Should assessing financial similarity be part of your corporate portfolio strategy?
Businesses with different financial profiles can tax managers and put performance at risk. When divesting isn’t an option, here’s how to manage the conflicts.
Strategic connections among, for example, a company’s suppliers, customers, skills, and technology have long been the sine qua non of corporate portfolio decisions. Businesses that are strategically similar—or related, in the parlance of portfolio theory—belong in the same company. Those that aren’t, the theory posits, would be better owned by someone else.
What we are calling financial similarity may be just as relevant. In a recent survey of more than 1,200 executives, we found that those managing portfolios of financially similar businesses are 20 percent more likely than those managing financially dissimilar portfolios to describe themselves as more profitable and faster growing than their peers (exhibit). Financial similarity is not an issue addressed in discussions of theory, and (other than among executives at complex conglomerates) we frequently find that it’s a subconscious issue for many executive teams. As a result, they underestimate the difficulty of managing businesses with fundamentally different economic characteristics—including revenues, margins, capital intensity, and revenue growth.
How does financial dissimilarity affect performance? In part, it’s a cognitive challenge for managers to make comparisons across businesses with dissimilar business models, growth rates, and maturity. Using different metrics to evaluate and capture the complexity of the portfolio complicates comparisons, while turning to coarser metrics or crude rules of thumb leads to worse decisions.
Managers of financially dissimilar businesses also often face greater internal political challenges. Performance goals and resource allocation necessarily vary across units that differ in business model, scale, or maturity, and that variability can generate conflict. This is especially true when some units are given a budget to invest and grow while others are asked to cut costs, or when one unit’s goals seem easier to hit than do another’s. As a result, large, established units often end up with more of a company’s resources than their performance warrants—at the expense of small, faster-growing businesses. Large, powerful business units are often not cash cows but rather just fat cows.
When strategic linkages among businesses are limited or nonexistent, often the most value-creating solution is just to divest or spin off those with significantly different financial characteristics from the core business. But in many cases, the strategic advantages of keeping financially dissimilar businesses in the same portfolio may outweigh the inevitable challenges. For example, consider a company that serves the same customers with two businesses: one that supports a legacy, analog technology and another that supports a transition to an emerging digital one. Or consider companies with units that offer complementary goods to common customers, such as the manufacturing, servicing, and financing of equipment or combinations of products and an advisory/data business.
In these cases, a company must make an extra effort to ensure that all units are managed to maximize value. This might entail combining financially dissimilar businesses into a separate unit with distinct and specialized management— much as Google did when it renamed itself Alphabet. Managers there left the core business in a central Google division and designated smaller, newer businesses as separate units—which it reports collectively to investors as “Other Bets”—under Alphabet’s CEO.
A company might also implement a flat accounting structure, eliminating most intermediate reporting units. With unit results reported at a highly detailed level, for as many as 50 or more units, managers could more easily identify smaller, faster-growing businesses, protect their resources, and foster their development. Both approaches protect the budgets and other resources of small units embedded in larger ones from cuts to their product development or advertising spending to meet the larger unit’s budget. A company might also consider more structural protection for smaller-unit budgets, commonly known as ring-fencing.
Similarly, a company’s planning processes must differentiate performance targets for different units, rather than applying broad corporate programs to all units. For example, some units may need to be exempt from a broad general and administrative cost-reduction program. For very new fast-growing units, more emphasis might be shifted to revenue targets rather than profit targets, or even to meeting specific nonfinancial objectives, such as launching a product by a certain date. Targets for more mature units might put more weight on margins and return on capital.
Financial similarity is an issue that’s seldom a part of corporate portfolio discussions. Our research suggests that companies will benefit if more leaders become more aware of the challenge and look for opportunities to address it.
About the author(s)
Tim Koller is a partner in McKinsey’s New York office, where Zane Williams is a senior expert. Dan Lovallo is a professor at the University of Sydney Business School and an adviser to McKinsey.