McKinsey on Finance

Perspectives on What public companies can learn from private equity  1

Corporate Finance Public companies will need to raise their governance game if
and Strategy they are to compete with private firms.

Number 22, Are companies getting better at M&A?  7

Winter 2007 The latest boom in merger activity appears to be creating more value
for the shareholders of the acquiring companies.
The truth about growth and value stocks  12
Investors and fund managers build entire portfolios around the premise that
growth stocks grow faster than value stocks. The problem is that they don’t.
Governing China’s boards: An interview with
John Thornton 16
The ex-president of Goldman Sachs talks about his experiences as a
reformer of board governance in China.

Why accounting rules shouldn’t drive strategy 23

When changes in accounting rules provide no new information, they don’t
register with investors. Nor should they lead managers to shift focus.
McKinsey on Finance is a quarterly publication written by experts and practitioners in
McKinsey & Company’s Corporate Finance practice. This publication offers readers
insights into value-creating strategies and the translation of those strategies into company
performance. This and archived issues of McKinsey on Finance are available online at
www.corporatefinance.mckinsey.com, where selected articles are also available in audio
format. A McKinsey on Finance podcast is also available on iTunes.

Editorial Contact: McKinsey_on_Finance@McKinsey.com

To request permission to republish an article send an e-mail to

permission@mckinseyquarterly.com.

Editorial Board: James Ahn, Richard Dobbs, Marc Goedhart, Bill Javetski,
Timothy Koller, Robert McNish, Herbert Pohl, Dennis Swinford
Editor: Dennis Swinford
External Relations: Joanne Mason
Design Director: Donald Bergh
Design and Layout: Veronica Belsuzarri
Managing Editor: Sue Catapano
Editorial Production: Roger Draper, Drew Holzfeind, Karina Lacouture, Scott Leff, Mary Reddy
Circulation: Susan Cocker
Cover illustration by David Hollenbach

Copyright © 2007 McKinsey & Company. All rights reserved.

This publication is not intended to be used as the basis for trading in the shares of any
company or for undertaking any other complex or significant financial transaction without
consulting appropriate professional advisers. No part of this publication may be copied
or redistributed in any form without the prior written consent of McKinsey & Company.
 

What public companies can learn

from private equity
Public companies will need to raise their governance game if they are to
compete with private firms.

Andreas Beroutsos, The more successful private equity becomes, the more scrutiny it attracts. In November
Andrew Freeman, and 2006, the United Kingdom’s Financial Services Authority warned of the growing risk
Conor F. Kehoe to the industry as private equity firms set their sights on ever bigger targets, in the process
taking on ever higher debt. Elsewhere, the high fees and dividends that some firms
are extracting within months of closing deals suggest that the clubby industry may have
entered a period of excess. Some firms may well find that they have bitten off more
than they can chew. But it would be wrong to assume that the challenge private equity
firms pose to the public equity model is about to ease.

True, McKinsey research shows that three-
quarters of private equity firms perform
no better than the stock market over time.
Even so, the top 25 percent of private equity
firms do outperform the relevant stock
market indexes. Moreover, they do so by a
considerable margin—and persistently.
More important still is the source of their
success. Top performance does not, as
many imagine, come from unusual financial
acumen. In our observation of private-
sector deals worth more than $100 million,
very few of the successes came about
because firms paid less than prevailing
market prices for similar assets. Markets
are reasonably efficient, and most important
assets sold to private equity firms undergo
a relatively wide auction. Indeed, if anything,
the risk is that private equity firms over-
pay for their assets as they compete against
strategic public buyers. Nor do private
equity firms obtain the bulk of their returns
by profiting from a rising market or an
even more quickly rising sector within the
market. Their real—and often overlooked—
source of success is the governance model
they apply to the companies they own.
This is an advantage that public companies
find hard to emulate.
 McKinsey on Finance Winter 2007
Active ownership in private equity
To find out what the private equity
advantage entails, we examined the data
behind 60 deals completed by 12 top-
half private equity firms and interviewed
individual deal partners (the firm represen-
tatives in each company in our portfolio).
We asked these partners how much time they
spent on their respective companies, what
resources they had, and to what end—and
corroborated their input by interviewing
CEOs. We then correlated the reported
behavior with the amount of value created
in excess of what an equivalent investment
in similar quoted equities would generate.
Our analysis was skewed toward the better
deals by the better firms. It suggests some
lessons for public-company executives who
might wish to emulate their performance.
We found that private equity firms at the
top of their game exert ownership control
over management and in this way create
levels of sustainable above-average
performance that set them apart from public
companies, as well as from their rivals in
the private equity industry itself. All these
firms conduct deep research into their target
companies prior to acquisition. Once an
acquisition is completed, the contrast
in governance style between the good and
the great can be striking. It’s even more
striking when measured against the prac-
tices of traditional public companies,
which typically diffuse shareholder bases,
powerful CEOs, and nonexecutive directors
(who have no research staff, no budgets to
hire external support, and access only to
data that management supplies).
Top private equity firms seem more com-
mitted to effective oversight of their
investments. True, they use high levels of
compensation to align managers’ interests
with their own. But in addition they not
only commit their own time to make the
board more effective but also conduct
research to develop personal views about
the direction a company should take,
using their block vote to speed up decision
making. Among the 60 deals we reviewed
in depth, active private equity partners
devoted half of their time to the company
(usually at its premises) during the first
three months after the deal. Less active and
less successful deal partners spent only
about 15 percent of their time in this way.
Similarly, active deal partners had teams
of analysts working with them; less active
partners worked alone. Active partners
build up their own viewpoint about how a
company could create value, verifying or
modifying hypotheses they had developed
during the due-diligence phase of the deal.
Less active partners typically reviewed and
commented on plans drawn up by man-
agement. Active partners became familiar
with management, sometimes long in
advance of a deal, and made any replace-
ments quickly. Less active partners
made replacements too, but usually much
later. Finally, active partners measured
performance using operational indicators
(usually linked to the value creation plan),
whereas less active partners tended to rely
on standard financial measures.
In our view, this active assertion of owner-
ship is the crucial difference between
the best private equity firms’ concept of good
governance and the one put into practice
by public companies and less successful
private equity firms. Intriguingly, private
equity firms have longer time horizons—a
five-year holding pattern is the norm—
than the quarterly earnings treadmill of
public markets.
 What public companies can learn from private equity
In effect, today’s successful private
equity firms exploit what might be called
“governance arbitrage” rather than the
financial engineering or price arbitrage that
proved profitable when the industry was
less mature. The best private equity firms
can find and successfully realign businesses
whose governing structures (owners
and managers) are misaligned. So big is the
opportunity for this type of transaction,
we believe, that private equity is likely to
maintain, and perhaps to expand, its
presence as a parallel system to established
public markets. It would revert to mar-
ginal status only if the governance of public
companies improved dramatically.
Nonexecutives seldom enjoy great financial gains
if a company is successful, but they do stand to lose
if there are lapses in compliance; lawsuits may ensue
Of course, the private equity system is
not perfect, even though it provides for well-
supported, motivated, and professional
governance. The management fee in large
funds may now be so great that it will
blunt the hunger to create returns; large
private equity funds may be generating
annual revenues of $1 million to $2 million
per professional from fees alone. As funds
grow in size, they may outstrip the abilities
of private equity firms: a $40 billion
company may require governance skills that
are different from those needed to run a
$400 million company (though not so long
ago, a $400 million deal was considered
large). Some private equity firms, eager to
avoid endless fund-raising visits, are seeking
“evergreen capital” from stock market
issuance, but this approach might reduce
their attention to the investors’ needs.
Finally, although only the top 25 percent

of funds create significant value for
investors, the other 75 percent manage to
win financing, usually on the same terms
as the better performers. Their weakness
could threaten the industry’s long-term
sustainability.
Nevertheless, public equity markets
currently face a real challenge from private
equity—though not from its technocratic
excellence, let alone its sometimes giddy use
of financial leverage. Rather, the challenge
comes from private equity’s ability to align
owners and managers far more effectively.
The people who run public companies will
need to raise their game if they want to
better what the best private equity firms
can offer.
Active ownership in public
companies
Some might argue that governance
has greatly improved in public markets,
notably since the cleanups that followed
recent high-profile corporate scandals. But
this is to misunderstand what has been
happening. If you ask nonexecutive direc-
tors of public companies, you will find
that they overwhelmingly direct their efforts
not at value-creating governance but at
compliance—the need to ensure that none
of the growing number of codes and
regulations is breached.
This problem is reinforced by the structure
of incentives: nonexecutives seldom
enjoy great financial gains if a company is
successful, but they do stand to lose if
there are lapses in compliance; lawsuits may
ensue. Further, nonexecutives are often
drawn from the ranks of professional
managers, so they may naturally empathize
more with management than with owner-
shareholders. Also, they have little
  McKinsey on Finance Winter 2007
1  “ What directors know about their companies:
A McKinsey Survey,” The McKinsey
Quarterly, Web exclusive, March 2006; and
Robert F. Felton and Pamela Keenan Fritz,
“The view from the boardroom,” The
McKinsey Quarterly, 2005 special edition:
Value and performance, pp. 48–61.
share-voting power and few staff
resources to support their contributions
to board deliberations.
Furthermore, nonexecutive directors of
public companies may simply lack the
necessary information. Those McKinsey
polled in 2005 complained that they
wanted to spend more time on strategy and
on selecting and developing management
talent—and less time on audit and compen-
sation issues. But only about 10 percent
of these directors felt that the board had a
complete understanding of their company’s
strategy and long-term objectives or of
the key initiatives designed to achieve them
(the rough equivalent of the value creation
plan for private equity).1 Indeed, when
asked to describe the extent of the board’s
understanding of the long-term objectives,
more than half of our respondents answered
“limited” or “none.” Over a quarter felt
the same about the board’s understanding of
corporate strategy. Most felt starved of
operational and strategic information; more
than 70 percent wanted more of it, while
only a minority wanted more financial
information.
The survey suggests that public companies
would benefit from much greater engage-
ment between managers and nonexecutives,
including much more sharing of relevant
nonfinancial information, as well as a
greater commitment from nonexecutives to
develop their understanding of the business
and the industry context. The wishes
of nonexecutives serving on the boards of
public companies are likely, however,
to arouse hostility or ambivalence similar
to the feelings expressed by managers in
private equity–owned companies. Without
the incentives, resources, and voting power
of private equity nonexecutives, the public-
market cadre faces an uphill struggle.
Transferring private equity DNA
Many of the managerial approaches that
the best private equity firms use, however,
could be reproduced in publicly owned
companies. There is scope to do so at the
board level as well as in the way the
CEO and CFO interact with the units of a
multibusiness company. Several practices
offer the greatest potential.
A more intensive and externally focused
strategy process
Private equity firms conduct an intensive
strategic assessment of businesses they buy.
This assessment, which takes place during
due diligence and the first 100 days of a
private equity deal, identifies costs to slash,
new markets and profit pools to pursue,
and portfolio changes to make. Its outcome
is a value creation plan that—because of
the intensity of preparation—is believable to
all involved (including management)
and delivers a good sense of the major risks
and further opportunities. Publicly held
companies conduct similar activities in their
own strategic-planning processes, but they
typically lack the same intensity.
The process has some critical elements.
One is external benchmarking through a
range of key performance indicators
(KPIs) and processes (for example, overhead
costs, the utilization of assets, cost per
unit produced, purchasing processes, and
manufacturing processes), which may
identify best practices to emulate. External
benchmarking should extend beyond
industry best practice to that of the leading-
edge industry for the activity in question.
The process should also provide independent
verification of key assumptions about
the business, such as the outlook for the
industry (volumes, prices, input costs)
and the competitive position of the target
company.
What public companies can learn from private equity
Public companies can and should under-
take similar intensive and externally
focused assessments. However, since these
assessments are time consuming and
expensive, and because market outlooks and
opportunities do not change very quickly
for public companies, they need not under-
take the more intensive process annually.
In our experience, an assessment is neces-
sary only following a major deal in the
sector, a change in the industry structure,
or major changes in input costs, such as
raw-materials prices. Otherwise, every
three to four years should be adequate. In
off years, the normal strategic-planning
process ought to suffice—and could involve
no more than a cursory update of a few
key assumptions.
Tough but realistic targets linked to
significant incentives
For private equity players, the first element
of performance management is to forge a
close link between the KPIs used to evaluate
management and the value creation plan
developed during due diligence and the
100-day phase. Private equity firms expend
a lot of effort to design KPIs that are focused
and comprehensive and to ensure that
they cascade down the organization. In this
respect, private equity players resemble
good performance managers in public com-
panies; the difference is the way private
equity firms create incentives, based on the
KPIs, and use them to manage acquisitions.
At companies governed by private equity
firms, managers have significant incentives
in the form of equity stakes, coinvestment
opportunities, and bonus payouts for
meeting key objectives. In the private equity
deals we reviewed, top managers typically
owned 5 to 19 percent of the equity and had
invested a substantial amount of their
own net worth to obtain it. In addition to

this participation in the upside, the high
leverage of private equity deals imposes its
own discipline and motives to perform.
Incentives at private equity–owned companies
often are significantly better than
those at publicly listed ones, especially in
mature industries; management, with its
own wealth invested, bears greater risk.
This incentive structure is also better
designed to align the interests of the owners
and the managers. While the incentives
that publicly listed companies can offer are
sometimes constrained (for example,
by executives’ fear of being labeled as “fat
cats”), many of them actually can offer
greater incentives that are better aligned
with the shareholders’ interests.
Finally, performance-management con-
versations in private equity–owned
companies are frequent, fact based, and
hard edged. When their performance
suffers, private equity players are quick to
act, spending more time with management,
replacing underperforming teams, and
hiring external experts. While many publicly
held companies have similar conversations,
few are as rigorously implemented and as
focused on value creation as those at private
equity firms. In this vein, public companies
should review these conversations to ensure
that the performance challenge is robust,
fact based, and transparently linked to value
creation initiatives.
Evaluation of key managers and an ongoing
search for talent
One of the most important yet challenging
aspects of conducting a private equity–style
program in a public company is forming
a management team that is fully ready for
radical change. In the case of multibusiness
companies, corporate senior executives
must stand 100 percent behind the business-
unit-management teams they are backing
 McKinsey on Finance Winter 2007

and be ready to make changes to meet their
goals. The senior executives must there-
fore get to know the team’s strengths and
weaknesses, identify who must be replaced
and which new roles must be filled, and
have enough knowledge to supplement the
team with external support that plugs any
remaining gaps. To do all this, they need
to spend enough time on site; the private
equity best practice is 50 percent of a
partner’s time for the first three months.
Finally, they should assess whether
the management team is a credible agent of
change: a team that has been happy with
the status quo for a long time may find
that it cannot generate the “followership”
needed for a radical program, no matter
how strong its desire to do so. In these cir-
cumstances, the solution is to rotate in new
teams to manage the business unit.
The challenge for public companies is not
so much securing the skills to undertake the
tasks described here but rather developing
the will to undertake these tasks without the
incentives, powerful and well-supported
board members, and an exit time frame that
the private equity system provides. Public
companies also face the challenge of finding
the time for senior management and
the board to undertake these value-creating
tasks while dealing with the growing
demands of compliance. The alternative,
of course, is to go private.
Private equity, as a governance system,
will no doubt suffer its own ups and downs,
particularly if the industry’s performance
falters. However, if private equity continues
to offer superior governance in a range
of circumstances, we believe that it could
rival the public market system in size.
That scenario presents a clear challenge to
public companies and their boards: they
simply must raise their governance game.
MoF

The authors would like to thank Braam Verster for his contributions to this article.

Andreas Beroutsos (Andreas_Beroutsos@McKinsey.com) is a partner in McKinsey’s New York

office. Andrew Freeman is an adviser based in the London office, where Conor Kehoe
(Conor_Kehoe@McKinsey.com) is a partner. Copyright © 2007 McKinsey & Company. All rights reserved.
 

Are companies getting better

at M&A?
The latest boom in merger activity appears to be creating more value for
the shareholders of the acquiring companies.

Richard Dobbs, With announced merger activity approaching $4 trillion globally in the first 11 months1
Marc Goedhart, and of 2006, the year had already surpassed the record levels set in 2000 (Exhibit 1). That
Hannu Suonio earlier boom was known not only for the number of deals completed but also for a lack
of discipline and the number of deals that destroyed value for the shareholders of the
acquiring companies; in fact, earlier McKinsey research shows that as many as two-thirds
of all transactions failed to create value for the acquirers.2 Are shareholders doing any
better this time around?
1 As of December 11, 2006.
2 Tom Copeland, Tim Koller, and Jack Murrin,

Valuation: Measuring and Managing the They appear to be. But there is still room From our analysis of announcement effects,
Value of Companies, first edition, Hoboken
NJ: John Wiley & Sons, 1990, pp. 318–21. for improvement. we compiled two indexes of M&A value
3 Paul Healy, Krishna Palepu, and Richard
creation. The first, deal value added (DVA),
Ruback, “Do mergers improve corporate
performance?” Journal of Financial We reviewed nearly 1,000 global mergers tracks the financial markets’ assessment
Economics, 1992, Volume 31, pp. 135–75;
and Todd Hazelkorn, Marc Zenner, and
and acquisitions from 1997 to 2006, of how much total value a deal will create,
Anil Shivdasani, “Creating value with mergers comparing share prices two days before and irrespective of whether the buyer or seller
and acquisitions,” Journal of Applied
Corporate Finance, 2004, Volume 16, Issue two days after each deal was announced in captures it. DVA measures the aggregate
2–3, p. 84.
4 Announcement effects are useful to assess
order to assess the financial markets’ initial value change at the time of announcement
the impact of M&A on its own, as they reaction to the deals. Academic research across both companies as a percentage
strip out many of the other factors that drive has found a positive correlation between of a transaction’s value (adjusted for market
share price movements beyond just the M&A
announcememt. But because the market’s these so-called announcement effects movements). The second index, proportion
initial response to deals can be either wrong or
and long-run value creation,3 so in the aggre- of companies overpaying (POP), examines
affected by factors other than the value of the
deal (such as bid speculation before the deal, gate, announcement effects are useful in the success of acquirers in capturing value
signaling, and tax and market liquidity issues),
announcement effects cannot be used to assess
assessing trends in the ability of M&A to from deals, by measuring the proportion of
the value that any individual deal creates. create value.4 all transactions in which the initial share
 MoF 22

M&A index
McKinsey on Finance Winter 2007
Exhibit 1 of 5
Glance: Global M&A activity in 2006 surpassed the peak level reached in 2000.
Exhibit title: A new boom in M&A activity

Exhibit 1
A new boom in M&A activity Volume of announced M&A deals,1 $ trillion
Private equity
Global M&A activity in 2006 surpassed the peak Corporate
level reached in 2000.

4.0 3.8

3.5 3.2 3.3

2.9
3.0
2.5 2.3
2.0
2.0 1.7
1.5 1.4
1.5 1.3
1.0
1.0 0.8

0.5
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1 Includes announced deals (not withdrawn) >$25 million in value; 2006 data as of December 11.
Source: Dealogic; McKinsey analysis
MoF 22
M&A index
Exhibit 2 of 5
Glance: Both cash and stock deals are doing better in the current boom than during the one that
ended in 2000.
Exhibit title: Creating more value
Exhibit 2
Creating more value Average deal value added (DVA),1 %

Both cash and stock deals are doing better Previous M&A boom Current M&A boom Average,
in the current boom than during the one that 20 1997–2006
ended in 2000.
15 Pure cash deals 14%
10 Total DVA 4%
5
0 Pure stock deals –3%

–5
–10
–15

–20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Number
90 126 139 133 89 39 49 78 93 108
of deals

1 ForM&A deals involving publicly traded companies; DVA defined as combined (acquirer and target) change in market capitalization,
adjusted for market movements, from 2 days prior to 2 days after announcement, as % of transaction value; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis
 Are companies getting better at M&A? 

price reaction for the acquirer was negative,
indicating that the acquirer overpaid
(adjusted for market movements). In other
words, POP represents the proportion of
acquirers that the market perceives to have
transferred to the sellers more than 100 per-
cent of the value created in their deal.
Our analysis of these measures indicates
that deals in the boom beginning in 2003
are creating proportionally more value—
and that acquiring companies are keeping
more of it for their shareholders.5
average DVA of +13.7 percent, compared
with –3.3 percent for pure-stock deals.
This greater share of cash deals during
the present boom partially explains
the market’s more favorable reactions. Yet
even when we compared those reactions
on a like-for-like basis, both cash and stock
deals did better in the current boom. Both
kinds of deals have also created more value
as it has progressed; in contrast, during
the previous boom, both types of deals
created progressively less value (Exhibit 2).

The current boom is creating . . . and acquirers are keeping

more value . . . more of it
According to our research, the market’s In the earlier M&A boom, the market
estimate of the value that deals created in judged that in more than two-thirds of the
the past ten years for the buyer and deals, all of the value created went to
seller combined (as measured by the DVA the target companies’ shareholders. This
index) averages around 3.4 percent of the time, however, shareholders of acquiring
5 Given the methodology, our analysis excluded

deals by private equity and other privately transaction value. During the current boom, companies appear to be keeping more
owned companies, since to measure the share however, the average DVA has been 6.1 per- of that value, as measured by the lower
price impact on both the acquirer and the
target company both must be publicly listed. cent, with the annual numbers trending proportion of acquirers that the market
We established other criteria for inclusion upward to +10.6 percent, from +2.1 percent. believes to be overpaying for deals (our POP
as well: (1) The absolute size of the deal had
to exceed $500 million, to ensure the liquidity Today, in fact, the DVA index is at a ten- index). In the current boom, the proportion
of the target and materiality; (2) The target year record high. Those numbers stand in overpaying has averaged 57 percent,
had to be at least 5 percent of the acquirer’s
size (measured by market capitalization), stark contrast to the previous boom’s, decreasing annually from 63 percent in 2003
so that the resulting impact on share prices
would adequately reflect the transaction
when the DVA averaged only 1.6 percent for to 56 percent in 2006. In contrast, from
and not other events or noise in the share price; the whole period—and trended downward 1997 to 2000 the overall average was
(3) Transactions had to involve a full change
of ownership (defined as the acquirer going from from +8.6 percent in 1997 to –5.9 percent6 65 percent, with the level of overpayment
0 to 100 percent ownership) to ensure that in 2000. increasing significantly, from 54 percent
the premium paid reflected a full change of
control and that the combined company in 1997 to 73 percent in 2000. Today’s POP
would be fully capable of capturing the intended The financial structure of the deals index stands near a ten-year low, despite
value from the combination.
6 The DVA is negative when the stock market’s announced during these two periods of greater competition from private equity firms,
reaction to a deal announcement is so
intense M&A activity differs as well. which conduct more than 20 percent of
unfavorable (possibly because of the loss of
creditability for the management team) that the This time around, cash deals represent a all global merger activity. Both the DVA and
decline in the acquirer’s market capitalization
more than offsets the increase in the acquired
much greater percentage of the public-to- POP indexes, which were moving in the
company’s share price. public transactions making up our data- wrong direction during the last M&A boom,
7 Gregor Andrade, Mark Mitchell, and Erik

Stafford, “New evidence and perspectives on base—nearly half, compared with the 1999 are now moving in the right one (Exhibit 3).
mergers,” Journal of Economic Perspectives, to 2000 range of 20 to 30 percent. Like
2001, Volume 15, Number 2, pp. 103–20.
8 One way to understand this difference is to some academic researchers,7 we also found While today’s lower POP could reflect many
think of a cash deal as a stock deal with a share that cash deals in our sample received a factors, one explanation is lower deal
buyback, with all its corresponding positive
effects. See Richard Dobbs and Werner Rehm, more favorable market reaction than stock premiums (Exhibit 4). In contrast to the
“The value of share buybacks,” McKinsey deals, possibly because of trading and 1990s, when the typical price premium
on Finance, Number 16, Summer 2005,
pp. 16–20. signaling effects.8 Cash deals generated an hovered around 30 percent, acquirers now
 MoF 22
10 M&A index
McKinsey on Finance Winter 2007
Exhibit 3 of 5
Glance: Both deal value added and proportion overpaying, which headed in the wrong direction
during the last M&A boom, are now heading in the right one.
Exhibit title: Dramatically different trends
Exhibit 3
Dramatically different Trends in deal value added (DVA) and proportion overpaying (POP) during 2 most recent M&A booms1
trends DVA,1 % POP,1 %
Previous M&A boom Current M&A boom Previous M&A boom Current M&A boom
Both deal value added and proportion 15 80
overpaying, which headed in the wrong
direction during the last M&A boom, 10 70
are now heading in the right one.
5 60

0 50

–5 40

–10 30
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1 For M&A deals involving publicly traded companies; DVA defined as combined (acquirer and target) change in market capitalization,
adjusted for market movements, from 2 days prior to 2 days after announcement, as % of transaction value; POP defined as proportion
of transactions where share price reaction, adjusted for market movements, from 2 days prior to 2 days after deal, was negative for
acquirer; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis

MoF 22
M&A index
Exhibit 4 of 5
Glance: Average deal premiums were around 30% in late 1990s but nearer 20% now,
helping to reduce the proportion of overpayers.
Exhibit title: Paying lower premiums
Exhibit 4
Paying lower premiums Median 1-week premium,1 %

Average deal premiums were around 30 percent Previous M&A boom Current M&A boom
in the late 1990s but nearer 20 percent now, 80
helping to reduce the proportion of overpayers. 70
60
Proportion of
50 overpayers
40
30
20 Average deal
10 premiums

0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1 For
M&A deals involving publicly traded companies; 1-week premium = price offered per share vs target company’s share price 1 week
before announcement; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis
 MoF 22
M&A index
Are companies 11
Exhibit 5 of 5 getting better at M&A?
Glance: The POP index is also lower for cash versus stock deals, but currently both deal types
receive a more positive initial market reaction.
Exhibit title: Cash deals are better received

Exhibit 5
Cash deals are better Proportion overpaying (POP),1 %

received
Previous M&A boom Current M&A boom Average,
90 1997–2006
The POP index is also lower for cash versus
stock deals, but currently both deal types 80
receive a more positive initial market reaction POP for pure 69%
70 stock deals
than during previous boom.
60
Total POP 62%
50 POP for pure 49%
40 cash deals

30

20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1 ForM&A deals involving publicly traded companies; POP defined as proportion of transactions where share price reaction,
adjusted for market movements, from 2 days prior to 2 days after deal, was negative for acquirer; 2006 data as of December 11.
Source: Datastream; Dealogic; McKinsey analysis

pay just slightly more than 20 percent
to win their target acquisitions, suggesting
that boards and management teams may
be more cautious about overpaying. Not that
prices are low—indeed, acquirers are
paying very high multiples. But on average,
price premiums are lower than they were
before, and especially lower than they were
at the last boom’s peak, in 2000.
Another explanation for the lower propor-
tion of deals that are deemed value
destroying to the acquirer is the market’s
reaction to cash deals versus stock deals
at the time of announcement. In pure cash
deals an average of around 49 percent
of acquirers overpay, compared with 69 per-
cent for pure stock deals—a difference
that has remained fairly constant over time
(Exhibit 5). The overall POP index has
improved considerably, thanks to the grow-
ing proportion of cash deals. Even when
we consider cash deals and stock deals
separately, however, the POP index is consid-
erably lower today than it was in 2000.
Mergers can and often do create value
in the eyes of investors. The improvements
reflected in our M&A indexes are encour-
aging: despite the recent intense volume
of M&A , it appears that acquirers have
been disciplined about creating value.
Nonetheless, plenty of room remains for
acquirers to improve their M&A performance
by focusing on the scope to create value
and to ensure that they don’t overpay.
MoF

The authors wish to thank Himanshu Wardhan and Silvio Wenzel for their contributions to this article.

Richard Dobbs (Richard_Dobbs@McKinsey.com) is a partner in McKinsey’s London office, Marc Goedhart

(Marc_Goedhart@McKinsey.com) is an associate principal in the Amsterdam office, and Hannu Suonio
(Hannu_Suonio@McKinsey.com) is an associate principal in the Helsinki office. Copyright © 2007 McKinsey &
Company. All rights reserved.
 12
Bin Jiang and
Timothy Koller
1 Although there is no universal definition of
growth and value stocks, most investors agree
on the broad characteristics of companies
in each category: growth stocks tend to have
higher price-to-earnings ratios or market-
to-book ratios, while value stocks have low P/Es
and M/Bs and may have high dividend yields.
2 Sophisticated investors do sometimes defy
the growth and value stereotypes. Legg
Mason Value Trust, one of the most successful
mutual funds over the past 20 years and
widely considered to rank among the leading
value investors, includes in its top ten
investments some companies that would defi-
nitely be classed as growth companies. As
of October 2006, Legg Mason Value Trust
holds more than 9 percent of its total
assets (worth $1.9 billion) in Amazon.com and
Google, both clearly growth rather than
value companies.
McKinsey on Finance Winter 2007
The truth about growth and
value stocks
Investors and fund managers build entire portfolios around the premise that
growth stocks grow faster than value stocks. The problem is that they don’t.
What’s in a name? In the vernacular of equity markets, the words “growth” and “value”
convey the specific characteristics of stock categories that are deeply embedded in the
investment strategies of investors and fund managers. Leading US market indexes, such
as the S&P 500, the Russell 1000, and the the Dow Jones Wilshire 2500, all divide
themselves into growth- and value-style indexes. Academics also use these categories as
shorthand, arguing at length over which investment approach creates more value—a
value strategy or a growth strategy. These names explicitly convey the expectation that
growth stocks will have higher revenue growth prospects than value stocks.1 And
investors, even large institutional ones, often make investment decisions based largely
on those expectations.2
It’s not illogical that executives would in deference to presumed shareholder
often draw from this reality an assumption expectations of growth.
that having the label growth or value
attached to a company’s shares can actually The trouble is that such thinking is wrong
drive prices up or push them lower. In our in both cases. Evidence comes from
experience, many executives have expended a recent McKinsey analysis of the S&P/
considerable effort plotting to attract Barra indexes of S&P 500 companies.3
more growth investors, believing that an Although growth stocks are indeed valued
influx of growth investors leads to higher at a higher level than value stocks on
valuations of a stock. Some executives average, as measured by market-to-book
even turn this assumption into a rationale ratios (M/Bs),4 their revenue growth rates
for using a high share price to defend are virtually indistinguishable from those
risky acquisition programs—for example, of value stocks (Exhibit 1). The growth

Exhibit 1
No advantage in growth
Companies that show up on growth indexes
actually don’t grow appreciably faster
than those that show up on value indexes.
3 Barra (which in 2004 merged with Morgan
Stanley Capital International to form MSCI
Barra) offers financial models and analytics
intended to provide insight into the risks
behind investment decisions. S&P and Barra
collaborated from 1992 to 2005 to produce
the official S&P 500/Barra Value and the S&P
500/Barra Growth indexes. Constituents for
the S&P 500/Barra Value and Growth indexes
studied in this article are as of the end of 2005.
4 The median M/B for growth stocks was 4.8 at
the end of 2005, while the median M/B for
value stocks was 2.2. The medians are the same
with or without financial-sector stocks.
5 See Bing Cao, Bin Jiang, and Timothy Koller,
“Balancing ROIC and growth to build value,”
McKinsey on Finance, Number 19, Spring
2006, pp. 12–6.
MoF 22
Growth stocks
The truth1about 13
Exhibit of 2 growth and value stocks
Glance: Companies that show up on growth indexes actually don’t grow appreciably faster than
those that show up on value indexes.
Exhibit title: No advantage in growth
Median value = 8.7% Median growth = 10.1%
14
Frequency of growth and value stocks
12
exhibiting given growth rate,1 %
Growth stocks
10
Value stocks
8
6
4
2
0
–3 –1 1 3 5 7 9 11 13 15 17 19 21 23 25 >25
Growth rate, 3-year average, 2002–05,2 %
1 S&P 500/Barra Growth Index and S&P 500/Barra Value Index as of Dec 2005.
2 Excluding goodwill; does not include financial-sector stocks; 3-year average adjusts for annual volatility.
index’s 10.1 percent median compounded stocks; it is that the concepts of growth
revenue growth rate for 2002 to 2005 versus value are just not meaningful.
is not statistically different from the 8.7 per- Companies can have high price-to-earnings
cent median of the value index. Thus, the ratios (P/E s) and M/B s because they have
probability that a company designated as a high growth and moderate ROIC s, low
growth stock will deliver a given growth growth and high ROIC s, or high growth
rate is virtually indistinguishable from the and high ROICs. Branded consumer
probability that a value company will do so. products companies, for example, have high
ROIC s but modest growth, while hot
What does distinguish companies on retail companies have high growth and
growth indexes from those on value indexes modest ROIC s. This point may seem
is return on invested capital. For the value counterintuitive, but it is actually consistent
index, the median ROIC , averaged over with the conceptual drivers of value. Both
three years, and excluding goodwill, is a company’s ability to grow and its ability
only 15 percent, compared with 35 percent to earn returns greater than its cost
for the growth index (Exhibit 2). In other of capital generate higher cash flows—and
words, the average growth stock is likely to hence higher valuations.5 Therefore, a
deliver twice the average value stock’s book high M/B or P/E for a company that is not
return on capital. In fact, the correlation growing fast is hardly surprising. At such
of M/Bs with ROIC in 2005 was 20 percent, companies, higher returns simply make up
versus 1 percent for growth rates. for slower growth.
The point is not that ROIC is a better filter Consider two otherwise similar companies,
for separating growth stocks from value one with a higher ROIC . For these

14
Exhibit 2
Instead, better returns
on capital
Growth stocks have much better returns on
invested capital than do value stocks.
6 This comparison can be reduced to a simple
formula: growth = ROIC × reinvestment rate.
7 We compared the companies in the S&P
500/Barra Growth and Value indexes at the
end of 1995 with the companies in those
indexes at the end of 2005. The comparison
yielded a list of 84 companies that have
switched at least once from one classification
to another during that ten-year period. Of
these, we identified companies that made
a clear one-way switch from value to growth
or growth to value and then examined the
change in their investor base in relation to the
market valuation changes.
MoF 22
Growth stocks
McKinsey on Finance Winter 2007
Exhibit 2 of 2
Glance: Growth stocks have much better returns on invested capital than do value stocks.
Exhibit title: Instead, better returns on capital
35
30
stocks exhibiting given ROIC,1 %
Frequency of growth and value
25
20
15
10
5
0
–5
1 S&P 500/Barra Growth Index and S&P 500/Barra Value Index as of Dec 2005; ROIC = return on invested capital.
2 Excluding goodwill; does not include financial-sector stocks; 3-year average adjusts for annual volatility.
companies to generate the same growth
in future cash flows, the higher- ROIC
company needs to invest less capital back
into its business than the lower-ROIC
company. The excess cash at the higher-
ROIC company can then be plowed into
higher-return projects or given back
to shareholders.6 Naturally, a company with
a higher ROIC is valued at a higher level.
In fact, any growth index includes many
familiar names that enjoy high ROICs but
actually have delivered limited growth
relative to their industries from 2002 to
2005. Examples include Boeing (0.5 per-
cent), Heinz (1.6 percent), Anheuser-Busch
(3.5 percent), Altria (3.5 percent), DuPont
(4.5 percent), Kimberly-Clark (5.4 percent),
Hershey (5.5 percent), Coca-Cola (5.7 per-
cent)—compared with a median growth
rate of 9.6 percent for S&P 500 companies.7
Furthermore, executives who believe that
attracting more growth investors will
improve the value of businesses are bound
to be disappointed. Our analysis of
Median value = 15% Median growth = 35%
Value stocks
Growth stocks
0 5 10 15 20 25 30 35 40 45 50 >50
ROIC, 3-year average, 2002–05,2 %
companies whose stocks have been newly
designated as growth stocks clearly shows
that growth investors don’t precipitate
a change in valuation levels. Rather, they
respond to it, moving into a stock only after
the share price has already moved to a
higher M/B or P/E . And while the number of
growth investors does sometimes increase up
to three months before a sustained increase
in the M/B , it often takes them as long
as 12 months after an increase in valuation.
Stocks downgraded from growth to value
show a more striking pattern: when
these stocks changed to value status, their
M/B s peaked and then headed into a
sustained decline. Here again, growth inves-
tors hold onto a stock until they regard
its revaluation as a trend. Sometimes
they reach that conclusion fairly quickly,
divesting within the first quarter after
the stock’s revaluation. Often they take
much longer—as long as two and a
half years.
The truth about growth and value stocks 15

Simple attempts to discriminate between may mislead investors. Many so-called

companies by a dimension or two will
always fail to capture the variety of their
characteristics, particularly in cyclical
industries, where a company’s ROIC may
change radically from year to year. Even
worse, simple classification attempts
value companies are distressed and in
need of a turnaround. Companies and
investors would be better off focusing on a
company’s fundamental performance and
valuation rather than making arbitrary
style comparisons. That’s what the best
investors do. MoF

Bin Jiang (Bin_Jiang@McKinsey.com) is a consultant in McKinsey’s New York office, where Tim Koller
(Tim_Koller@McKinsey.com) is a partner. Copyright © 2007 McKinsey & Company. All rights reserved.
16 McKinsey on Finance Winter 2007

Governing China’s boards:

An interview with John Thornton
The ex-president of Goldman Sachs talks about his experiences as a reformer
of board governance in China.

Dominic Barton As a banker at Goldman Sachs in the 1980s and 1990s, John Thornton made his mark
and Richard He Huang blazing new financial trails with clients in Europe and Asia—trails that eventually led him
to the presidency of that prestigious investment bank. Three years ago, Thornton set out
on a radically different path: he retired from Goldman to start up a leadership program at
Beijing’s elite Tsinghua University.

That path has taken Thornton deep
into the heart of the world’s most intriguing
business environment. He spends five
months of the year in China, where his
teaching duties put him in contact with top
students, government officials, and China’s
emerging business elite. Yet this activity
is just a part of Thornton’s diverse efforts
to assist China’s bold but challenging
march toward economic development and
reform; he also advises government officials
and business leaders in China, Europe,
and the United States. Thornton is one of
the few Westerners to serve as a director
on the boards of several major players in
China’s economy, including telecom giant
China Network Communications (China
Netcom) and the Industrial and Commercial
Bank of China (ICBC), which completed a
$21.9 billion initial public offering
in October 2006. Thornton also serves as
a director of Ford Motor, Intel, and
News Corporation, giving him a unique
vantage point on the workings of Chinese
boardrooms and how they compare with
their Western counterparts.
Upon joining China Netcom’s board,
Thornton initiated an effort to establish a
corporate-governance committee—the
first of its kind for a major Chinese
state-owned enterprise. The committee’s
establishment has since led to a broader
effort to redefine how the company relates
to its stakeholders, including the Chinese
government. Today Netcom stands at the
Governing China’s boards: An interview with John Thornton
vanguard of a fledgling movement among
China’s state-controlled companies to
understand Western governance standards
and tailor them to the country’s unique
circumstances. Thornton recently sat down
in his New York office with Dominic
Barton, a director in McKinsey’s Shanghai
office, and Richard Huang, an associate
principal in the Beijing office, to discuss
China’s corporate-governance landscape and
the country’s reform challenges in general.
McKinsey on Finance: Let’s start with
some context: how should outside investors
and executives think about corporate
governance in China?
John Thornton: China today faces a set
of challenges—many unprecedented in
Vital statistics
Born January 2, 1954
Married with 4 children
Education
Graduated in 1976 with degree
in history from Harvard University
Received BA and MA in jurispru-
dence from Oxford University
in 1978
Earned master’s degree in private
and public management from
Yale University in 1980
John L. Thornton
17
complexity and scale in the history of any
nation—that need to be better understood
and appreciated by the outside world. The
Chinese government is trying to maintain a
degree of social stability that is the essential
foundation for the country to achieve
anything, while at the same time growing
and transitioning what was, until not long
ago, still essentially a command economy.
And the government is doing all of this in
the context of an incredible rate of change.
Pick an issue: the health care system,
environmental degradation, energy needs,
mass urbanization, or poverty in the rural
population. Any one of these challenges
would be a formidable task for a country
and its leaders. China has dozens of
problems of this magnitude. Clearly, a key
factor in raising the odds that the broad
Career highlights
Brookings Institution (2003–present)
• Chairman
Tsinghua University, Beijing (2003–present)
• Professor,
director of global leadership program
Goldman Sachs
• President
(1999–2003)
Fast facts
Serves on numerous boards, including Brookings
Institution, China Network Communications (China
Netcom), Ford Motor, Industrial and Commercial Bank
of China (ICBC), Intel, and News Corporation
Serves on the board of trustees of Asia Society, China
Institute, China Securities Regulatory Commission,
the Eisenhower Fellowships, Financial Services Volunteer
Corps, The Hotchkiss School, International Advisory
Committee of the China Reform Forum, Morehouse
College, National Committee on US-China Relations,
Tsinghua University School of Economics and Manage-
ment (Beijing), and the Yale School of Management
Serves as member of the Council on Foreign Relations
18 McKinsey on Finance Winter 2007
economic transformation underway can
succeed even in the face of such challenges
is to ensure that the managers of the
economy’s core enterprises are focused on
the right issues. This is where corporate
governance can play a critical role.
McKinsey on Finance: How does
that play out at the level of individual
enterprises?
John Thornton: There are 163 large
state-owned enterprises that are overseen
and controlled by one Chinese ministry:
the state-owned Assets Supervision and
Administration Commission. They are the
enterprises that senior officials focus
on the most because they have the broadest
impact on the economy and employment.
They are the ones that, historically,
the Communist Party has been responsible
for managing in the fullest sense. These
very large companies are also meant
to serve as models for smaller state-owned
enterprises. There is also, of course,
the rapidly growing Chinese private sector,
which is hard to generalize about in terms
of corporate governance. Finally, there
are the joint venture companies and Western
subsidiaries, which in terms of governance
are doing more or less what Western
companies do anywhere in the world.
McKinsey on Finance: Historically,
the management of these large state-owned
companies has reinforced the notion
that the party is all powerful. What is the
incentive for bringing in a more Westernized
approach to corporate governance?
John Thornton: I can tell you, from
the many conversations I’ve had, that
officials at the highest levels recognize the
need to put in place what might be called
a modern system of corporate governance.
They know that they’ll be required
to meet certain standards when they list
their major companies in public markets
in Hong Kong, London, or New York.
They’re also increasingly convinced that
better corporate governance leads to
better business results, greater efficiencies,
wealth creation—all of those things that
are good for companies, people, and
the country. They have seen that even non-
traded corporations like Saudi Arabia’s
Aramco have adopted leading corporate-
governance practices.
Yet for nearly all senior Chinese officials
and corporate leaders, up until now they
have had no personal experience with this,
no frame of reference. They know they
need to do it, but most don’t know exactly
how to go about it.
McKinsey on Finance: You serve as
an independent director on Chinese
company boards. What do the efforts to
establish better governance look like
from the inside?
John Thornton: The China Netcom
project is a very interesting example.
The topic of corporate governance first arose
when the chairman asked me to join the
board. I said I would but suggested that he
create a corporate-governance committee.
It would be the first ever in a Chinese
state-owned enterprise, and I thought if
it succeeded it could become a model that
works for the 162 other largest ones.
This obviously could be a tremendous force
for good within the Chinese system.
What is fascinating about the Netcom
project is its attempt to recognize reality.
The reality is this: the Chinese want to
Governing China’s boards: An interview with John Thornton
adopt state-of-the-art corporate-governance
practices that pass the Western tests. On
the other hand, they also want to do this in
a paced manner and to build a system that
works for China. In China the government
controls nearly all of the largest companies,
and that’s not going to change anytime
soon. Maybe in Western parlance, we could
conceptualize the government as the
majority shareholder for all of these com-
panies. Like any majority shareholder,
it’s not about to give up its primary levers
of influence just because someone else
wants it to. The goal is to build effective
corporate governance within this reality.
McKinsey on Finance: What, specifically,
did you focus on?
John Thornton: In Netcom’s case we
focused on putting in place the right
structures, processes, and interactions. We
defined specific roles for the Communist
Party and left the rest to the board—for
example, the party participates and votes
on key matters through nominated directors
on the Netcom board, but fewer than half
of the board members are party designees.
We clearly defined the boundaries of party
mandates for senior-executive appointments,
company strategy development, and key
investments. We gave authority to nominate
and approve CEO and CFO candidates
back to the board. The CEO now owns the
strategy-setting process and is supported
by a newly created strategy department.
We also set up formal channels to com-
municate better with Netcom’s stakeholders
and to provide its unions with more
appropriate involvement in governance.
We defined the roles and duties of the board
committees and secretariat, including
responsibility for managing risks.
19
McKinsey on Finance: What were some
of the tough issues that Netcom had to
grapple with, and what do the end results
say about the pace of reform?
John Thornton: At the top of the list was
shifting mind-sets, particularly regarding the
role of the board and minority shareholder
protection. In the past the boards of most
Chinese state-owned enterprises have been
seen as more of a rubber stamp rather
than as an organ that is able to add real
value to a company. While it is still very
much a work in progress, we are making
headway on changing the perceptions of
people—not only at the top, but throughout
Netcom—so that they understand that a
well-functioning board can be a real asset.
Similarly, there is greater cognizance that,
for listed state-owned enterprises like
Netcom, minority interests must be taken
into account.
As you might expect, it has been quite
challenging to carve out a meaningful role
for the board while at the same time
allowing the party to influence key decisions
as appropriate. Formalizing clearly the
roles for each and developing the processes
to arrive at key decisions was a significant
achievement. For example, the board set
up a detailed system for selecting top
executives and evaluating their performance.
The nominating committee comprises
five directors, three of whom the party
designates and two who are external.
In this way the party, as the majority share-
holder, is able to veto candidates in
committee, but external directors are able
to provide significant input to all directors
before the board discusses any candidacy.
The experience at Netcom suggests that
the government genuinely wants to proceed
in a principled manner but is treading
20 McKinsey on Finance Winter 2007
carefully as it moves forward. The chairman
of Netcom likes to say that he does not
see a contradiction between party influence
and the protection of minority shareholders
because the goals of the two are the same—
namely, Netcom’s success as a business.
No one wants Netcom and all the other
state-owned enterprises to succeed more
than the Chinese government and Commu-
nist Party do, because the success of
these businesses will better allow the party
and government to tackle the myriad
problems the country faces, which I men-
tioned before.
McKinsey on Finance: What do changes
at Netcom mean for other Chinese state-
owned enterprises?
John Thornton: Netcom is without a
doubt a pioneer of the governance
transformation. As a key player in the
telecom industry and a pillar of the Chinese
economy, its governance reforms will
have a significant impact on other large
state-owned enterprises. Perhaps more than
anything else, Netcom illustrates that
practical and balanced solutions acceptable
to both the investing community and the
Chinese government are achievable. The
reforms there can also change the attitude
of Chinese authorities toward corporate
governance, from one of complying with
minimum legal requirements to aiming
for best practices to advance the business
interests of all the shareholders.
McKinsey on Finance: What of the
broader swath of companies?
John Thornton: When you get to the
second category of state-owned enterprises—
that is, below the 163 largest—I think
almost by definition the story becomes both
more disparate and less clear. Any one
party secretary in a small city can have a
huge impact.
McKinsey on Finance: What’s
the operating style of Chinese company
boards?
John Thornton: In the case of ICBC —
China’s largest commercial bank—a board
meeting can feel almost more like an
internal operating meeting than a Western
board of directors meeting. So the topics
of conversation, the level of detail, and the
honest interchange are quite impressive.
There’s very little formality, and if directors
have disagreements they argue it out right
in front of you.
There is, of course, always room for
improvement. The other day I was asked to
be on a board committee call at 9:00 PM
here in New York—9:00 AM Beijing time.
The call ended at 10:30. Then I was told,
“By the way, we’re going to call you back at
5:00 AM your time to have a board meeting
to discuss with the whole board what we
just discussed.” So at times, basic operating
practices need to be improved: notification
of meetings, timely provision of succinct and
useful information, a good chair to run
the meeting and ensure that members have
their say.
McKinsey on Finance: How do Chinese
company executives regard Western
governance standards?
John Thornton: One of the trends
I’ve seen recently is a reluctance on the part
of Chinese companies to list in the United
States because of the very high standards
being imposed by Sarbanes-Oxley and other
rules that they feel they can’t or don’t
 Governing China’s boards: An interview with John Thornton
want to meet. Instead they’re listing in
Hong Kong and perhaps London, where the
standards are very high but the way
those standards are posed relates more to
the spirit of the rules rather than the
statute-based, legal-based system that exists
in the US .
‘Foreign directors, however, can bring a fresh and
different perspective that is often extremely valuable’
to Chinese companies
McKinsey on Finance: Does the West
send the wrong signal to China on this kind
of issue?
John Thornton: I tend to think that
high-level conceptual advice actually isn’t
all that valuable. Senior Chinese leaders
have all heard the expression “corporate
governance.” They’ve all heard the
expression “transparency.” What they really
need is people who can actually make
these things happen in a way that is effective
and that works in the Chinese system.
That goes to the question of internal train-
ing programs at companies, to the question
of university education in China, to the
kinds of real experiences that Westerners
have inside China, and to the question
of not just taking a conceptual framework
that works somewhere else and trying
to impose it. I’m very sympathetic to the
Chinese desire to build a system that
works for them, because I think we have to
acknowledge from experience, especially
over the past few years, that there’s no one
system that’s perfect.
McKinsey on Finance: What needs
to happen to feed and advance the
momentum that has built up for governance
reform?
21
John Thornton: Improving what might
be called the national human-resources
system is one key. You find an outstanding
person, he’s put in to be the chief executive
of the XYZ Chinese state-owned enterprise.
He’s there for three to five years, does
a good job, and is then snatched away to be
the party secretary in XYZ province, the
mayor of a city, or the chief executive of
a competing firm. From the standpoint, as
it were, of the ultimate shareholder—the
government—these are all human resources
to be deployed in whatever way they
need to be deployed. This clearly needs to
be changed.
McKinsey on Finance: How can
a foreign director be most helpful on a
Chinese board?
John Thornton: First, ask thoughtful
questions and be willing to challenge
management in a constructive way. As I
mentioned earlier, it is not that Chinese
directors don’t do this. They do. Foreign
directors, however, can bring a fresh and
different perspective that is often extremely
valuable. Second, they can leverage their
experience and personal networks and serve
as a window to the Western business
world. Finally, having gained an understand-
ing of China-unique issues and com-
pany culture, it’s important for them to
be a catalyst for real change.
McKinsey on Finance: Do you have any
tips on the dos and don’ts of being a
foreign director on the board of a Chinese
company and how to be effective?
John Thornton: I think one of the
dos would be, absolutely, to have a very
close personal relationship with some
people on the board, preferably including a
22 McKinsey on Finance Winter 2007

senior executive. It’s always difficult McKinsey on Finance: Obviously, your

as an outside director to truly understand
what goes on inside a company, in any
country. And in China I think it’s that much
more difficult for a whole variety of
reasons, including language, culture, and
some of the issues we’ve discussed today.
To be an effective director in a Chinese
company takes a lot more work because
every day can pose a different challenge.
Your Chinese colleagues on the board are
also learning, and they themselves are
looking for real advice. You cannot assume
that even things you consider to be basic
are being done in ways that are familiar to
you. And one other thing: the quality
of translation can vary widely. So another
good piece of advice is to have your own
translator.
presence on Chinese company boards
must be reassuring to Western investors.
Do you personally face higher risk in
an environment such as this?
John Thornton: I think by definition
there has to be more risk, yet I really don’t
think about it in those terms. I do think
that Western investors should have a deeper,
more realistically grounded understanding
of the complexities involved in these state-
owned enterprises. By doing so, they
would be doing themselves a favor—that is,
knowing better what they were investing
in. But also they could be forces for positive
change because they could be talking
to the management in a way that was more
honest and realistic. MoF

The authors wish to thank Simon Wong for his contributions to this interview.

Dominic Barton (Dominic_Barton@McKinsey.com) is a partner in McKinsey’s Shanghai office, and Richard

Huang (Richard_Huang@McKinsey.com) is an associate principal in the Beijing office. Copyright © 2007
McKinsey & Company. All rights reserved.
 When should CFOs take the helm? 23

Why accounting rules shouldn’t

drive strategy
When changes in accounting rules provide no new information, they don’t
register with investors. Nor should they lead managers to shift focus.

Timothy Koller The US Financial Accounting Standards Board (FASB) recently adopted new rules to
and Werner Rehm require that companies reflect the value of their pension funds on the balance sheet. Critics
almost immediately began complaining that the change would cause investors to rethink
the value estimates of a wide swath of companies. Those with significant pension liabilities,
the critics argued, would face lower valuations as they moved off-balance-sheet assets
and liabilities onto the balance sheet.

1 In some states, for instance, companies may
not pay dividends if the level of book
equity falls below the par value of the shares.
Basing legislation on accounting rules, as in
this case, also is ill advised.
Yet we are certain that knowledgeable
investors won’t pay much mind. After all,
they’ve seen such rule changes before.
Remember the rules that govern accounting
for M&A and for expensing stock options?
In both of those high-profile cases, none of
the changes made the slightest bit of
difference to the valuation that knowledge-
able investors placed on stocks.
The greater risk, however, is that the new
accounting rules could lead managers to
make strategic mistakes that might actually
destroy value. The new accounting
rules merely move data from one page of
an annual report to another. Yet we’ve
already heard executives pondering plans
to change capital structure policies,
dividend payouts, or buyback programs
to accommodate greater volatility
in shareholder equity as expenses and
liabilities appear on balance sheets.
With few exceptions,1 these managers would
be ill advised to use financial-accounting
changes to guide strategic decisions.
Investors already know the level of pension
liabilities from the ample disclosures in
the footnotes to financial statements.
With no new information, they will value
businesses just as they did before. In short,
managers should not change their behavior
 24
2 Goodwill is the amount paid for a target above
the fair value of its book assets.
3 Neil W. Harper, Robert S. McNish, and Zane
D. Williams, “Shed no tears for pooling’s
demise,” McKinsey on Finance, Number 1,
Summer 2001, pp. 17–20.
4 T. Lys and L. Vincent, “An analysis of value
destruction in AT&T’s acquisition of NCR,”
Journal of Financial Economics, October
2006, Volume 39, Issues 2 and 3, pp. 353–78.
5 Richard Dobbs, Billy Nand, and Werner Rehm,
“Merger valuation: Time to jettison EPS,”
McKinsey on Finance, Number 15, Spring
2005, pp. 17–20.
McKinsey on Finance Winter 2007
merely because accounting rules have
changed—and they must learn to ignore
the pundits and to focus on investing
in projects with a positive net present value
(NPV), even if next quarter’s accounting
earnings drop.
Remembrances of things past
Before managers make strategic mistakes,
they would do well to recall some earlier
episodes of controversy over changed
accounting rules. In 2001 intense lobbying,
news coverage, legislative reviews,
and general bluster accompanied proposed
new accounting rules for mergers and
acquisitions. Before then, companies could,
in certain well-defined circumstances,
carry over the book value of an acquired
company with no goodwill, 2 using an
accounting approach known as pooling
of interest. After the rule changed,
all transactions automatically generated
goodwill, which is recorded as an asset
and must be tested periodically for a loss in
value. If the test indicates such a loss, the
company must write down the difference
and charge it against earnings. Either
method results in identical cash flows, and
therefore value, since any write-down of
goodwill is a noncash charge.3
Back in 2001, though, managers, lobbyists,
and banks alike feared that the elimination
of pooling accounting would make
acquisitions more difficult, thus stifling
activity. Yet four years later, such fears
have proved unfounded; M&A volumes and
values are back to their peaks before
September 11, 2001. This makes sense.
The value created by an acquisition is driven
by the fundamental value of the acquired
company, the price paid, and cash flow
synergies, not from the way the company
accounts for them on the balance sheet.
The real value destruction came from
managers, who prior to the rule change
jumped through hoops—and spent
substantial sums on accountants—in an
effort to make the pooling of interest
possible for deals that were straightforward
takeovers. Take, for example, AT&T’s
acquisition of NCR , in 1991. To get NCR
to agree to pooling accounting, AT&T
incurred costs on the order of $500 million,
according to outside-in estimates.4 That
money was wasted because investors don’t
care about the accounting treatment of
a deal. Similarly, executives still often use
accounting rationales such as earnings
per share (EPS) accretion to drive M&A
decisions. Finance theory and practice make
it crystal clear that using changes in EPS
as a proxy for value creation is misleading
at best and completely wrong at worst.5
Another accounting tempest erupted in 2004,
when FASB began requiring companies to
account for employee stock option expenses
on their income statements—more than ten
years after the first attempt to change the
rules. Coalitions of companies, politicians,
and business publications joined hands to
argue that the change would ruin busi-
nesses, especially in the high-tech industry,
by limiting their freedom to issue employee
stock options.
Of course, all the information necessary to
put a value on issued and outstanding
stock options had long been available in the
footnotes to the financial statements of
US listed companies. Investors, predictably,
were nonplussed by the furor. Market par-
ticipants had for years been able to estimate
the dollar value of claims for employee
stock options from the disclosures, and
nothing in the rules change would affect
the market’s view of what companies are

6 Fraud, of course, is new information.
If investors learn that a company wrongly
reported data on anything, they will
react to the news. But the discovery of fraud
is far different from the reporting of data
in the income statement rather than in the
footnotes.
7 According to data from Bear Stearns.
8 “A corporation will recognize in its statement
of financial position an asset for a plan’s
overfunded status (or a liability for a plan’s
underfunded status) and recognize changes in
the funded status in the year in which
the changes occur through the statement
of comprehensive income.”
9 For instance, International Accounting
Standards (IAS) rules also require
recognition of gains and losses in the P&L,
not the statement of comprehensive income.
10 “Market impact of pension accounting
reform,” Merrill Lynch, October 2006.
Why accounting rules shouldn’t drive strategy
worth.6 One sell-side analyst we talked with
summarized his feelings succinctly: “I don’t
care as long as the information is there.”
Rationally, the expensing of stock options
should have been a nonevent. But managers,
partially driven by politics and punditry,
started to base their compensation policies
on accounting rules rather than the value
employees added. Many well-known
companies changed the way they compensate
employees, moving away from options
and toward other means, such as restricted
stock options and straightforward cash
bonuses. In itself, this could be a neutral
move. It’s the accounting-based rationale
that indicates the wrong priorities of
executives. Worse, about 900 companies
from many industries decided to vest their
options early,7 most likely to avoid option
expenses in the first year that the new rule
went into effect. This move had a negative
NPV: employees who previously had
to work for several years to gain access to
options suddenly had the immediate right
(though not the obligation) to exercise them.
Since any increase in flexibility increases
the value of options to employees, this early
vesting inevitably drained value away from
shareholders. Again, in some of these cases,
the decisions may well have been based
on a business rationale. Still, we doubt that
it was a good one if the force behind
the decisions was accounting rather than
the creation of shareholder value.
Pension accounting rules: More
of the same
FASB Statement 158,8 which went into
effect on December 15, 2006, changes how
corporations account for the funding
status of their pension and other postemploy-
ment benefit plans. Beyond the headlines,
this change once again provides investors
25
with no new information: the rule simply
means that financial information about
the fair value of the under- or overfunding
and about the annual financial performance
of all postemployment plans must move
from the footnotes to the balance sheet and
the statement of comprehensive income.
The data from the footnotes will replace the
current amounts on the balance sheet,
which were in essence obsolete estimates and
often not even close to the market value
of the funded status.
This new standard, which is similar (but
not equal) to the requirements of
international accounting rules,9 could result
in a drop in shareholder equity on the
order of $200 billion, or 5 percent, for the
S&P 500.10 Yet absent some new infor-
mation that investors previously didn’t have,
they probably won’t care. Nor will they
care about the increased equity volatility
that might come with the implementation
of the new rule. The changes might require
amendments to some tightly written
debt covenants, but we doubt they will force
renegotiations. Savvy lenders understand
the difference between accounting and cash
flow: for example, credit-rating agencies
have long incorporated in their ratings the
debt from pension liabilities and other
off-balance-sheet items (for example, leases).
Pension regulations in general are of course
important. The US Pension Protection Act
of 2006 aims to improve the funding of
corporate pension plans by imposing tighter
funding requirements, which influence
cash flows to equity and therefore equity
value. Similarly, scholars and practitioners
alike rightfully debate whether the
discount rates used in estimating pension
liabilities are correct, given macroeco-
nomic developments. But this is a good
26 McKinsey on Finance Winter 2007

debate about the NPV of liabilities—and
very different from moving data from one
page to another.
Watch out for what’s important
Given these changes in accounting rules—
and the certainty that more will come—
value-minded managers, boards, and
advisers must be disciplined about keeping
their focus on fundamentals. Too much
time is wasted debating the impact of
accounting rules that simply do not matter.
In our experience, when managers plan
to change capital funding or payout regimes,
pensions, compensation, or other financial
plans solely as a result of revised accounting
rules, value is typically destroyed. Share-
holder value depends on cash flows and the
cost of capital, not on the method of
accounting for them. MoF

Tim Koller (Tim_Koller@McKinsey.com) is a partner in McKinsey’s New York office, where Werner Rehm
(Werner_Rehm@McKinsey.com) is a consultant. Copyright © 2007 McKinsey & Company. All rights reserved.
Running head 27
28 McKinsey on Finance Winter 2007
Podcasts

Download and listen to these and other selected McKinsey on Finance

articles using iTunes. Check back frequently for new content.

Are companies getting better at M&A?

The latest boom in merger activity appears to be creating more value for the
shareholders of the acquiring companies.
Richard Dobbs, Marc Goedhart, and Hannu Suonio

A long-term look at ROIC

Finance theory isn’t enough when companies set their expectations for
reasonable returns on invested capital. A long-term analysis of market and
industry trends can help.
Bin Jiang and Timothy Koller

Capital discipline for Big Oil

The oil and gas industry has a history of overinvesting at the top of a cycle.
This time it should break the habit.
Richard Dobbs, Nigel Manson, and Scott Nyquist

How to make M&A work in China

The conditions are right for China’s nascent M&A market to flourish.
Companies should try a new approach to deal making.
James Ahn, Thomas Luedi, and Isiah Zhang

Measuring long-term performance

Earnings per share and share prices aren’t the whole story—particularly in
the medium and long term.
Richard Dobbs and Timothy Koller

Do fundamentals—or emotions—drive the stock market?

Emotions can drive market behavior in a few short-lived situations.
But fundamentals still rule.
Marc Goedhart, Timothy Koller, and David Wessels

The irrational component of your stock price

In the short term, emotions influence market pricing. A simple model explains
short-term deviations from fundamentals.
Marc Goedhart, Bin Jiang, and Timothy Koller

The misguided practice of earnings guidance

Companies provide earnings guidance with a variety of expectations—and
most of them don’t hold up.
Peggy Hsieh, Timothy Koller, and S. R. Rajan
Copyright © 2007 McKinsey & Company