Why Portfolio Transformation Is the Need of the hour for Firms

Why Portfolio Transformation Is the Need of the hour for Firms

“Which business should this organization be in is a question often asked by CEOs?” However, this question can’t get asked once as markets change; hence, answers should change over time. These Successful companies put their portfolio of businesses on the progress resulting in superior performance. CEOs who seldom question settle up with static business and serially underperform. The reason is that the market shifts on, and their company doesn’t. That’s why inertia in decision making is usually the worst choice you can make. In this post, I will provide my hypotheses on why portfolio transformation is the need of the hour for firms, especially in the era of digital disruption.

Mckinsey analyzed complete financial results of more than 1,000 of the world’s leading public firms in 2007 and 2017, in a long cycle of downturn, recovery, and growth. Four takeaways, indistinct, developed from their analysis:

  1. Evolve the business portfolio. There is an optimal rate to pivot the sectors you engage in—a Goldilocks speed that the most skilled companies adhere consistently. Successful companies manage to adapt their portfolios, not hastily steadily and skirt holding them fixed.
  2. Align with the industry, shifting ways if you have to. Headwinds and tailwinds weigh a lot. Leading firms recognize where the winds are changing and marshal resources aggressively where they prognosticate the value creation.
  3. Employ Mergers and Acquisitions to advance your way. Mergers, acquisitions, and, not least, divestitures are frequently necessary to achieve value creation. Successful firms employ programmatic M&A approach to achieve success in their M&A pursuits.
  4. Focus acquisitions at the edge of your portfolio. Success rates in M&A are high when companies applied M&A to expedite a move toward new opportunities in current but secondary businesses (that is, outward, but not too distant out, of their core areas).

The Business Case for Portfolio Transformation

business case of why portfolio transformation increases performance, and how to go through the challenging task of really turning your business mix is crucial. The following five steps proved the most compelling.

Keep the portfolio changing.

Companies that adjust their portfolios by 10-30% in every ten years achieved superior returns than companies that continued static. For instance, companies with revenues ~$10B, new businesses should account for $1B-$3B in ten years. Such companies have a strategy to turn toward more value-creating business models that produce economic profit performance and above-industry shareholder returns in the long run.

Flow with the market, changing paths if you have to

When firms measure their performance, they seldom disaggregate in being fortunate and being right. How much of their returns stem from operating in a high-value-creating industry? How much arises from exerting steps to get there? 

Mckinsey designed a baseline of industry momentum to study how a starting portfolio would have grown had each component delivered in line with its pure-play peers. This method enabled them to estimate whether variations within a portfolio either expedited up or stalled down performance. The sum of a company’s movements for each of its business units denotes total portfolio momentum.

Successful companies explore market insights to determine which industries and markets are inclined to flourish and actively configure their portfolios to benefit those forecasted tailwinds. It takes strength to move ahead—but if you’re not leading, you’ll be too late. For instance, Thomson Reuters, in 2007, 40% of its revenues, collectively grew from its publishing and education businesses; its financial-research arm added about one-third of the company’s top line and its data and analytics businesses deemed for the rest. Recognizing the hurdles ahead for the publishing industry, the company divested its publishing business to PE investors and focused on financial research and analytics. By 2017, 50% of its revenues derived from economic analysis, and its financial-data-solutions business gave ~50% of the top line.

Why Portfolio Transformation Is The Need Of The Hour For Firms

These moves were undoubtedly ahead of the tide. Between 2007 and 2017, the average gross margin of information services companies increased by ~$2 billion, while the average gross margin of the publishing industry declined by $73 million. The business impact of departing out of the slow path of publishing and into the quick lane of financial data helped add $400 million of the $850 million in economic profit “lift” that Thomson Reuters experienced over that span.

Leverage Mergers and Acquisitions (M&A) to expedite your goal.

Mergers, acquisitions, and divestitures are crucial to getting strategy work. It is imperative to do deals to place your business for value creation. Firms employing mostly organic-only strategies have faced deterioration in their performance steadily.

Programmatic M & A approach when a firm makes about two or more small or midsize deals in a year, acquiring significant total market capitalization, is more successful. When a company executes a significant acquisition where the original deal size is more than 30% of the acquirer’s market capitalization, most of its portfolio story is by this large bet. Such deals are often risky and have high chances of failure.

In the instance of a programmatic M&A, a constant stream of deals gives a company access to the latest market intelligence and develops its transaction and integration capabilities. While deal success rate may not be 100%, doing them as a component of your regular business measure strengthens portfolio-management discipline, supports your team to get more intelligent about industry levers and trends, and raises investor confidence. By contrast, firms that do large deals assume that their M & A strategy has achieved the next few years. When they return to M & A afterward, they lose grasp of the process and market insights.

Focus acquisitions at the edge of your portfolio

How distant from your core business should you look at M&A targets? A company can focus on target acquisitions that add value to its base business or adding to an existing, secondary industry segment. In the case of declining sectors, companies focus on buying into a section adjacent to an existing business; or stepping out into an unrelated industry. Companies that make acquisitions to scale up existing but secondary activities have the highest success rate. In top growth industries, the best M & A strategy is to focus on their core industries, as there is a little reason to shift out of their fast lane. Conversely, for sluggish sectors, it is better to change lanes and move further from their core.

Why Portfolio Transformation Is The Need Of The Hour For Firms

Source – Mckinsey

Run harder when you are in a tight spot.

How much do these portfolio moves make sense to a company that is lagging behind its competitors? My argument is that it would be very pertinent. Traditional wisdom holds that companies must “secure the equity” to engage in M & A and master their businesses before they look to acquire others. Many underperforming firms do pause to become buyers, and if they do execute an acquisition, it favors to be a small one. 

In case of declining business, concentrating on performance improvement only, and neglecting your portfolio, does little for your odds of pointedly shifting things around. These companies need to become more urgent to grow on a faster path by focusing on aggressive acquisition strategy, and portfolio reallocations as performance improvements focused solely on organic moves do not yield dramatic growth. The M&A approach would be risky as these companies should focus on target companies that are adjacent to their business, but if successful, they will yield higher shareholder returns.

A narrative of ‘from–to.’

The core principle behind the portfolio shift is to move toward value creation systematically. Please don’t exaggerate it with drastic action, unless you get ambushed. Speed can give issues when integrating new capabilities within the organization. However, most importantly, don’t remain still. Statistically, that’s the most detrimental choice you can make.

Some of the proven methods toward portfolio transformation are

  • Shift the default. Companies should assume a private equity mindset for portfolio management, with the awareness that most businesses must get sold in the future. Companies need to continually assess if they are the best owners for the asset. That serves to make portfolio change the default plan, and not seem like the occasional one-off.
  • Drive confidence. Focus on value creation should be supreme. When a growth opportunity surfaces, companies need to be aggressive to seize it, especially at the perimeter of its operations. 
  • Develop a blueprint. The majority of the firms give attention to quarterly results, making them short signed rather than having a long term approach. When companies do make a transaction, they can often be “reactive”—a swift response to the competitors’ actions. Companies that build in portfolio transformation as part of their DNA develop a detailed M&A blueprint to set a baseline of the company’s market position, ambitions, and gaps, as well as boundary conditions (such as types or sizes of deals) that will focus the scope of their deal hunt. Progress toward the target portfolio needs to be evaluated by the board and CEO every quarter to ensure that transactions are deliberate and not opportunistic. Top performers are constant capital reallocators. They assign their current businesses to the categories “grow,” “maintain,” or “dispose” of—and have modified rules for how much capital goes to each.
  • Develop a mechanism. Portfolio optimization demands a holistic perspective and an integrated process, and resource allocation and corporate planning should become organized. Experienced dealmakers run their dealmaking operations as core business operations. For instance, they carry due diligence and integration planning while carrying negotiations early in the deal process about how to get under the veil of deal value and reimagine the opportunities that the acquired company could unleash once the deal gets concluded. They further have an integration plan, headcount, and budget in place before the acquisition is closed, and get rolling to fill in any gaps on personnel or tools so that integration can commence immediately at closing. That happens only when you build comprehensively recognizing corporate planning and developing M & A as a lasting capability—not as a singular event.

Closing Thoughts

Leading companies relentlessly run their business portfolios, continually advancing into new opportunities for value creation and regularly divesting business units. As competition intensifies, lingering in static position leads, nearly axiomatically, to slipping behind.

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