
stakeholder interests. Nevertheless, our
survey raises many questions about the two
ownership models and how best to enhance
a board’s effectiveness. How, for example, can
public boards be structured so that their
members can put more time into managing
 17

strategy and performance? Moreover, can— strategic leadership and more effective
and should—the interests of public- performance oversight, as well as their
board members be better aligned with those management of key stakeholders (Exhibit 1).
of executives?
Strategic leadership
How both models add value In almost all cases, our respondents described
Respondents observed that the differences in private-equity boards as leading the
the way public and private-equity boards formulation of strategy, with all directors
operate—and are expected to operate—arise working together to shape it and define
from differences in ownership structure the resulting priorities. Key elements of the
and governance expectations. Because public strategic plan are likely to have been laid
companies need to protect the interests of out during the due-diligence process.
arm’s-length shareholders and ensure Private-equity boards are often the source of
the flow of accurate and equal information strategic initiatives and ideas (for example,
to the capital markets, governance issues on M&A) and assume the role of stimulating
such as audit, compliance, remuneration, and the executive team to think more broadly
risk management inevitably (and appro- and creatively about opportunities. The role
priately) loom much larger in the minds of of the executive-management team is
public-board members. Our research did to implement this plan and report back on
indeed suggest that public-company boards the progress.
Web 2008
scored higher on governance and on
PE & PLC Directors
management development. However, respon- By contrast, though most public companies
Exhibitsaw
dents 1 ofprivate-equity
2 boards as more state that the board’s responsibility includes
Glance: Among UK directors interviewed,
effective overall because of their strongermost say boards of private-equity
overseeing portfolio
strategy, companies
the reality is that the
are more effective than those of their public counterparts.
Exhibit title: Private boards excel

Exhibit 1 Interviewees’ rating of boards (on a scale of 1 to 5, where 1 = poor, 5 = world class)
Private boards excel
Boards of private-equity Boards of public limited
portfolio companies companies (PLCs)
Among UK directors interviewed, most say
boards of private-equity portfolio companies Overall effectiveness 4.6 3.5
are more effective than those of their
public counterparts.
Strategic leadership 4.3 3.3
Performance
management 4.8 3.1
Management
development/succession 3.8 4.1
Stakeholder
management 4.8 3.3
Governance (audit,
compliance, and risk) 3.8 4.2

Source: Interviews with about 20 UK-based directors who have served, over the past 5 years, on the boards of both
private and public companies (FTSE 100 or FTSE 250 businesses and private-equity owned), most with an enterprise value
of >£500 million
18 McKinsey on Finance Spring 2009
executive team typically takes the lead in
proposing and developing it, and the board’s
role is to challenge and shape manage-
ment’s proposals. None of our interviewees
said that their public boards led strategy:
70 percent described the board as “accompa-
nying” management in defining it, while
30 percent said that the board played only
a following role. Few respondents saw
these boards as actively and effectively
shaping strategy.
Performance management
Interviewees also believed that private-equity
boards were far more active in managing
performance than were their public counter-
parts: indeed the nature and intensity of the
performance-management culture is perhaps
the most striking difference between
the two environments. Private-equity boards
have what one respondent described as
a “relentless focus on value creation levers,”
and this focus leads them to identify
critical initiatives and to decide which key
performance indicators (KPIs) to monitor.
These KPIs not only are defined more
explicitly than they are in public companies
but also focus much more strongly on
cash metrics and speed of delivery. Having
set these KPIs, private-equity boards monitor
The executive team typically takes the lead in proposing
and developing strategy, and the board’s role is to challenge
and shape management’s proposals
them much more intensively—reviewing
progress in great detail, focusing intently on
one or two areas at each meeting, and
intervening in cases of underperformance.
“This performance-management focus is
the board’s real raison d’être,” one respon-
dent commented.
In contrast, public boards were described as
much less engaged in detail: their scrutiny
was seen at best as being on a higher level
(“more macro than micro,” one interviewee
said) and at worst as superficial. Moreover,
public boards focus much less on fundamen-
tal value creation levers and much more
on meeting quarterly profit targets and
market expectations. Given the importance
of ensuring that shareholders get an
accurate picture of a business’s short-term
performance prospects, this emphasis
is perhaps understandable. But what it
produces is a board focused more on
budgetary control, the delivery of short-term
accounting profits, and avoiding surprises
for investors.
Management development
and succession
Private-equity boards scored less well on
their development of human capital—both
absolutely and relative to public boards.
Private-equity boards do focus intensely on
the quality of the top-executive team, in
particular the CEO and the CFO, and are
quick to replace underperformers. But such
boards invest little or no time exploring
broader and longer-term issues, such
as the strength of the management team,
succession plans, and developing man-
agement. “Their interest in management
development is frustratingly narrow,”
one interviewee said.
Public boards, by comparison, were seen as
more committed to and effective for people
issues. Such boards insist on thorough
management-review processes, discuss not
only the top team but also its potential
successors, debate the key capabilities needed
for long-term success, are more likely
to challenge and influence management-
development processes, and play a more
active role in defining remuneration
policies and plans. There are weaknesses,
however: public boards can be slower
to react when change is needed, and their

2  See David Walker, Guidelines for Disclosure
and Transparency in Private Equity, Walker
Working Group, 2007.
3  See Derek Higgs, Review on the Role and
Effectiveness of Non-Executive Directors, UK
Department of Trade and Industry, 2003.
The voice of experience: Public versus private equity
voice on everything but the CEO succession
tends to be more advisory than directive.
Remuneration discussions are thorough, but
public boards can seem more concerned
about the reaction of external stakeholders
to potential plans than about their impact on
performance. Overall, however, public
boards are more focused on people, tackle
a broader range of issues, and work in
a more sophisticated way.
Stakeholder management
Our respondents felt that private-equity
boards were much more effective at manag-
ing stakeholders, largely as a result of
structural differences between the two models.
Public boards operate in a more complex
environment, managing a broader range of
stakeholders and dealing with a disparate
group of investors, including large institu-
tions and small shareholders, value and
growth investors, and long-term stockhold-
ers and short-term hedge funds. These
groups have different priorities and demands
(and, in the case of short-selling hedge
funds, fundamentally misaligned interests).
The chairmen and CEOs of public compa-
nies therefore have to put a lot of effort into
communicating with diverse groups.
The challenge for private-equity boards is
more straightforward. Their effective
shareholders (the investors in private-equity
funds) are locked in for the duration of
the fund. The shareholders’ representatives
(the private-equity house) are in effect a
single bloc (or a very small number of blocs
in a club deal) and so act in alignment.
Furthermore, these representatives are more
19
engaged than board members in the public
world are—they are literally “in the
room” with executives and are much better
informed about business realities than
are investors in public companies. It’s not
surprising, therefore, that the burden of
investor management is much less onerous
for private-equity boards and the quality
of the dialogue much better.
Yet private-equity boards are much less
experienced in engaging with broader stake-
holders, such as the media, unions, and
other pressure groups. This inexperience was
evident in the initial response of these
boards to the greater scrutiny they attracted
in 2007. The Walker report2 and the changes
private-equity houses subsequently made to
increase the frequency and transparency of
their communications do
go some way in addressing the shortcomings,
but public boards typically are still
more sophisticated and effective in this area.
Governance and risk management
Public boards earned their best scores
in governance and risk management, a result
that reflected the drive to improve gover-
nance standards and controls in the wake of
the various scandals that led to the Sar-
banes–Oxley legislation and the initiatives
suggested in the Higgs report.3 The
typical board subcommittees (audit, nom-
ination, remuneration, and corporate
social responsibility) are seen as conducting
a thorough, professional scrutiny of the
agreed-upon areas of focus, while the overall
board supervises effectively and can draw
on a broad range of insights and experiences
 Web 2008
PE & PLC Directors
20 McKinsey on2 Finance Spring 2009
Exhibit 2 of
Glance: Nonexecutive directors of public companies focus more on avoiding risk than on
creating value.
Exhibit title: Risk vs value creation

Exhibit 2 Top 3 board priorities, number of respondents

Risk versus value Boards of private-equity portfolio Boards of public limited
creation companies companies (PLCs)

Value creation 18 5
Nonexecutive directors of public
companies focus more on avoiding risk
Exit strategy 11 0
than on creating value.
Strategic initiatives
5 9
(including M&A)

External relations 5 4

100-day plan 5 0

Governance, compliance,
0 9
and risk
Organization design
0 7
and succession

Source: Interviews with about 20 UK-based directors who have served, over the past 5 years, on the boards of both
private and public companies (FTSE 100 or FTSE 250 businesses and private-equity owned), most with an enterprise value
of >£500 million

to identify potential risks. Compliance with
the United Kingdom’s Combined Code on
Corporate Governance is high—an important
factor in building investor confidence.
Yet there are important underlying concerns.
Unsurprisingly, many respondents held
that some elements of governance are over-
engineered and, as a result, consume
much time while generating little value.
Of greater concern, perhaps, many
respondents felt that, in emphasizing gover-
nance, public boards had become too
conservative. “Boards seek to follow prec-
edent and avoid conflict with investors
rather than exploring what could maximize
value,” commented one respondent.
“The focus is on box-ticking and covering
the right inputs, not delivering the right
outputs,” said another.
Private-equity boards scored lower on
governance, reflecting their lower level of
emphasis on it and their typically less
sophisticated processes for managing it. In
every case, governance efforts focused on
a narrower set of activities, though almost
all private-equity boards embraced the need
for a formal audit committee. Interestingly,
though, private-equity boards in general were
seen as having a deeper understanding of
operational business risks and financial risks.
They were also perceived to be more
focused on, and skilled in, risk management
as opposed to risk avoidance.
Sources of difference?
Since our respondents felt that private-
equity boards were typically more effective
than public ones were in adding value,
we sought to learn why. The comments
of the respondents suggest two key
differences. First, nonexecutive directors
of public companies are more focused
on risk avoidance than on value creation
(Exhibit 2). This attitude isn’t necessarily
illogical: such directors are not financially
rewarded by a company’s success, and
they may lose their hard-earned reputations
if investors are disappointed.
The voice of experience: Public versus private equity 21

Second, our respondents noted a greater level time. In both models of ownership, they
of engagement by nonexecutive directors spend around 15 to 20 days a year on
at private equity–backed companies. The formal sessions, such as board and commit-
survey suggested that private-equity tee meetings. However, private-equity
directors spend, on average, nearly three nonexecutives devote an additional 35 to
times as many days on their roles as 40 days to hands-on, informal interactions
do those at public companies (54 versus 19). (such as field visits, ad hoc meetings with
Even in the bigger FTSE 100 companies, executives, phone calls, and e-mails), com-
the average commitment is only 25 days a year. pared with only 3 to 5 days a year for
Respondents also observed differences nonexecutive directors at public companies.
in the way nonexecutive directors invest their MoF

The authors are grateful to Ann Iveson, the executive director of the London Business School’s Private
Equity Institute, for her invaluable support in conducting the interviews and synthesizing their findings, and
to David Wood, a consultant at McKinsey, who led the data analysis.

Viral Acharya is a professor of finance and the academic director of the London Business School’s Private
Equity Institute; Conor Kehoe (Conor_Kehoe@McKinsey.com) is a partner in McKinsey’s London office;
and Michael Reyner, a McKinsey alumnus, is a partner at MWM Consulting. This article is an excerpt from
a longer report published by London Business School and MWM Consulting. Copyright © 2009 McKinsey &
Company. All rights reserved.
 22

The economic impact of

increased US savings
US consumers are spending less and saving more. The economic impact
of that combination will depend upon how fast incomes grow.

Charles Atkins and Two forces that until recently turbo-charged US consumer spending—growing household
Susan Lund debt and a falling savings rate—have gone into reverse. In late 2008, as households started
reducing their indebtedness and saving more, consumption tumbled.

1  US household liabilities relative to disposable
income rose from 85 percent in 1990, to
101 percent in 2000, to 139 percent in 2007.
New research from the McKinsey Global
Institute shows that the economic impact of
further US consumer deleveraging will
depend on income growth. Without it, each
percentage point increase in the savings
rate would reduce spending by more than
$100 billion—a serious drag on any
recovery. Relatively healthy income growth,
on the other hand, would help households
reduce their debt burden without trimming
consumption as much.
The significance of any fall in consumption
could be profound. US consumers have
accounted for more than three-quarters of
US GDP growth since 2000 and for more
than one-third of global growth in private
consumption since 1990. These trends
were fueled by a surge in household debt,1
particularly after 2000 (Exhibit 1), and
a decline in the personal savings rate—to
a low of –0.7 percent, in 2005. From 2000
to 2007, US household debt grew as much,
relative to income, as it had during the
previous 25 years.
Appreciating household assets—the “wealth
effect”—enabled consumers to spend
and borrow more even as they saved less.
The value of US household assets rose
by some $27 trillion from 2000 through
2007. Rising home values, as well as
stocks and other financial assets, accounted
for more than two-thirds of this gain.
This dynamic sputtered to a halt when the
housing bubble burst and the financial and
economic crisis ensued. Falling values for
homes, stocks, and other assets have battered
US households: from mid-2007 through the
end of 2008, their net worth fell by roughly
$12 trillion. These recent losses erased all
 MoF 31 2009
MGI Consumption
23
Exhibit 1 of 3
Glance: The rise in household leverage from 2002 to 2007 raises concerns about the effects of
deleveraging in the years ahead.
Exhibit title: Household debt soars

Exhibit 1 Household liabilities as share of disposable income, %

Household debt soars
140
Actual data
The rise in household leverage from 2002
130
to 2007 raises concerns about the effects of 27 percentage points
deleveraging in the years ahead. 120
1970–2000 trend
110

100

90

80

70

MoF 31 02009
1970 1980 1990 2000 Q3 2008
MGI Consumption
Exhibit 2 of 3
Glance:USThe
Source: decline
Bureau in household
of Economic Analysis;net
US worth
Federalrelative to incomeGlobal
Reserve; McKinsey has erased
Instituteall of the increase in
analysis

wealth since the early 1990s.

Exhibit title: Paradise lost

Exhibit 2 US household net worth relative to disposable income, %

Paradise lost
640
The decline in household net worth relative 620
to income has erased all of the increase in 600
wealth since the early 1990s. 580
560
540 –26%
520
500
480
460
440
420
400
0
1952 1960 1970 1980 1990 2000 Q4 20081

1Estimated.

Source: US Bureau of Economic Analysis; US Federal Reserve; McKinsey Global Institute analysis

the gains in net worth, relative to disposable
income, since the early 1990s (Exhibit 2).
It’s not surprising that US consumer spend-
ing fell at a 3.5 percent annual rate in
the fourth quarter of 2008—a major reason
for the broader economic contraction.
The flip side of falling consumption is
a rising personal savings rate, which
reached 3.2 percent in the fourth quarter
of 2008. Net new borrowing by house-
holds also has fallen sharply from its 2006
peak. In the third quarter of 2008, it
24 McKinsey on Finance Spring 2009

turned negative for the first time since
World War II (Exhibit 3).
Several forces underlie these shifts. Some
households are responding to worries
about possible unemployment or underwater
mortgages by paying down debt or avoid-
ing new debt. Others have found their credit
lines shut down or can’t get new credit,
because banks have tightened their lend-
ing standards.
How far these trends will go is a critical
economic uncertainty in the months
ahead. The economic impact of today’s
deleveraging will depend on how it
unfolds—through income growth, higher
savings, or some combination of
the two.
a one percentage point increase in the
savings rate. Many macroeconomic forecast-
ers, such as Macroeconomic Advisors,
predict that the US personal savings rate will
reach 5 percent by 2010. If incomes didn’t
grow, this would reduce the household debt-
to-income ratio by five percentage points—
which still wouldn’t be enough to restore the
levels of indebtedness prevailing in 2000,
before borrowing started to accelerate.
But if incomes rose, households could
both reduce their debt burden significantly
over time and continue to consume. If
US incomes grew by 2 percent a year, for
instance, households could reduce their
debt-to-income ratio by as much as they
would in the scenario above—but with
a personal savings rate of only 2.3 percent.

MoF
If 31 2009stagnated, for example, house-
incomes These different scenarios have serious
MGI Consumption
holds could deleverage only by saving more. implications for the US and global economies
Exhibitpercentage
Every 3 of 3 point reduction in the because, holding incomes constant, each
Glance: In the thirdratio
debt-to-income quarter of 2008,
would household
require net new percentage
nearly borrowing fellpoint
sharply, turninginnegative.
increase the savings rate
Exhibit title: Fallen borrowing

Exhibit 3 Net new borrowing by US households,1 % of GDP

Fallen borrowing Crisis begins
11
In the third quarter of 2008,
10
household net new borrowing fell
9
sharply, turning negative.
8
7
6
5
4
3
2
1
0
–1
1952 1960 1970 1980 1990 2000 Q3 2008

1Includes
households and nonprofits; negative figures indicate that households paid back debt instead of
borrowing more.
Source: US Bureau of Economic Analysis; US Federal Reserve; McKinsey Global Institute analysis
The economic impact of increased US savings 25

translates into roughly $100 billion less
in consumer spending. A 5 percent savings
rate would mean $530 billion less in
spending each year if US incomes fail to rise;
if they rose by 2 percent a year, a 2.3 per-
cent savings rate would mean $250 billion
less spending, all else being equal.
In short, the importance of income growth is
difficult to overstate. With it, households
can simultaneously reduce their debt burden,
rebuild savings, and boost consumption.
But without significant income gains,
deleveraging could undermine consumption
and the global economy for years to
come. One implication: policy choices that
favor productivity and employment
growth—critical determinants of income
growth—will make deleveraging less
painful. Efficiency breakthroughs in sectors,
such as health care and government,
that employ large numbers of people—but
that have not enjoyed productivity revolu-
tions similar to those experienced in
industries like retailing and wholesaling—
would make a dramatic difference. MoF

Charles Atkins (Charles_Atkins@McKinsey.com) is a consultant in McKinsey’s San Francisco office, and

Susan Lund (Susan_Lund@McKinsey.com) is a consultant in the Washington, DC, office. Copyright © 2009
McKinsey & Company. All rights reserved.
 26

Opening up to investors
Executives need to embrace transparency if they want to help investors
make investment decisions. But what should be disclosed?

Robert N. Palter and As the credit crisis sorts itself out, one outcome investors and regulators will almost certainly
Werner Rehm demand is more transparency into the strategy and the underlying operating and financial
performance of companies—not only the financial ones at the storm’s center but all compa-
nies. Managers should enthusiastically embrace such reforms.

1  See Robert N. Palter, Werner Rehm, and
Jonathan Shih, “Communicating with the right
investors,” mckinseyquarterly.com, April 2008.
In our ongoing research into investor com-
munications, we’ve concluded that companies
should provide more detail about how
their businesses create value, give an honest
assessment of performance, and provide
guidance on the most important operating
metrics that illuminate what underpins
value creation in the medium to long term.
Too often, managers are cowed by fears
that a more detailed discussion of the issues
and opportunities facing a company
would reveal sensitive information to com-
petitors, generate too much work for
the investor relations department, or create
excessive pressure to report too many
numbers or to meet unrealistic performance
expectations. As a result, managers
typically provide only the data required
by generally accepted accounting principles—
leaving the more detailed and specific
performance and value contributions of the
business’s various pieces hidden from
investors, who are left to wonder what
the company is hiding.
More transparency would benefit all
investors but should prove particularly
attractive to those seeking to build
a deep understanding of a company’s
strategy, current performance, and potential
to create long-term value.1 The better
informed these intrinsic investors are about
the true value of a business, the more
likely the share price will reflect an align-
ment between market value and
intrinsic value.
 27

Our discussions with investors and our own (SG&A). A failure to report such infor-
experience in helping companies estimate mation often leaves investors with the
value suggest at least three ways for them to impression that management does not under-
be more forthcoming. stand what really drives value or is trying
to obscure some underlying performance
More detail issues. In another case, a US media conglom-
Disclosure limited to the data required by erate provides detailed income-statement
securities regulators and accounting information by business unit, but the sched-
procedures may give executives considerable ules leave it to the investor to sort out the
leeway to interpret the rules. But more balance sheet by business units, which are as
important, such limited disclosure often diverse as movie production (which capital-
obscures the metrics investors need izes costs) and traditional paper publication
most to make informed investment decisions. (which does not).
For example, both international financial
reporting standards (IFRS) and US generally How much detail is enough? In the case
accepted accounting principles (GAAP) of financial data, it depends on whether the
require a company to disclose sales, a profit- information is critical to assess value
ability metric, depreciation and amortization, creation. IBM discloses constant currency
capital expenditures, and some balance growth below the business unit level.
sheet items for each significant business seg- Nestlé does so on a product and regional
ment. However, this information does level. This kind of detailed financial
not always allow investors to assess value information is very helpful to investors and
across business units with very different doesn’t give competitors any insight
economics—such as widely different operat- that they wouldn’t already have into busi-
ing leverage or working-capital intensity. ness models or sources of strategic
advantage. As a rule of thumb, to determine
the optimal level of disclosure, companies
The better informed intrinsic investors are about the should provide a detailed income statement,
true value of a business, the more likely the share price down at least to the earnings before inter-
est and taxes (EBIT) level, for each business
will align with market value and intrinsic value unit. They should also provide all oper-
ating items in the balance sheet (if not a full
One large global electronics company, balance sheet), reconciled with the
for example, in a section of its 10-K, reports consolidated reported numbers required
gross margins by geographic segment as by securities regulators and accounting
a metric of segment profitability. In another procedures. Even companies in a single line
section, it reports sales and gross mar- of business can improve their disclosure
gins of both product and service businesses. without giving away strategically sensitive
Nowhere does it provide operating mar- information. Whole Foods Market,
gins for various products targeting business a US grocery chain, provides a return-on-
and consumer markets—information that capital metric by age of store. This gives
is crucial to help investors value businesses investors deeper insights into the economic
with different intensity of R&D and lifecycle of different businesses and assets,
of selling, general, and administrative costs as well as the trajectory the company
 28
2  See Timothy Koller and Werner Rehm,
“Better communications for better investors:
An interview with the CFO of Gartner,”
mckinseyquarterly.com, November 2008.
3  Erik Holm, “Buffett will give more
information on derivatives,” bloomberg.com,
November 24, 2008.
McKinsey on Finance Spring 2009
expects for economic profit under different the company. One quarter the preferred
growth assumptions. metric may be unit sales, in the next it could
be revenue growth, and in the next growth
On the operating side, what to disclose in Asia. This approach probably hurts more
depends on the key value drivers of than it helps, because consistency matters.
a business or business units. Ideally, these Investors rightly wonder why management
should be the metrics management has stopped providing the figures for any
uses to make strategic or operational given metric and, in all likelihood, assume
decisions. Each quarter, the IT research firm the figures are worse now than they were
Gartner Group, for example, discloses when the company published them. Instead,
a narrow but detailed set of metrics for each a company should change the metrics it
of its three business units. As Gartner’s reports only when the key drivers of its cur-
CFO explains,2 the firm publishes only the rent growth performance change. In such
most important of the metrics that man- cases, the company may add to the metrics
agement uses to examine the performance of or substitute one for another, but only
the business. Companies in some industries, if it offers a candid explanation.
such as steel and airlines, likewise regularly
disclose volumes and average prices, In the current environment, transparency
as well as the use and cost of energy—the is more important than ever and more highly
key drivers of profitability. valued by investors. Take the case of
Berkshire Hathaway, which had to take
Thanks to technology, some companies can accounting losses on some derivative
make such disclosures almost continuously. positions in recent months. These losses
Continental Airlines, for example, promi- were determined by a model used inter-
nently displays a daily updated load factor, nally to assess the value of the positions. The
one of the key drivers of value, on its actual method for the valuation was not
investor relations Web page (one click away transparent to investors, and it was unclear
from the home page). Some may wonder whether Berkshire Hathaway had to post
if such frequent updates are really very use- collateral against these positions. Only after
ful, but there is no doubt companies can public discussion and a promise to dis-
use technology to improve the way they com- close (in the next annual report) “all aspects
municate the value drivers that matter of valuation,” including “deficiencies
most to investors. Executives should ask in the formula” for pricing derivatives, did
whether a company discloses enough investors calm down.3
for an investor to obtain a clear picture of
its performance. Such information helps More candor
intrinsic investors make informed buy and To make sound investment decisions,
sell decisions—the foundation of intrinsic investors require management to be
what investor relations should be trying honest in its public assessments of the
to accomplish. business. This is an area executives typically
approach quite cautiously. Most manage-
A common mistake among companies ment presentations and publications
disclosing operating data is to provide dif- today offer only a celebration of the past
ferent metrics from quarter to quarter, year’s performance, with limited details
depending on which of them reflects best on or a less than candid assessment of shortfalls.
Opening up to investors 29

Very few presentations discuss the impact Consider the case of Progressive Insurance.
of strategic trade-offs on the numbers—for In the third quarter of 2006, the com-
instance, how a pricing initiative drove pany lowered its policy rates to encourage
growth at the expense of margins. All too faster growth, making what CEO Glenn
often, the only explanation investors Renwick described as “an explicit trade-off
receive is a vague letter to shareholders and of margin for longer-term customer growth.”
boilerplate in the “management discus- He acknowledged that “while we will
sion and analysis” section of regulatory never know the outcome of alternative deci-
filings. These tend to be tedious descriptions sions, we feel very good about the focus
of dollar movements in the accounts, on customer growth.” When the strategy
with some detail on the business background. did not work out as planned, Renwick
In reality, most astute investors want to addressed the subject directly in the first two
understand the drivers of performance sentences of his letter to the shareholders
in greater detail. The risk in not disclosing in the 2007 annual report. “Profitability and
this information to the markets is that premium growth are both down and
certain critically important investors won’t they directly reflect the pricing strategy we
understand the nuances of what is happen- enacted,” he wrote. That strategy “did
ing to a company and may thus make not produce the aggregate revenue growth
incorrectly informed investment decisions— we had hoped for.” Long-term investors
or none at all, since a lack of data tends look for this kind of candid assessment when
to create doubt. they decide to bet on a management team.

Companies that openly discuss what hap- Better long-term guidance

pened during the year and, even in
good times, disclose where management has
identified pockets of underperformance
will help investors to assess the quality of the
executive team and thus the potential for
future value creation. More important, when
strategic decisions go bad, investors want
to understand what management has learned.
Intrinsic investors, in particular, understand
that business is risky and take a relatively
long-term view. Such investors value forth-
rightness and will probably support
a company through a course correction.
There is an increasing awareness in the
North American business community that
quarterly earnings per share (EPS) guid-
ance is not helpful in assessing the value of
companies. More and more of them are
abandoning the practice, including GE , which
announced in December 2008 that it
will no longer give annual or quarterly EPS
guidance. One reason for the change
is that intrinsic investors are less interested
than casual speculators in whether
a company “hits the numbers.” Instead,
intrinsic investors look beyond the
30 McKinsey on Finance Spring 2009
next quarter and beyond EPS , which can
be influenced not only by important
value drivers (such as growth and operating
margins) but also by tangential items
(such as tax effects and share buybacks). In
addition, some important measures of
value creation, such as capital intensity
through depreciation, only indirectly affect
EPS , so they are at best a proxy for true
economic earnings. Lastly, in the current
uncertain environment, promising a
bottom-line number for next year’s earnings
can raise questions about how a company
will get there, given the prevailing economic
uncertainty. That “how” becomes more
important than the actual numbers.
As an alternative, in the normal course
of business, executives should provide short-,
medium-, and long-term guidance on
the real value drivers—and do so in ranges
rather than point estimates. Companies
as diverse as GE and Arrow Electronics
provide target ranges for returns on capital.
Other companies provide a range of
possibilities for revenue growth under a
variety of assumptions about inflation
and they discuss the growth of individual
business units when that matters (in
the semiconductor industry, for example).
Other metrics help investors to divide
the drivers of income growth into those that
are sustainable and those that are not.
Humana, for example, provides guidance on
estimated membership in its health care
plans—including plans whose membership
the company expects to decline. Gartner
sets out a range of long-term goals, such as
growth targets by business unit, margin-
improvement targets, and capital-
spending goals.
In project-based businesses, a detailed
discussion of investments, timing, and
targeted returns might be most helpful. One
leading North American industrial com-
pany with a large exposure to big capital
expenditures, for instance, provides
more details on the performance of current
projects and the timing and expected
returns of potential projects than many
competitors do. The company’s disclosures
include revenue risks, estimated equity
returns, and debt-to-equity ratios—informa-
tion that allows investors to assess the
growth potential in detail.
Companies coping with complex income
streams; changes in the macroeconomic, tax-
ation, or regulatory environment; or
significant exchange rate exposure should
also provide estimates on nonoperating
items if they materially affect cash flows.
One European company, for example,
provides analysts and investors with a tax
estimation tool, which uses the inves-
tors’ assessments of regional growth rates
to provide a best guess on the tax rates
the company will face.
In providing such target ranges, manage-
ment shares with investors its view of how
a company will fare, given its estimate
of various macroeconomic factors. Investors,
of course, may estimate them differently
and therefore reject management’s view of
Opening up to investors 31

the company’s prospects. It is therefore Greater transparency about financial

often best to disclose assumptions about
GDP growth, inflation (where it matters),
and other underlying drivers. As one investor
relations professional explained, “These
numbers are simply our best estimate. If you
have a different view on the economy, you’re
welcome to come up with your own num-
bers,” using the company’s disclosures about
how much the drivers affect its business.
and operational data, an honest assessment
of performance, and guidance about
the metrics that executives use in running
a company all help investors to develop
informed opinions about the long-term value
creation potential, the quality of manage-
ment, and the risk profile of its various parts.
In the process, management receives
valuable feedback from investors who share
their own ideas about topics such as the
company’s growth and performance relative
to peers. MoF

Robert Palter (Robert_Palter@McKinsey.com) is a partner in McKinsey’s Toronto office, and Werner Rehm
(Werner_Rehm@McKinsey.com) is a consultant in the New York office. Copyright © 2009 McKinsey & Company.
All rights reserved.
32 McKinsey on Finance Spring 2009
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