The Next Winning Move in Private Equity

To outperform their rivals, private equity firms will need to enhance their ability to spur organic growth in the companies they own. (And public companies will need to follow.)

strategy+business magazine
by Ken Favaro and J. Neely

Illustration by Kate Edwards

Image via WikipediaWhere does private equity go from here?

…There is the shift in the way fund raising is being handled, especially at a time when many of the limited partners who invest in private equity firms have “maxed out” their PE allocations — and the few who haven’t are being courted by every major firm. There is the shift toward public ownership of the PE firms, led by Blackstone, KKR, and, most recently, Apollo Management. And there is the firms’ shift toward diversifying revenues away from their core business, the leveraged buyout (LBO), with many firms getting into credit investing, real estate, advisory services, proprietary trading, and other areas. (See Exhibit 1.) As Stephen Murray, the chief executive of CCMP Capital Advisors, put it, “The LBO business has become just another asset class for many firms.”

What’s more, private equity firms are going through this process of reinvention at a time when they’re facing plenty of other issues: bad press about fees, bad press about the practice of secondary buyouts (in which one PE firm sells a portfolio company to another PE firm rather than to investors via an initial public offering or to a corporation), turnover among limited partners, and the question of succession planning at the biggest firms (where at least some of the founders are getting on in years, and their peers are wondering how long they will stay in the game).

Image via WikipediaAll these things are distractions, however. The real issue for private equity is whether — and how — the general partners who manage PE firms can revitalize the leveraged buyout.

The reality is that buyout returns are down … (See Exhibit 2.) For a long time, the top tier of LBO firms were returning in excess of 20 percent, but much of that was attributable to the exuberant public markets that prevailed in the 20 years leading up to 2008. Cheap debt helped too, …“You cannot just bet on interest returns and multiples going up,” says Gilbert Saada, an executive at Eurazeo, a mid-market private equity firm in Paris. “It doesn’t work anymore.”

Having been forced to write down the value of many of their portfolio companies in recent years, the general partners of private equity firms have taken steps to implement cost savings across those companies. …
These improvements, however, aren’t sufficient to salvage investments that may be deeply underwater. ... A third wave of innovation in private equity’s value creation model is needed, and we believe it will be “organic growth enhancement,” or the ability to systematically increase the top line of portfolio companies organically. This will require adding new capabilities at the PE firms themselves, rebalancing their engagement with portfolio companies toward organic growth, and making organic growth “net free” (meaning that it’s funded out of each portfolio company’s own current costs and investment, with no hit to the firm’s short-term earnings). (See Exhibit 3.)

Some experienced PE players have already reached similar conclusions about the need for organic growth. The kind of cost cutting that firms initiated in the aftermath of the 2008 crash, says Henry Silverman, chief operating officer of Apollo Management, “is great, but it’s not really an outcome-driver. …you have to generate revenue growth — top-line growth — somehow.”
The math of organic growth may not be as instantly gratifying as the math of financial engineering, … It may not be as straightforward as removing head count and expenses to drive up EBITDA, with the automatic value increase that produces. The playbook for organic growth includes many more pages and is much more complicated. …
… As the PE firms learn to enhance the organic growth of their portfolio businesses, managers at public companies… may need to rethink their own ability to spur the organic growth of their businesses. …

The Third Innovation

…Since private equity’s emergence as a high-profile asset class in the 1980s, the industry has profited from two major innovations. The first was financial engineering …
By the 1990s, however, … private equity firms seized on a second big innovation:  Take out cost. …
Although not all private equity firms may yet recognize the focus on organic growth as their industry’s third major innovation, some have already been moving in this direction. “A lot of the guys I know [in PE firms] have been thinking about the growth and the strategy” of their portfolio companies, says Steven Neil Kaplan, the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago’s Booth School of Business, singling out TPG, KKR, and Bain Capital. “They are all trying to [address] it in different ways.”
TPG is a good example of a private equity firm that’s leading the way. Like many other firms, TPG looks to its portfolio companies’ top executives, whether those it has inherited or those it has installed, to drive organic growth. However, its 60-person operations team includes experts in the areas of pricing and sales-force effectiveness, two disciplines that can have a big impact on revenues. In addition, the many TPG operations personnel whose backgrounds are in “lean” — an approach to reducing costs that focuses on process improvements, using customer benefits as the compass — occasionally help TPG’s portfolio companies grow, albeit indirectly….
Indeed, one big caveat attached to the idea that private equity firms need to find ways to spur organic growth is that spotting a growth opportunity usually requires an innate grasp of how a specific group of customers in a particular industry behave, and what those customers want. “You don’t understand how to create value unless you deeply understand an industry,” the University of Chicago’s Kaplan says. Most private equity firms do organize themselves by so-called industry verticals (health, consumer, retail, and technology are some common ones), but the expertise in those verticals is primarily for purposes of sourcing and making deals. …
…[Private] equity firms … will need to do three things: add new growth capabilities, rebalance the engagement with their portfolio companies in favor of growth, and find ways to make growth net free.

Adding Growth Capabilities

Of course, it’s always best, and simplest, if one has capable, growth-oriented executives running a portfolio company and the divisions within it…Where the right people aren’t already running, say, product development or marketing, private equity may need to provide external support for those functions.
An infusion of organic growth capabilities can take several forms, and which one is best probably depends on the specifics of the private equity firm… One is better pricing ability. Another is improved sales-force practices, since the direct sales forces of acquired companies often have faulty structures or incentives, or aren’t disciplined about getting rid of underperformers….
Yet even with growth capabilities like these, many private equity firms don’t build them internally. …

Rebalancing the Engagement

PE firms need to make organic growth the primary focus of their engagement with their portfolio companies, so that it’s not crowded out by attention to costs. One way to do this is to introduce the concept of headroom as a framework for thinking about the growth available in a market. Headroom is a simple concept: It is the market share that a company doesn’t have minus the market share it won’t get. This framework has the advantage of breaking down the growth challenge into two binary questions. First, there is the question about who the potential switchers are — the customers in the market that aren’t 100 percent loyal to a rival. Second, there is the question of what it would take to get these less-than-loyal customers to switch. These are the needs-offer gaps.
Headroom is particularly valuable as a tool for identifying organic growth opportunities in mature, highly competitive markets, …
For many companies, the other valuable outcome of a headroom approach is that it exposes areas of activity that can’t produce growth (for example, activities aimed at customers who are too loyal to other providers). …
Of course, headroom initiatives are only one example of how private equity firms can work with their portfolio companies to get them to think more explicitly about organic growth. …

Making Growth Net Free

…[The] funding for portfolio companies’ growth initiatives be net free, meaning the cash to invest must come from savings realized elsewhere within the portfolio company or from an “organic growth investment charge” that’s taken when the buyout is made. (See “A Different Way of Funding Organic Growth.”)…

Reinforcing PE’s Baseline Capabilities

…Indeed, part of the promise of organic growth enhancement, as a PE innovation, is the impact it will have on the two capabilities that most general partners would say are as important as adding value to their portfolio investments — fund raising and deal making….
In the future, having demonstrable organic growth capabilities will be part of what general partners sell, and something that reinforces their fund-raising ability…
The bottom line is that without a strategy for expanding organic, top-line growth at their portfolio companies, private equity firms will become less competitive at raising investor funds and making deals. …
By embracing private equity’s third innovation of enhancing organic growth — adding new growth capabilities, changing the dialogue with portfolio companies, and making organic growth net free — the most innovative PE firms will enrich their “solutions business,” and gain market share and improve their overall profitability in the process. As they succeed, they will ensure that their core business continues to be a vital force in the capital markets, and at the same time will help promote a more productive, growth-oriented perspective throughout the corporate sector.

Might the Contract Change?

In a world where private equity returns will depend to a greater extent on portfolio companies’ ability to grow organically, there may be an argument for lengthening the life of certain funds. The typical seven- to 10-year cycle of fund raising, acquisition, and exit may not make sense with investments that are generating good returns. After all, … it may be that after five years in the portfolio, the portfolio company is at the very beginning of what may be a decades-long rise in revenue and profits….
“We’ve seen a couple of big investors that have been going through a broader bid process saying, ‘Is there a way to build a different partnership?’” adds the executive. But those inquiries, he says, have been less about changing the terms of private equity deals than about investing in other asset classes now under some equity firms’ roofs, like mezzanine funding and debt financing.
— K.F., J.N.

A Different Way of Funding Organic Growth

Investments in organic growth are often in R&D, sales-force expansion or restructuring, marketing, and advertising. These investments are often called revex (revenue expenditures) because they hit the income statement, whereas capex (capital expenditures) hit only the balance sheet.
In the chase for bottom-line growth, revex creates a dilemma for most companies: The more they invest in revex to grow the top line, the more their bottom line suffers in the short term (other things being equal). Conversely, the more they skimp on revex, the more their top-line growth will eventually suffer.
No company is ever perfectly efficient, so there are almost always ways to take out costs and reduce other investments in order to fund more productive revex. Often, however, these opportunities are difficult to see, and companies are thus faced with real tension.
Many leaders of public companies, such as Robert Walter when he was CEO of Cardinal Health, have addressed this tension by setting up a corporate investment account that their company’s business units could tap into to fund organic growth investments. In Walter’s case, this was a way of not letting the accounting for organic growth get in the way of the need to invest in growth.
PE firms face the same tension, even though they are privately held, which makes us think they may have to do something similar in the future. Perhaps an “organic growth investment charge” could be taken when the investment is made, creating a cash account that could be drawn upon over time for investing in organic growth with less short-term accounting impact on the bottom line.
— K.F., J.N.
Reprint No. 11208

Author Profiles:

• Ken Favaro is a senior partner with Booz & Company based in New York. He leads the firm’s work in enterprise strategy and finance.
• J. Neely is a Booz & Company partner based in Cleveland. He specializes in mergers and restructurings in the consumer products, retail, and industrial sectors.
• Also contributing to this article was s+b contributing writer Rob Hertzberg.

Related articles

• Private Equity Firm Buys California Pizza Kitchen For $470 Million (huffingtonpost.com)
• Private equity and financial distress (truthonthemarket.com)

Preparing your organization for growth

Companies that address their organizational weaknesses as they implement growth strategies give themselves an advantage.

McKinsey Quarterly
MAY 2011 • Martin Dewhurst, Suzanne Heywood, and Kirk Rieckhoff


Most senior managers … underestimate the importance of organizational factors in translating a growth strategy into reality. This oversight can dampen a company’s growth plans: organizational processes and structures that are well suited to today’s challenges may well buckle under the strain of new demands or make it impossible to meet them. Likewise, key employees may lack the skills needed to cope with the additional complexity that growth brings. By reviewing the experiences of three organizations that faced the stresses imposed by new growth initiatives, this article seeks to illustrate such “pain points” and suggests some approaches for coping with them.

1. Stifling structures

Well-defined organizational structures establish the roles and norms that enable large companies to get things done. Therefore, when growth plans call for doing things that are entirely new … it’s well worth the leadership’s time to examine existing organizational structures to see if they’re flexible enough to support the new initiatives. …
A European retailer, for example, decided to expand beyond its base of small-format stores in urban areas by including a number of large-format stores in suburban ones. …[The] new stores would require a new mix of products, ... The new stores would also offer lower prices than the old ones. All this meant that the new stores would have special supply chain requirements and that the stores’ managers would need to focus more intently on price and cost than had been customary for the retailer.
As the company’s senior executives planned the new stores, they began questioning whether to operate them as part of the existing organizational structure or at arm’s length. Although launching them within the existing structure would be simpler, the executives concluded that doing so would deny the new stores the unique resources needed to become a meaningful growth platform. …
So the company launched the large-format stores as a separate business unit, with its leader reporting to the CEO. The new stores’ management team was independent of the parent company and included mostly newcomers who would not seek to replicate its culture or processes. …
The new stores’ managers developed their own local distribution centers and store designs, at a significantly lower cost per square meter than the company’s other stores had achieved. They also found new suppliers; modified some existing systems, such as IT; and created a different overall customer experience that was more focused on lower costs. …
Keeping the new stores separate helped get them up and running quickly but also made some processes at the corporate level more complex than they might have been. The IT systems supporting the new stores, for example, handled a number of processes differently, including store-level profit-and-loss statements. It was therefore difficult to consolidate sales figures, cost of goods sold, or wages across both types of stores.
Nonetheless, in just two years, six of the new-format stores were firmly established and meeting their financial targets. At this point, as planned, the parent company integrated all of the stores—large and small—into a single business unit. …
In our experience, such separated approaches work best when a company can develop a convincing business case that existing structures and processes will make it very difficult to launch a new undertaking. … In some cases, the necessary customization can be as minor as enabling people to work in a local language; in others, as large as creating a whole new business unit with different suppliers and customers.¹
Deliberately making these approaches temporary, as the European retailer did, is critical. In our experience, two to three years is usually enough time for new operations to gain sufficient maturity to hold their own within the organization. It is also crucial for companies to reintegrate these innovative pockets before they reach substantial scale, or they will simply create an additional layer of complexity that makes the company as a whole harder to manage and could inhibit its next growth spurt.

2. Unscalable processes

… It’s important for a company to determine which processes will come under particular stress when it grows. The case of a European biotech company illustrates the dangers of not addressing potential problems early.
Before the company began an ambitious growth strategy, it used a small group of ten key scientists to make decisions about its product portfolio. The group’s culture of collegiality, informality, and communal decision making worked quite well, and each scientist actively helped to shape and refine every project. Quarterly reviews of the research portfolio took one or two days.
But as the company grew and the volume and diversity of its projects increased, the number of scientists involved in portfolio management also had to expand. … By the time the company had 40 scientists involved, the process had become unmanageable. … The scientists became defensive and territorial, and the company was saddled with a bloated, expensive, and slow-moving set of projects.
Fixing these problems required formalizing the portfolio review process. This move, in turn, meant rethinking the scientists’ governance processes—determining, for example, who would attend, lead, and set the agenda for meetings. …
Getting the large—and frustrated—group of scientists to accept these changes was much harder than it would have been had the company addressed the issues before it grew. This was particularly true because the changes involved culture and mind-sets, not simply different documents or meeting formats. The scientists had, for example, enjoyed receiving and giving input on the full set of research projects and initially found it difficult to accept more defined responsibilities and a sense of exclusion from important discussions.² It took two years to implement these changes, and not all of the scientists were comfortable with them. Within nine months, however, most of them saw that the projects with the greatest scientific interest were getting more resources, which boosted morale and corporate results.³

3. Unprepared people

Growth naturally creates new interactions and processes, expected and unexpected, and often at a fast pace. To manage them, the employees who face the greatest complexity—for example, those in functions or businesses that will see increased activity—must have “ambidextrous” capabilities. …
… A manufacturer of cutting-edge technology products that was seeking to expand from its domestic base, for example, found itself limited by the surge in complexity associated with operating under several different national regulatory regimes. The company’s cautious legal department rejected deviations from home country procedures. … The expansion plans stagnated until senior executives realized that the company’s legal department needed new leaders who felt comfortable assessing and mitigating the risks in these new, ambiguous environments. …
The specific organizational challenges companies face as they grow will differ according to their growth strategies. By managing organizational complexity early, however, any company can improve the odds that its growth plans will succeed—while making it less difficult than ever to get things done.

About the Authors

Martin Dewhurst is a director in McKinsey’s London office, where Suzanne Heywood is a principal; Kirk Rieckhoff is an associate principal in the Washington, DC, office.

Related articles

• The Organizational Structure of a Business (thinkup.waldenu.edu)

Nampa investigates new energy source

KBOI 2 - Boise, Idaho
Watch the video
NAMPA, Idaho – …Nampa city council has green-lighted a study that looks into turning their garbage into energy.
…Garbage in a special landfill is heated, which speeds up the natural decomposition process. This turns the solid garbage into a gas that can be used to turn a generator and create energy. …
"This technology allows us to take trash thrown off by people who are done with it and produce a sustainable energy supply," Nampa mayor Tom Dale said….
If the city approves the project, supporters say 90 percent of the trash that ends up in the county landfill would instead be used to make energy. …

Trash Inc: The Secret Life of Garbage

CNBC

Watch the FULL PROGRAM

ABOUT THE SHOW

Garbage. It's everywhere — even in the middle of the oceans — and it's pure gold for companies like Waste Management and Republic Services who dominate this $52 billion-a-year industry. From curbside collection by trucks costing $250,000 each, to per-ton tipping fees at landfills, there's money to be made at every point as more than half of the 250 million tons of trash created in the United States each year reaches its final resting place.

Image via WikipediaAt a cost of $1 million per acre to construct, operate and ultimately close in an environmentally feasible method, modern landfills are technological marvels — a far cry from the town dump that still resonates in most people's perceptions. Not only do they make money for their owners, they add millions to the economic wellbeing of the towns that house them. Technologies, such as Landfill Natural Gas and Waste To Energy, are giving garbage a second life, turning trash into power sources and helping to solve mounting problems. It's particularly important in places like Hawaii, where disposal space is an issue, and in China, where land and energy are needed and trash is plentiful.

One sure thing about the garbage business: it's always picking up.

• Talking trash with garbage truck manufacturer McNeilus
• Slideshow: America's Largest Landfills

PROGRAM HIGHLIGHTS

The Landfill Across the world, we’re producing more trash than ever before…nearly a ton per year for every man, woman and child in the U.S. Nearly half of it winds up in landfills and with the arrival of each ton, someone gets paid.
Photo Credit: Jason Hawkes | The Image Bank | Getty Images



Hawaiian Trash When you think of Hawaii, trash probably isn’t the first thing that comes to mind. But trash is bombarding the shore, turning parts of paradise into a wasteland.
Photo Credit: NOAA’s National Ocean Service

• A tour of "the plastic beach"

China The second largest economy in the world is in the midst of crisis. The country has little infrastructure to deal with the garbage generated by 1.3 billion people.
Photo Credit: Getty Images



Tons of Trash In every town and every city, garbage collectors work to rid the country of trash. The largest sanitation department is in New York City where 12-thousand tons of garbage is generated every day.

• How NYC garbage is collected and shipped out-of-state

The Power of Trash Today, trash is re-born as an energy source. A $2 billion BMW auto manufacturing plant in South Carolina is powered by trash from a nearby landfill.

• How a landfill generates energy to a BMW plant

Related articles

• Waste Management's Quest To Turn Trash Into Power (fastcompany.com)
• Where Does The Garbage Go? New York's City Recycling Program (briarhillsinfo.wordpress.com)

The value proposition in multichannel retailing

Consumers love low prices, but retailers shouldn’t overlook the way shoppers perceive value online and in stores.

McKinsey Quarterly
MAY 2011 • Jeffrey Helbling, Josh Leibowitz, and Aaron Rettaliata
Source: Marketing & Sales Practice




… Yet while price competition is tough, our consumer research and client experience show that perceptions of value still matter in the ever-more-complex multichannel-retailing environment. Retailers can employ proven tactics to shape perceptions and take advantage of the fact that consumers care about more than just the price tag when they buy.
A recent survey we conducted¹ shows that price is just one of a range of factors consumers take into account when buying products: they also consider the degree of trust they have in a retailer, its product assortment, and their previous buying experiences (Exhibit 1). So even in the most competitive product categories, … retailers can look beyond price and actively shape perceptions of the value they offer. None of this happens by chance; retailers can implement strategic moves to get credit for superior value.

Exhibit 1: Consumers consider more than price in deciding whether to purchase a product.

Consider, for example, how consumers view leading sellers of women’s apparel in the United States (Exhibit 2). While actual average prices at Kohl’s and JCPenney are similar (the x-axis), consumers clearly perceive Kohl’s as offering lower prices (the y-axis). Amazon.com—which typically has among the lowest prices in categories such as consumer electronics—charges more for similar types of apparel than Kohl’s and JCPenney do, yet retains a “halo” of value among the consumers we surveyed.

Exhibit 2: There is a gap between what US retailers charge for women’s apparel and how their prices are perceived.

In our experience working with dozens of offline, online, and multichannel retailers, we’ve found that they can use certain pricing moves to play the value card. The first is identifying key value items—products that have the greatest impact on value perceptions. … Second, these items must be priced competitively to create a public perception that a retailer offers good value, and discounts on them can be recouped with higher prices on less visible products. Finally, prices should be the same no matter which retail channels a consumer uses: stores, the Web, or catalogs.
Retailers also can carefully craft product assortments in ways that influence value perceptions. For instance, in categories with clear “good,” “better,” and “best” ranges—such as flat-screen TVs—retailers can display models side by side, attract consumers with hot prices on good models, and then encourage trading up by clearly articulating the features and benefits of the better and best options. …
Second, value “heroes” with low price points should be overrepresented in online, in-store, and external marketing. An apparel retailer, for example, can disproportionately showcase $15 men’s business shirts in marketing materials while keeping the majority of its product assortment well above that price point. Third, tactics such as free shipping, in-store pickup, generous return policies, and price-match guarantees are critical drivers of value perceptions. For the consumer pondering the wall of TVs—or, for that matter, browsing a Web page of them—any money saved by purchasing one elsewhere may seem trivial compared with benefits such as free shipping, in-store pickup, a range of financing and extended-warranty plans, and options for expert installation.

About the Authors

Jeffrey Helbling is a principal in McKinsey’s Chicago office, Josh Leibowitz is a principal in the Miami office, and Aaron Rettaliata is an associate principal in the Pittsburgh office.

Notes

¹ Multichannel pricing survey of 6,000 US consumers and price checks (conducted during September and October 2010) of more than 1,100 items at 20 retailers.

Related articles

• Cracking the Code of Electronics Retailing in India- Part I (supplychainlinkages.wordpress.com)
• Multichannel precision marketing at the store shelf (econsultancy.com)
• Rise in April's Retail Sales Comes With a Warning (nytimes.com)

Paying back your shareholders

Successful companies inevitably face that prospect. The only real question is how.

McKinsey Quarterly
MAY 2011 • Bin Jiang and Tim Koller



Most successful companies eventually find themselves generating more cash than they can reasonably reinvest in their businesses at attractive returns on capital. … In fact, European and US companies currently hold a total of around $2 trillion in excess cash.¹
… How much cash should they return to shareholders and how much should they retain for investment and for managing volatility? When they do return cash to shareholders, how should they do so—through cash dividends or share repurchases?

Return cash—or invest it?

Some executives and board members argue that returning cash to shareholders reflects a failure of management to find enough value-creating investments. … But in most cases, simple math leaves such companies with little choice: if they have moderate growth and high returns on capital, it’s functionally impossible for them to reinvest every dollar they earn.
Consider this example: a company earning $1 billion a year in after-tax profits, with a 25 percent return on invested capital (ROIC) and projected revenue growth of 5 percent a year, needs to invest about $200 million annually² to continue growing at the same rate. That leaves $800 million of additional cash flow available for still more investment or returning to shareholders.³ Yet finding $800 million of new value-creating investment opportunities every year is no simple task—in any sector of the economy. Furthermore, at a 25 percent ROIC, the company would need to increase its revenues by 25 percent a year to absorb all of its cash flow. It has no choice but to return a substantial amount of cash to shareholders (Exhibit 1).

Exhibit 1: Returning cash is inevitable.

Moreover, concerns about negative signals to the market are misplaced. … As many companies are currently finding, investors typically anticipate distributions to shareholders long before managers decide to undertake them, since it’s obvious that there aren’t many alternatives. …It therefore comes as little surprise that, in aggregate, US companies have returned to shareholders around 60 percent of earnings in dividends and share repurchases each year over the past 50 years (Exhibit 2)—even if some individual companies hold on to more cash than they need for operational purposes.

Exhibit 2: On average, US companies have returned about 60 percent of their net income to shareholders.

Image via CrunchBaseA number of leading companies have adopted the sensible approach of regularly returning to shareholders all unneeded cash and using share repurchases to make up the difference between the total payout and dividends. … Over the five years ending in 2010, for instance, IBM generated $48 billion of cash flow from operations after capital expenditures and acquisitions and returned $56 billion to shareholders⁴ in dividends and share repurchases. …

How to pay it out

While distributions to shareholders, relative to income, have been stable for a long time, the split between dividends and share repurchases has changed significantly. Until the early 1980s, less than 10 percent of distributions involved share repurchases. Now, about 50 to 60 percent do.
Why the shift? … Companies, especially in the United States, have conditioned investors to expect that dividends will be cut only in the most dire circumstances. … So companies are reluctant to establish a dividend level that they aren’t confident of sustaining. They opt, instead, to buy back shares.
Some investors, too, prefer repurchases because they can then choose whether or not to participate. …
Does it matter whether distributions take the form of dividends or share repurchases? Empirically, the answer is no. Whichever method is used, earnings multiples are essentially the same for companies when compared with others that have similar total payouts (Exhibit 3).⁵ Total returns to shareholders (TRS) are also the same regardless of the mix of dividends and share repurchases (Exhibit 4).⁶ …

Exhibit 3: Earnings multiples are not affected by the payout mix.

Exhibit 4: Returns to shareholders are unrelated to the payout mix.

Setting the right mix

So how should a company decide between repurchases and dividends? That depends on how confident management is of future cash flows—and how much flexibility it needs.⁷
Share repurchases offer companies more flexibility to hold onto cash for unexpected investment opportunities or shifts in a volatile economic environment. … Thus, managers should employ dividends only when they are certain they can continue to do so. … Share repurchases also signal confidence but offer more flexibility because they don’t create a tacit commitment to additional purchases in future years.⁸ … As you would expect, changing the proportion of dividends to share buybacks has no impact on a company’s valuation multiples or TRS, regardless of payout level.
One argument for share repurchases that doesn’t hold up to scrutiny: share repurchases increase value because they increase earnings per share. … The net effect on share value is zero. Another argument for share repurchases is that companies can repurchase undervalued shares for the benefit of those shareholders who hold on to them. In theory this is correct; however, …more often than not, we see companies repurchasing shares when prices are high.
Successful companies inevitably get around to returning cash to shareholders in some form, if only because they simply can’t reinvest their cash as fast as it accumulates. And while there’s no fundamental difference in the value of dividends when compared with share repurchases, companies need to balance their approach against the flexibility that management needs.

About the Authors

Bin Jiang is a consultant in McKinsey’s New York office, where Tim Koller is a partner.

Notes

¹ “Excess cash” is defined as the amount of cash outstanding over and above operating cash, which is defined at 2 percent of revenue.
² Over and above replacement capital expenditures that, we’ve assumed, equal depreciation. If the company has some debt financing, it could return even more of its profits.
³ The same basic principle applies to different companies, depending on their levels of growth and returns on capital.
⁴ IBM returned $73 billion to investors and received $17 billion from issuing new shares (primarily the exercise of employee stock options), for net distributions of $56 billion. IBM could pay out more cash than it generated from operations because it also generated cash flows from divestitures, borrowing, and changes in cash balances.
⁵ We also examined the value of companies by using statistical techniques and found no impact on the dividend or share repurchase mix once we adjusted for differences in total payouts, growth, and returns on invested capital.
⁶ After adjusting for differences in total payout.
⁷ See Marc H. Goedhart, Timothy Koller, and Werner Rehm, “Making capital structure support strategy,” mckinseyquarterly.com, February 2006.
⁸ The academic research is not conclusive on whether dividend increases or share repurchases send a stronger signal to investors.

Related articles

• The Most Promising Dividends in Integrated Circuits (fool.com)
• IBM Lifts Dividend 15% (online.wsj.com)
• Costco raises dividend, plans $4 billion stock buyback (seattletimes.nwsource.com)