The New Dynamics of Managing the Corporate Portfolio
Early in 2006, the Dutch media concern VNU announced that it would accept the €7.6 billion takeover bid of a private-equity consortium, which, together with activist shareholders, had criticized a large planned acquisition and instead suggested a review of the company’s portfolio of businesses. In January 2007, the British aerospace technology company Smiths announced the sale of its aerospace business to GE after shareholders steadily criticized that unit’s performance relative to peers. A month later, the London-based hedge fund TCI called on the Dutch bank ABN Amro to “actively pursue the potential breakup, spin-off, sale, or merger of its various businesses.”
In a buyout market where suddenly it seems that everything is for sale, companies throughout the world face mounting pressure to actively manage their portfolio of businesses. A new breed of investor, among private-equity firms, hedge funds, and activist shareholders, is aggressively looking for opportunities to create value from portfolio moves in companies the investors regard as too passive. Complicating matters further, companies that do actively manage their portfolios are finding that the traditional “rebalancing” logic of portfolio management—invest free cash flows in more attractive businesses, preferably with synergies to existing ones, and look to build a strong position—often creates little value. Given the breadth and pace of today’s global markets, companies must constantly compete for acquisitions across the world and pay a hefty premium for highly attractive businesses. Often, merely reinvesting free cash flows makes little difference to the portfolio’s value.
Concepts and approaches that might help boards and management teams go beyond the conventional wisdom of portfolio management are often loosely defined and difficult to pin down analytically, so there is a tendency to make ad hoc decisions grounded more in gut feelings than actual data. However, in our experience, managers can quantify several of these concepts of portfolio strategy and bring them together in a more cohesive approach. Portfolio strategy, at its core, is about being or becoming the natural owner of businesses and balancing investment opportunities against the supply of capital, given the predicted returns of current and potential investments.
The Right Approach
Given the complexity of portfolio decisions, how should managers go about defining a portfolio strategy? Here are four useful hints, drawn from a broad range of portfolio projects, for companies wanting to apply a more rigorous methodology.
1. Understand the context and objectives. Approaches to portfolio strategy can vary considerably, depending on the context. One company may want to determine which businesses it can divest with minimal loss of value and strategic coherence. Another might want to assess the range of investment options for cash flows generated by its current, maturing businesses.
2. Manage agency issues. Operational managers do not have the best position for making portfolio decisions: they are often inclined to favor the businesses they are currently responsible for, so they are reluctant to recommend reallocating capital to new opportunities. To overcome such agency issues, a company should charge people who are independent of the operating businesses—typically, the board, advised by the CEO and the CFO— with the responsibility for making all final portfolio decisions.
3. Apply analytical rigor. Any rational portfolio decision depends on a true understanding of a business’s performance and upside. Managers often claim they have all the data, although those data are purely internally focused. To analyze a portfolio, a functional team, led by the CFO, should rigorously and quantitatively benchmark the returns and growth of individual businesses as compared with those of their peers. The team also needs to challenge internal plans by comparing them with the historical performance of the business or that of peers.
4. Keep capital discipline. Even the best portfolio strategy cannot adequately account for all future developments. Investors do not expect a company to predict the future, but they do expect it to show discipline once projected returns do not materialize.
The more private-equity firms, hedge funds, and activist shareholders step up the pressure on companies to generate value, the more it makes sense for them to be selective about creating a truly distinctive portfolio of businesses.