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Outsourcing grows up 1
Perspectives on
Many outsourcing deals are tantamount to strategic divestitures and joint
Corporate Finance
ventures. Executives should start treating them that way.
and Strategy
Finance 2.0: An interview with Microsoft’s CFO 7
Number 14, Winter
Microsoft is paying cash to shareholders, stressing transparency in its diverse
2005
businesses, and embracing Sarbanes-Oxley. CFO John Connors explains why.
Editorial Board: James Ahn, Richard Dobbs, Marc Goedhart, Bill Javetski,
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1
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think senior executives would be wise to
apply the same rigorous approach to these
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divestitures, and joint ventures. Both the
2 McKinsey on Finance Winter 2005
customer and the vendor must find the Companies also cede management control
relationship valuable over the longer term. to vendors, since the contract governs
the formal relationship. Unfortunately,
Applying M&A principles most managers still think about their
When outsourcing deals were smaller and outsourcing contracts as if they can recover
limited to noncore processes, executives all their assets at the end of a deal. In fact,
could treat the transactions as fairly while many outsourcing agreements include
standardized, the strategic implications as provisions for the return of assets, the
limited, and the risks as well understood. vendor often retains access to intellectual
Today, the executive team no longer has property and has already reassigned its
the luxury of easy decision making, and best people to other contracts. As with any
not merely because the average size divestiture, companies should consider such
of deals has grown. How a company a move only if the loss of flexibility won’t
develops its outsourcing relationships hurt business performance.
directly affects its core strategic
planning: the shape and boundaries of One financial-services institution
its corporate portfolio and the focus learned this lesson the hard way when it
of its executives. Some guidelines can structured the outsourcing of its lending
increase the odds of outsourcing success. operations as a divestiture. The company
relinquished control of its people and IT
Clarify deal strategy from the beginning systems in return for guaranteed service
The strategic objective of an outsourcing deal but lost the flexibility to support new
must be explicit from the outset. The goal of products. The managers who structured
some deals is simply to have a low-value job the deal had focused primarily on cost
done more cheaply, to make the cost base cutting without considering this crucial
more variable, or to leverage a provider’s skills, component. They discovered the flaw
expertise, technology, or processes. Many of when the institution was unable to offer
today’s arrangements go further, aspiring to new forms of lending: it was precluded
improve operational performance and service by contract from developing the product,
levels or to free managers to focus on higher- and the vendor was unable to develop it.
value-added activities.
On the other hand, if the goal is to
Once the objective of the deal is clear, the improve the performance of a strategically
best way to structure it becomes clearer important function or process, then
too. It often makes sense to go far beyond managers should consider structuring the
a traditional procurement-type contract. deal like a joint venture. Under this type
If the outsourced function or process is of arrangement, both companies share
noncore, for example, and if cost cutting ownership and control of assets, splitting
is the primary goal, then often an outright the costs of new applications, technologies,
divestiture makes sense. Many of today’s and operating improvements. An approach
formalized outsourcing arrangements are that incorporates the best features of a joint
effectively divestitures, even if managers venture—without necessarily creating one—
don’t think of them that way. Such can help align incentives for both parties to
arrangements transfer assets—including make the deal work and to create economic
people, systems, intellectual property, and value. Specifically, it rewards the vendor’s
even buildings—to a vendor and create successes while allowing the buyer to retain
obstacles to bringing them back in-house. flexibility and control.
Outsourcing grows up 3
One European company structured an level of vendor support and its current cost.
outsourcing agreement as both a divestiture A pricing expert, organizational-change
and a joint venture. It transferred specialists, and experienced negotiators
ownership and control of its desktop and should also be included on the team. One
network IT assets to the vendor but shared company that sent its development of IT
a core-application platform critical for applications to India assembled a team of
addressing changes in the marketplace. One five technology experts and three human
year later, both companies are working resources (HR) managers, along with
together to improve the effectiveness of the representatives from each business unit,
applications and reduce costs. Meanwhile, third-party consultants who understood
the vendor has freed the company’s offshore economics, and specialists in
management from the time-consuming task M&A , law, and tax. The team, led by
of redesigning and improving the desktop the CIO, reported biweekly to the global
platform and network. executive committee. Over the course of its
eight-month tenure, the team structured the
Assemble the right team scope and incentives of the deal, planned
Companies typically rely on teams with the transition, managed the economics, and
a heavy concentration of IT managers selected and negotiated with the suppliers.
to execute and oversee outsourcing
relationships. While the use of a third-party consultant
Innacurate estimates of the Historically, IT can be beneficial to both sides in an
functions were outsourcing negotiation, its role often
total value of an agreement lead to
early targets for deteriorates into commodity procurement—
incorrect revenue distribution outsourcing, so to the detriment of customer and vendor
between the buyer and the vendor. these managers alike. These firms usually position them-
developed expertise selves as intermediaries, often precluding
in this area. Today’s complex arrangements, any direct contact between the customer
however, require a deal-making team with and the vendor. As a result, negotiations
a wide range of skills that go well beyond become exercises in adherence to a proposal
those of most IT experts. written without the creative input and
experience of vendors. Furthermore,
As in any M&A deal, at least one team third-party consultants often discourage
member should focus on the economics of customers from discussing any alternative
the deal. In addition to handling the typical proposals from vendors, even if this step is
merger questions, this individual should in the interest of both companies.
be fluent in the process to be outsourced
as well as the vendor’s economics. We find Focus on value, not cost
that often companies accept a vendor’s Many companies with traditional outsourcing
target prices or risky promises at face agreements have focused only on the
value. Other team members should be able embedded value of an agreement—the cost
to draw on that knowledge to determine savings realized by the buyer or the new
appropriate service levels and transition revenue streams created by the vendor. As a
plans and to manage supply and demand. result, inaccurate estimates of the total value
lead to incorrect revenue distribution between
Such detailed knowledge is critical, since the buyer and the vendor or undermine
a key component of negotiating for shared the deal altogether. One financial-services
value is setting the right baseline—the basic company, for example, hoped to transform its
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4��������������������������� McKinsey on Finance Winter 2005
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The key is to consider all the components
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of value, along with the risks (Exhibit 2).
What is valuable to the buyer may cost
����������������� ���������������������� the vendor, and vice versa. Higher service
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levels can typically increase the vendor’s
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cost base by requiring more resources, for
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Similarly, retaining architectural control
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���������������������������������������������� customer, but doing so eliminates one of
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the primary sources of value creation in
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consolidation, and standardization of
applications and hardware. Even though
��������� ������������������������������������������ ����������������������������������������� a vendor may try to protect itself by
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extracting promises from customers to
perform some of these transformations
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themselves, it often has little recourse if
customers don’t follow through.
Create transparency
Increasingly, the initial proposal is used
customer-service and back-office functions by as the baseline for the asset and labor
outsourcing the development and operation pool that the outsourcer will handle, and
of its new customer-service platform. The vendors are not permitted to conduct their
company spent three months negotiating solely own due diligence before signing the deal.
on price, and while it ultimately got the lower Furthermore, in many cases the contracts
price it had sought, it did so at a considerable don’t even contain the ability to verify the
cost: the supplier no longer guaranteed deal’s assumptions—and thereby the price.
performance, shared the operating risk, or This arrangement creates significant and
contributed staff. The deal changed from a unnecessary risks for vendors, since the
partnership focused on business improvement structure and cost of a technical solution
to simple software procurement. are critical to the amount and level of
services a vendor must provide.
A more complete examination of the
sources of value—a key principle of smart In extreme cases, the denial of due diligence
M&A—can help an executive team set is combined with a so-called sweep clause,
a realistic and fair target price. Many which requires a vendor to assume all
outsourcing agreements also generate value physical assets, labor resources, and services
through options including new business formerly provided by the customer’s IT
opportunities, such as the vendor’s resale of department—even if they were not included
deal-related software or the buyer’s offering in the initial proposal or even in the
of new products to new markets. Other contract’s statement of work. Omissions
teams create value by changing the liability in the proposal’s baseline are often one-
and risks their company faces. sided, however, since customers often are
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against unfavorable changes in management
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or key personnel; and exit clauses.
difficult to gain consensus on their value which ultimately rejected the deal because
and strategic implications. Last, suppliers they didn’t fully understand its economics.
frequently offer such a wide array of scope, The company had to start from scratch,
service levels, and pricing options that which delayed the deal by six months—a
comparing deals is difficult. time marked by major internal confusion
and uncertainty among employees.
As a result, negotiating teams must work
internally with the business managers who Plan for transition and delivery
control the process to be outsourced, with As M&A practitioners know, effective post-
employees and union representatives who deal management can mean the difference
will be affected by the move, and with between success and failure. Yet this aspect of
the executive team. Internal stakeholders outsourcing is often given short shrift as the
should agree on service levels, the degree deal team becomes focused on the near-term
of flexibility, the controls that the team objectives of evaluating and negotiating the
will secure from a vendor, and acceptable deal. Before signing a contract, a company and
transfer conditions (and their implications its outsourcing vendor must clearly structure
for staffing levels). Without alignment on the new management organization, define the
these critical issues, the effective handoff roles and responsibilities of each party, design
of processes to external vendors will be and install reporting and control mechanisms,
difficult. The negotiating team must also and plan hiring for new roles.
agree with executives on pricing as well as
compare the value of the deal against the Uncertainty during an outsourcing
next-best alternative, which is typically an transition also increases the risk of staff
internal-improvement plan. turnover, so companies should design a
retention program that targets and retains
These interactions within the company pave key personnel. One hotel chain was able
the way for successful vendor negotiations, to keep its best employees by setting up
in which services, procedures, assets, and performance-based bonuses for staying
total value are hammered out, along with on through the transition. In another case,
pricing and the other mechanisms for the vendor held one-on-one sessions with
sharing value. more than 100 employees of the customer
company to articulate the value of staying
The bargaining process is most effective with the new organization.
when it is driven by a stand-alone
negotiating team—one that is separate from
the overall deal team and excludes the head
Outsourcing deals have become bigger, more
of operations or the business managers who
complex, and more strategically important.
run the process to be outsourced. Operations
By applying M&A deal principles rigorously,
managers tend to focus on liabilities and
executives can avoid costly errors. MoF
service and commitment levels instead of
keeping in mind the total value of the deal.
David Craig (David_Craig@McKinsey.com) and
The head of operations at one company went
Paul Willmott (Paul_Willmott@McKinsey.com)
forward with an outsourcing agreement are partners in McKinsey’s London office. Copyright
without first consulting the executive team, © 2005 McKinsey & Company. All rights reserved.
Running head 7
investors who simply wanted the cash but John Connors: We have a relatively unique
it would also have been a monumental model, in that our business is not capital-
undertaking. Our analysis also showed intensive. What drove our approach is that
that if we had committed ourselves to a Bill [Gates] and Steve [Ballmer] and the
$60 billion share buyback, we could have board are pretty conservative. We don’t want
ended up purchasing 5 to 8 percent of our to be in the position where we have to make
stock every day that the Nasdaq allows us decisions because of the balance sheet. And
to buy our own shares for the next three while we don’t anticipate that we would ever
years, and some of that inevitably would have a year with expenses but no revenue,
have been uneconomic. So we decided to we’ll probably keep at least one year of
take that $60 billion and use roughly half operating expenses and cost of goods sold in
of it for a special onetime dividend, with cash on hand—that’s around $20 billion in
the rest committed to a multiyear buyback. cash and short-term investments.
That’s a pretty significant percentage of
the enterprise value, and a fairly decent We also want to have enough for
percentage of the shares. acquisitions. We have made a series of
acquisitions, some of them for cash. And
We believe that this strategy will reward while most of them have been fairly small,
all of our investors. It will also increase we also want to be able to make some
growth in profits and cash flow, which are game-changing investments if we so choose.
what drive our valuation and our return to Any large acquisition would likely be a
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shareholders. combination of cash and equity.
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McKinsey on Finance: Any rules McKinsey on Finance: The high-tech
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of thumb about how much cash
������������������������������������������������� industry is seriously underleveraged. Are
companies need to remain flexible? we seeing the beginning of a fundamental
change in capital structure? Do you think the
industry will take on more debt over the next
couple of years in order to increase returns
on equity?
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John Connors: I don’t think we have
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seen any large-scale move in that direction
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� ���������������������� industries. The growth rate assumption
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priced into tech companies’ stock is that
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� ������������������������������������������������������������������������������������
���������������� � ��������������������������������������������������� industries, although the differences in
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industries have begun to narrow.
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������������������������������ ��������������������������������������������������������������������������������� The real question would be whether
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the market starts assessing technology
companies the way it measures companies
Finance 2.0: An interview with Microsoft’s CFO 9
in order for our customers to earn the best our businesses had flown under the radar,
returns on the purchase of our products and while we would talk about their
they also needed specialist salespeople long-term opportunities in a way that
who understood the supply chain, data investors appreciated, after a while they
warehouses, and financial flows. In some also wanted to see how those investments
rapidly growing categories, we also lacked were performing. Now there’s a quarterly
a coherent worldwide brand proposition scorecard that reports—both relatively and
for certain unique products, compared with absolutely—how we are doing.
our brand proposition for the company as
a whole. In the end, we had to decide what Second, it was surprising how difficult
areas required continued investment—and it was to synchronize what we called
what areas did not. the “rhythm of the business” between our
field organization and the business groups.
As the bubble collapsed and technology Traditionally, our field, or geographic,
spending slowed, it became very clear that organizations could move both people and
we could not continue to invest at the same marketing around to take advantage of
levels. Today we all know how much money opportunities and to adjust to changing
we have to invest, and we all have to agree market conditions. While the P&Ls of our
on how much will go into R&D, sales, field organizations still matter today, and
marketing, and tactical initiatives. they still have a revenue quota, the business
groups now have the ultimate financial
The restructuring also forced a degree of accountability and make the final resource
organizational stability and continuity. allocation decisions. The field is secondary
Historically, Microsoft had a major in authority. That was a big shift, and if you
reorganization once a year that coincided look at companies that have had collapses
with our budgeting in the spring. This in financial performance, it often has to do
process worked very well when we with the shifting of financial reporting from
were smaller, had fewer units in fewer product to geography or vice versa. So we
geographies, and weren’t invested in so many took a relatively measured step over a two-
segments. But as the company got larger and year period.
more complicated, we heard from customers
and partners that Microsoft was hard to McKinsey on Finance: What about the
keep track of. So once we organized around impact of the restructuring on the finance
these seven business groups and reported function specifically?
along those lines, customers and partners
believed we were serious about them. John Connors: It has allowed us to push
much harder on performance because the
McKinsey on Finance: Did anything finance folks in those groups report solid
about the move surprise you? line into the business, dotted line back to the
finance function in the center of the company.
John Connors: It was surprising how And it’s much easier now for the center of the
many people within the company didn’t company to push on financial performance.
really understand how intensely analysts,
investors, and the press would follow It’s also helpful that this model can easily
each of these seven businesses. A lot of accommodate growth. When we want to do
Finance 2.0: An interview with Microsoft’s CFO 11
a deal, it’s very clear that the CFO and the in finance than we had prior to 2002.
business-unit leader are on point for that Of 125 corporate vice presidents, for
deal. If we want to add new businesses, we example, 9 are now from finance, whereas
have a model that will scale. before there would have been 2 or 3. And
corporate-finance leaders at that level also
Last, the restructuring has allowed us to have different requirements: they have to be
talk about the role of finance in the next able to nurture other great business leaders,
generation of Microsoft, which is quite who then move into marketing, services,
different from its traditional role. and sales, and they have to be articulate
spokespeople for the company at technology
McKinsey on Finance: How will finance conferences and industry events.
at Microsoft differ in the next generation?
McKinsey on Finance: What’s the most
John Connors: When we restructured, value-added role a CFO can play in a high-
we decided very early on to designate tech company?
as CFO the lead finance person in
each of our seven businesses. This John Connors: We are in an era today
model is fundamentally different from when technology isn’t really different from
the one Microsoft had in the past. any other industry. In the 1990s it was just
growing a heck of a lot faster than GDP. In
Historically, the top position outside the the late 1990s the dot-com and telecom
center of the company was a controller, meltdown made it pretty clear that such
whose role was to control and measure. But growth had been part of a bubble. It’s
today the finance function must do more. unrealistic to expect that an industry this
For example, if you look at the incredible large will grow substantially faster than GDP.
diversity of the company now—the
number of businesses, the different models, So a technology company’s CFO must be
and the economics of some of the new good at both top- and bottom-line growth.
businesses—Microsoft today requires much The skills that a CFO has at Wal-Mart or
stronger strategy and business-development GE or Johnson & Johnson are much closer
functions. Business units like MSN and to what will be expected at technology
Home and Entertainment are entering into companies now.
multibillion-dollar contracts and alliances
over long periods of time. Our mobile- Technology also resembles other industries
devices business requires a very different in that its consolidation focuses mostly on
alliance model with handset carriers and cost synergies rather than growth synergies.
telecom operators than any we have had. At least in the near term, Sarbanes-Oxley
Add the requirements of the Sarbanes- requires CFOs of companies in every
Oxley legislation and you find that the industry to spend a significant amount
control and risk-modeling function has to of time on how a company’s ethical or
be at a much higher level than it was three business-integrity tone emanates across the
or four years ago. organization. How does its internal-control
structure operate? How does its disclosure-
In practical terms, that means we have a control process operate? And is it being
greater number of senior business leaders really, really clear with investors in its SEC
12 McKinsey on Finance Winter 2005
filings and press releases? Sarbanes-Oxley Sarbanes-Oxley also really forces you
tends to make CFOs focus on similar tasks to evaluate the policies that are in place
regardless of the industry. and whether they make sense. One of its
requirements is that if a company has a
McKinsey on Finance: Speaking of written management policy, people are
Sarbanes-Oxley, what are the costs versus expected to follow it—whether or not it has
the benefits when it comes to implementing a financial impact. For example, how much
Section 404, for example?1 can people discount contracts? Even if a
company can record that contract exactly
John Connors: Publicly traded US right from a GAAP2 perspective and the
companies have historically had a premium financials are correct, are people following
on the equity side and a discount on the the discount policy? At Microsoft, we have
debt side relative to other markets because taken a really fresh and invigorating look at
of the value of transparency and trust that our management policy.
investors had in US markets. That trust
and transparency got violated, and we all McKinsey on Finance: Apart from the
have to bear the cost of earning it back. accounting issues, what was behind the
Microsoft accepts that. decision to give employees restricted stock
rather than options? What effect has the
Of course, there are negatives in Sarbanes- decision had?
Oxley. For example, there isn’t much guidance
on what is material for public-company John Connors: The options program
financial statements—not in the legislation was originally designed to give employees
itself or in the regulations or rules yet—nor is enough money for retirement or a vacation
there any case law defining this. There are far home or to pay for their kids’ education—
too many areas where companies could take a goals that usually take 15 or 20 or 25 years
reasonable risk with good business judgment to achieve. Yet because of the stock
but still be subject to litigation. performance, people were making enough
money to send 3,000 kids to college or build
Yet there are real benefits to Sarbanes- 30 vacation homes. Then the bubble burst,
Oxley. In our case, we knew what our our stock declined by half, and roughly
key controls were, we knew what our half our employees had loads of money but
materiality threshold was, we had tight were sitting in the same offices and doing
budgeting and close processes and strong the same jobs as the other half, who would
internal and external audits, but we didn’t likely earn nothing from their options.
document everything in the way that
Sarbanes-Oxley legislation requires. So we It was the worst of all possible worlds. At
1Section 404 of the Sarbanes-Oxley Act of
have done a complete business-process map the same time, we were diluting the heck
2002 requires all public companies to give the of every transaction flow that affects the out of shareholders, who were telling us
Securities and Exchange Commission ( SEC ) financials. In so doing, we have improved loud and clear that we should rethink
an annual assessment of the effectiveness
of their internal controls. In addition, the our revenue and procurement processes, the long-term value proposition of our
independent auditors of a corporation are
and we can use controls to run the company options program. Of course, shareholders
required to review its management’s internal-
control processes, with the same scrutiny as in a more disciplined way. So we have hadn’t paid much attention to that
its financial statements.
gotten real business value out of all that dilution when it was outstripped by
2Generally accepted accounting principles.
process documentation. growth, but when growth lags behind and
Finance 2.0: An interview with Microsoft’s CFO 13
expectations change, that dilution looks a people should leave a job in better condition
lot different. than it was when they started.
In the end, we wanted a program that Second, while it’s essential to be viewed
aligned employee and shareholder interests as a leader in investor relations, treasury,
over the long term. So we came up with tax, and corporate reporting, it’s also
the stock award program, and we were rewarding to be viewed as a leader in
very clear with employees about how many creating great finance talent. Keith Sherin
shares they would get, how the stock would from GE was here last week, and that
have to perform for them to be worse off, corporation is just a machine for producing
and how the program would work over a great talent. In the Puget Sound area alone,
multiyear period. the CFO at Amazon is from GE ; the CFO
at Washington Mutual is from GE . The
The reaction has been pretty positive, company takes good people and makes
and I think we have a good model. We them great, and its ability to export these
will have been wrong if Microsoft really business leaders is phenomenal.
outperforms the market and the market
performs extraordinarily well over the next I’m happy to say that we have also had
seven years—then a number of employees some success along these lines. In the
would have been better off with options. past six months, two of our business-unit
That was a bet we were willing to make. If CFOs have left for CFO positions at other
you look at the market in the 14 months corporations. It’s tough to lose good people,
since we made the announcement, and the but what a great thing it is for people who
predictions of most market prognosticators, are five or six years into their careers here
the bet is pretty good so far. to be able to say, “I can become a CFO —
either at Microsoft or somewhere else. I can
McKinsey on Finance: Having tackled be a business leader.”
such an ambitious agenda in your tenure,
what challenges are next for you? And, on a personal note, I’d like to figure
out how to have more time for my wife
John Connors: The big challenge is and our four kids so that I don’t wake up
probably institutionalizing the finance someday and find that my kids are off to
function and the finance 2.0 model we have college and I’m too old to climb Mount
been developing. And I feel the company is Rainier again. MoF
in a good place right now; if I got hit by a
bus, got fired, or decided not to work here
Bertil Chappuis (Bertil_Chappuis@McKinsey.com)
anymore, someone could step in and he
is a partner in McKinsey’s Silicon Valley office,
or she would be really successful. That’s and Tim Koller (Tim_Koller@McKinsey.com) is a
important to me because I will have worked partner in the New York office. Copyright © 2005
here for 16 years in January, and I believe McKinsey & Company. All rights reserved.
14 McKinsey on Finance Winter 2005
The impact of an operational-risk crisis far exceeds the actual loss. Operational crises in
Companies can protect their shareholder value by preparing in advance. financial institutions
The experience of the financial-services
industry yields useful insights into the long-
term effects of operational risk. Financial
Robert S. Dunnett, Many companies regard the funds they institutions are particularly vulnerable to
Cindy B. Levy, and allocate to meet the regulatory requirements events that make them appear risky in the eyes
Antonio P. Simoes concerning operational controls as money of their customers. Moreover, they typically
well spent. Avoiding operational risks— have a wealth of data to call on as well as
either dramatic (embezzlement and loan strict reporting standards. In general, these
fraud, for example) or mundane (such companies base their risk calculations and
as regulatory compliance)—can prevent allocate their capital on the probability that a
sizable losses from damages, fines, and particular incident will occur and the size of
sullied reputations. the resulting financial loss—the sum pocketed
by an embezzler, for instance, or the fine for
Yet few companies think strategically about breaking a rule. At present, few banks factor
operational controls. In our experience, potential market losses into their operational-
executives typically view paying a fine, for risk-management plans or capital allocations,
example, or reaching a settlement in a court for example.
case as merely the cost of staying in the game.
They approach operational-risk measures We analyzed more than 350 operational-risk
not as exemplary management practice but incidents1 at financial institutions in Europe
as regulatory requirements that should be and North America and found that as news
dispatched with a minimum of fuss. of a crisis reached the market, the initial
declines were limited to levels in line with
Perhaps they should think again. Many the actual fines, settlements, and monetary
companies underestimate the long-term losses. Yet over the next 120 working days,
effect of these events on their market the total returns to shareholders (TRS)
1Fitch Risk Management’s OpVar Loss value. Indeed, recent McKinsey research of our sample declined by a whopping
database provided our sample of events for
shows that a company’s loss from such $278 billion,2 more than 12 times the total
this study.
a crisis pales beside the eventual loss to actual loss of $23 billion (Exhibit 1).
2The combined market value of the institutions
level-3 classification scheme of the Bank for blows; share prices can plummet as a result varied with the kind of operational crisis that
International Settlements (BIS ) for actual of even the smallest events. caused it.3 First, we organized the 350-plus
losses stemming from operational-risk events.
incidents in our sample into a number of
4 Defined using the BIS level-3 classification,
Corporations can take a better-informed categories. We then analyzed those categories4
which is more discriminating than the
commonly used level-1 classification. and more systematic approach to preventing that included more than 20 incidents—
�������
The hidden costs of operational risk 15
�������
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companies can lose as much as 5.5 percent of
�������������
their TRS over the next 120 working days.
���������������������������������������������������
�������������������������������������������������
The way companies communicate
information about such events to investors
can delay or exacerbate the market’s
enough to yield reliable, in-depth results. Five response. European markets tend to
types of crises led to the harshest responses overreact at first, perhaps in the absence of
from the market (Exhibit 2): readily available information, and assume
the worst until contrary evidence emerges;
1. Embezzlement. This type of internal in contrast, the immediate response of US
fraud appears to have a contradictory effect investors is commensurate with the actual
on corporate market valuations: a net gain loss. As more information emerges, the
around the date when the event is first market continues to respond (Exhibit 3).
revealed but an eventual 3.5 percent loss in Investors in both Europe and the United
market value. States assume that the losses exceed the
amounts reported, perhaps in the belief that
2. Loan fraud. The market value of such events signify general mismanagement
companies reporting losses from borrowers and herald further losses (possibly too small
that fraudulently obtained credit and later to report) that will affect the company’s
defaulted declined by 3.5 percent of TRS. future ability to create value. This negative
reaction levels out at some point, as
3. Deceptive sales practices and investors either forget the event or come to
concealment. The market reacts negatively believe that the problem has been corrected.
to penalties—such as those resulting
from misleading equity research or from A shareholder value approach to
miscalculated pension annuities—handed managing operational risk
down by regulatory bodies or civil courts. These results suggest that CFOs and their
Recovery, if it occurs at all, is short-lived, and executive teams can protect and even improve
���
16 McKinsey on Finance Winter 2005
������
��������������
�������������������������������������������������������������������������������
���������
if risks aren’t clearly defined and
����������������
understood, efforts to measure and monitor
��������������������������������������������������
them—let alone rank them by cost—will
� � likely prove ineffective.
� ������������ � ����������
� �
���������
major problems. Companies can reduce
������������������
the number of small errors across their
���������������������������������������������������
operations by using tools such as the Six
�������������������������������������������������� Sigma approach or failure-mode analysis.
���������� ������������������� �������������������� But to reduce the number of larger errors,
��� they will need to review and strengthen
��� �������������� �� �� their business practices, compliance
������� �� � and risk-management culture, business-
���
����������� �� �� continuity planning, and corporate-
�
������������� �� �� insurance programs.
����
Act (FDICIA) and the Sarbanes-Oxley In our opinion, best practice starts with
accounting rules. defining the organizational and governance
responsibility for dealing with operational
A loss database. Tracking internal risk throughout the institution as a whole.
operational losses can help a company In this way, the roles and responsibilities
make forecasts and agree on key risk for managing corporate and business-unit
indicators. A database can also integrate risk are complementary, and their links
the reporting and analysis functions and to auditing, compliance, operations, and
thus alert managers of significant trends. technology are clear.
With the foregoing elements in place, a Increase transparency during a crisis. The
company can calculate its capital against knee-jerk reaction to a crisis is to clam up
the Basel II requirements, rank its risks, immediately—perhaps in the expectation
analyze their causes, and mitigate the that it can be minimized or that investors
damage, thereby focusing effort on the won’t find out. This approach is precisely
most serious risks. But the process will also wrong. If news of a crisis leaks to the
reveal numerous small and frequent errors market before a company comes forward on
in everyday processes as well as some large its own, the shareholders’ response is much
and infrequent events that can become worse. When efforts to prevent a crisis
18 McKinsey on Finance Winter 2005
don’t succeed, the company should make no long-term damage to its market value,
its communications with investors more and within six months its TRS had returned
transparent. Even where the size of the loss nearly to its predicted market-adjusted level
is quite significant, a company is better off had the event not occurred.
disclosing everything up front.
Companies attracted to the country’s potential must do With less of a focus on the initial entry and
more than merely transplant products and systems that with a longer-term view of what a thriving
have succeeded elsewhere. Indian business would look like, the more
successful companies have invested time and
resources to understand local consumers
Kuldeep P. Jain, India, for some time now the focal and business conditions: tailoring product
Nigel A. S. Manson, and point of the global trend toward strategic offers to the entire market, from the high-
Shirish Sankhe offshoring, has simultaneously become end to the middle and lower-end segments;
appealing as a market in its own right. With reengineering supply chains; and even
GDP growth more than double that of the skipping the joint-venture route. The reward
United States and the United Kingdom for this effort? Of the 50-plus multinational
during the past decade, and with forecast companies with a significant presence
continued real annual growth of almost in India, the 9 market leaders, including
7 percent,1 India is one of the world’s most British American Tobacco (BAT), Hyundai
promising and fastest-growing economies, Motor, Suzuki Motor, and Unilever, have
and multinational companies are eagerly an average return on capital employed of
investing there. around 48 percent. Even the next 26 have an
average ROCE of 36 percent (exhibit).
Yet the performance of the multinationals
that have tried to exploit this opportunity Getting local in India
has been decidedly mixed. Many of those India’s per capita income is half of China’s
notable for their strong performance and one-fourth of Brazil’s, and as much
elsewhere have yet to achieve significant as 80 percent of Indian demand for any
market positions (or even average industry industry’s products will be in the middle or
profitability) in India, despite a significant lower segments. As a result, multinationals
1The Economist Intelligence Unit forecasts
investment of time and capital in its must resist the temptation merely to replicate
6.9 percent real GDP growth from 2003 to
2008. industries.2 Why? Perhaps because the their global product offerings; the products
2 Based on McKinsey analysis of the market entry strategies that have worked and price points that are competitive in
Centre for Monitoring Indian Economy’s so well for these companies elsewhere— India are often considerably different from
Prowess financial database for average
bringing in tried and tested products and those that work well in other countries. In
industry profitability. The database is
highly normalized, built on CMIE’s business models from other countries, particular, in India companies must reach into
understanding of disclosures in India
on around 8,000 companies.
leveraging capabilities and skills from core the middle and lower-end segments or they
markets, and forming joint ventures to may end up as niche high-end players, with
3We reviewed the performance in India of more
than 100 multinationals, conducting detailed tap into local expertise and share start-up insignificant revenues and profits.
case studies of 15 that have had varying costs—are less successful in India. Our
degrees of success and interviewing 30 experts,
company managers, analysts, and current or research3 suggests that the most successful Multinationals that understand the
retired CEO s of leading multinationals. multinationals in India have been those that Indian consumer’s expectations and price
did not merely tailor their existing strategy sensitivities can tap into what is often
���
20 McKinsey on Finance Winter 2005
�����
��������������
������������������������������������������������������������
�������
a little over three years, with revenues of
�����������
nearly a billion dollars in India. And Toyota
�������������������������������������������������������������� Motor captured nearly a third of the multi-
� �������������������������
utility-vehicle (MUV) market by offering a
������������������������ significantly superior product at a limited
� ������������
����� ��������������������������� price premium.
�������������������������������������
�� ���������������������������
�������������������������� ���������� Very often, however, companies need
������������������������
� ������������ to develop completely new products to
���������������������������
only about 60 to 70 percent4 of their out of the country every two or three
components locally—buys 90 percent of its years—often a recipe for failure—most
components from cheaper Indian suppliers successful multinationals, such as Citibank,
rather than importing more expensive GlaxoSmithKline, and Unilever, have an
parts from its usual suppliers elsewhere. Indian CEO in their local operations. Given
Multinational pharmaceutical companies the need to tailor products, supply chains,
outsource a large share of their production and distribution systems to local markets,
to third-party manufacturers within local managers tend to be more effective.
India— an uncommon practice for major If the CEO is an expatriate, combining
pharma companies elsewhere in the world. longer postings with a strong local second
And both Hyundai and LGE have built in command, as in the case of the South
global-scale manufacturing facilities to Korean giant Hyundai, seems to be crucial
capture economies, making India a global to success. In addition, multinationals
manufacturing hub that can serve other such as Castrol have benefited from
markets as the local market develops. strong local boards to counsel,
challenge, and help local operations.
Using extensive third-party distribution
also helps. In India, organized retail Skipping the joint venture
distribution systems reach less than Multinationals entering new markets have
2 percent of the market, so there is traditionally struck up joint ventures with
considerable pressure to find innovative local partners for a variety of reasons,
ways of reaching retail consumers. This including their ability to influence public
third-party distribution system is crucial to policy, to bring into the venture existing
capturing demand created by the superior products as well as marketing and sales
price-to-value offerings available in smaller capabilities, and to comply with regulatory
cities and rural areas, which make up a requirements when foreign participation was
large share of the Indian market. In fact, restricted to less than 50 percent of a business.
successful multinationals such as Castrol
(acquired by BP in 2000), LG Electronics, While joint ventures are still crucial to
and Unilever have built deep third-party gaining access to privileged assets in some
distribution networks that serve second- industries—metals and mining, for example,
tier cities and villages. Here again, a local and oil and gas—our research shows that,
strategy is crucial. One multinational where possible, multinationals are better
company, for instance, used to own its off going it alone. Of the 25 major joint
entire worldwide distribution infrastructure, ventures established from 1993 to 2003,
including warehouses and trucks. Applying only 3 survive. Most foundered because
that business system in India, where large the local partner couldn’t invest enough
companies face high labor and overhead resources to enlarge the business as quickly
costs, made it impossible to attain as the multinational had hoped. As a result,
nationwide reach. Moving to a third-party most of the multinationals that initially
distribution system employing a network of entered the market through joint ventures
dealers and agents proved very successful. have exited them and pursued independent
operations. Multinationals, such as Hyundai
4The Automotive Components Manufacturers Finally, in contrast to companies that and LGE , that have achieved real success in
Association (ACMA) of India. rotate expatriate managers in and India have bypassed joint ventures entirely,
22 McKinsey on Finance Winter 2005
and newcomers are increasingly entering instead they have invested much time
the market on their own. Even when a and energy to identify and understand
joint venture is unavoidable, successful the key policy makers, to formulate
multinationals ensure from the outset that robust positions for investment, and
they retain management control and have a even to suggest regulatory changes. In
clear path to eventual full ownership. addition, these companies have garnered
support from constituencies such as
Participating in the regulatory process state governments, which compete for
Multinationals in deregulating industries investments, and industry associations that
often need to be flexible and patient during lobby for similar regulatory changes.
the natural process of regulatory evolution.
Regulations governing the mobile-telephony
sector, for example, have been amended
several times since 1994 as it has grown; it Clearly, any entry into a new market
had two licensed operators per region back requires a certain degree of tailoring to
then and now has as many as six. Although its specific needs and conditions. But for
most multinationals left the sector when the some companies, the entry into India has
regulations governing it changed, Hutchison forced a fundamental rethinking of product
Whampoa continued to invest in India. Ten offers, cost structures, distribution systems,
years later, Hutchison Essar is one of the top and management teams. Companies that
three telcos in the country (as reckoned by successfully tap into the promising Indian
market share), and interviews with industry market often ignore conventional wisdom,
experts suggest that the company enjoys including the need for joint ventures. MoF
strong profitability.5
available.
Running head 23