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Chapter 28

Why Do Capital Market Organizations Underachieve Their Planned ROI?

Firms that invest in acquisitions, such as private equity firms and investment bankers, achieve their end goal only by raising the market value of their acquired companies. Acquiring organizations are called capital market firms. Their ultimate financial gain is realized from the buy-sell spread when they divest each investment. But research studies reveal that only a minority achieve their targeted return on investment (ROI). One study reported that less than half of all mergers achieve their goal.1 Why do they have such poor results? Do they overplan but underexecute their economic value creation activities?

FIVE VALUE-CAPTURE CATEGORIES TO ACHIEVE RESULTS

Realizing actual economic value from mergers and acquisitions (M&A) is a “highstakes juggling act.”2 So many things must be correctly executed to maximize the potential economic value. But problems arise, such as the disruptions from executive and employee turnover and from poor strategy execution—both the modified business strategy and the M&A integration strategy.

Exhibit 28.1 displays five value-capture categories that each contribute to lifting shareholder value from an enterprise’s initial conditions. Although this exhibit describes opportunities for an M&A deal, it can be applied to any existing commercial organization.

Employees fear that the majority of the value lift will come from the third arrow, operating expense savings, which is perceived as code for employee layoffs. How can all five of the arrows generate the lift?

HOW CAN PERFORMANCE MANAGEMENT METHODOLOGIES UNLOCK POTENTIAL VALUE?

There is confusion about what performance management at the enterprise level is; and performance management is too often narrowly described as just visual dashboard measures and better financial reporting. It is much broader. Performance management is the integration of multiple managerial methodologies (e.g., customer relationship management, balanced scorecard, Six Sigma) with an emphasis on analytics of all flavors, and particularly risk management and predictive analytics. Performance management’s methodologies themselves are not new; but organizations tend to independently implement each of them sequentially, often using disconnected spreadsheet tools rather than formal and proven information technologies. True performance management deploys the power of business intelligence (BI) to enable decision making.

Exhibit 28.1 Value-Capture Opportunities

Source: Copyright © 2008 Deloitte Development LLC. All rights reserved. Permission to use granted.

Although there are interdependencies of performance management across all five value-capture categories, different performance management methodologies play a prominent role in each category:

 

1. Integration strategy and management. The heavy lifting is done in the next four categories to the right in Exhibit 28.1, but in this first category, the main performance management methodology is human capital management (HCM). Employees, like information, can be a powerful intangible asset to lift ROI. A robust HCM system is not just an automated personnel database, but is much more powerful in aiding employee selection and retention. For example, an analytics-powered HCM system can quantify historical employee turnover and apply statistical correlations from that history to the existing workforce to rank-order predict the most-to-least likely next employee to resign and therefore enable management interventions. Both the employer and employee benefit. With an aging workforce approaching retirement at many companies, an HCM system becomes essential.

2. Revenue growth. Several performance management methodologies are engaged here:

• Enterprise risk management (ERM). ERM goes beyond just monitoring the traditional three pillars of market risk, credit risk, and operational risk. ERM also formally manages an organization’s risk appetite with its risk exposure.

• Business strategy management and execution. David Norton, the coauthor with Robert S. Kaplan of The Balanced Scorecard book series, has stated that that nine out of ten companies fail to successfully implement their business strategy.3 Performance management addresses this with the integration of (1) strategy maps; (2) scorecards (for strategic objectives and their associated key performance indicators with targets); (3) dashboards (to cascade downward all measurements for operational actions); (4) incentives; and (5) analytics (to drill down to examine problem areas plus predict future outcomes).

• Price optimization. Pricing is too critical to be just a “thumb-in-the-air” intuitive feel for what price the market will bear. Performance management tools that optimize pricing include price elasticity analysis of consumer demand. This is incorporated into scalable forecasting and optimization routines that determine profit- and volume-maximizing price point, for example, for each retail stock-keeping unit at a store-specific level.

• Product, service line, channel, and customer profitability. Profit is calculated as sales minus costs, but few managerial accounting systems properly trace and assign consumed resource expenses into costs; they rely on antiquated broadly averaged cost allocations that distort true costs and profits. Traditional costing practices mask and hide costs of a product or service as a lump sum. Performance management’s inclusion of activity-based cost (ABC) principles resolves these deficiencies. It is critical to have visibility and transparency of the contributing elements of costs—with accuracy—and to understand the many layers of profit margins.

• Customer value management. To determine the value of a customer, marketing staffs have traditionally relied on basic customer recency, frequency, and monetary spend data (the RFM triad). That data is not enough. Today there is a much greater need for customer intelligence that measures psychodemographic information of customers as well as to apply customer lifetime value metrics to answer the key questions, “What types of customer microsegments should we retain, grow, acquire, and win back? Which types should we not? How much should we spend with differentiated deals or offers on each microsegment so we do not risk overspending on loyal customers or underspending on marginally loyal customers who may defect to a competitor?” The more powerful and scalable performance management technologies answer these questions and enable the ultimate microsegmentation—to the individual customer or consumer.

Maximizing ROI is not accomplished by just growing sales, but rather by growing sales profitably—that is, smart revenue growth rather than growth at any cost.

3. Operating expense savings. The recent popular improvement initiatives of Six Sigma and lean management help the workforce learn how to think (and performance management provides more reliable and useful data for them, such as ABC information). But performance management provides information for where to think. Performance management brings focus. Improved productivity from business process improvements will reduce expenses, but there are diminishing limits, and breakthrough innovations stimulated by performance management information will inevitably be required. Warranty and service parts expenses are often loosely managed, and performance management addresses these with analytics that quickly detect minor problems before they escalate into major ones. Performance management also facilitates sourcing with supplier management and consolidation tools.

4. Asset efficiency. For product-based companies, a large portion of their working capital is inventory. Performance management’s solution to reduce inventories leverages statistically based forecasts (updated periodically with demand history and potential influencing factors) to reduce uncertainty so a company can more confidently match its supply with demand. The objective is to minimize stockouts, shortages, and surplus unsold items. The resulting right-time and right-amount inventories increase inventory turnover rates that in turn improve the financial gross margin return on investment.

For fixed assets, a growing portion of an organization’s expense structure is its information technology (IT expenses. Performance management supports managing these infrastructure expenses with IT value management reporting. These are planning systems of capacity and usage for technologies, such as servers, software and laptop computers, as well as for associated workforce staffing level requirements.

5. Cost of capital reduction. The cost of capital has two components: (1) the amount required and (2) its composite rate. Performance management methodologies contribute to reducing both.

Performance management’s “more with less” productivity actions optimize the amount of assets and resources required to fulfill customer orders and meet strategic initiatives. For banks, this means better control of their capital reserves. Performance management provides risk mitigation and reduced earnings volatility through powerful predictive analytics to reduce the cost-of-capital rate.

PERFORMANCE MANAGEMENT’S BONUS METHODOLOGY: ROLLING FINANCIAL FORECASTS

Capital market organizations hate surprises. Performance management cannot prevent surprises from fraud, ethics violations, or unexpected financial restatements (but performance management’s analytics can provide earlier warnings). One surprise that performance management can reduce for capital market firms is an earlier alert that their acquired company will “miss its numbers.” Today, the annual budget is arguably outdated as a financial control instrument in part because it is obsolete soon after being published. But worse, the annual budget is criticized for not effectively allocating resources to their highest returns. Performance management addresses these shortcomings by shifting the accountants’ mentality from negotiating the next fiscal year’s incremental percent spending changes with managers to a more logical approach. This approach models resource capacity planning, staffing levels, and supplier spending.

Imagine producing a budget 12 times a year. That is a nightmare for the accountants. Budgets are financial translations of nonfinancial operations. Performance management tools combine future volume-based demand drivers (e.g., sales projections) with funding for strategic initiatives. Since sales forecasts are constantly updated and because a strategy is dynamic, not static, then with constant adjustments, various performance management methodologies automate the translation of operations into rolling financial forecasts.

WHAT LEADS TO THE UNFULFILLED PROMISES OF ROI FOR CAPITAL MARKET FIRMS?

Capital market firms place high importance on executive leadership. And they should. From reading this chapter you may conclude that the performance management methodologies are like cog gears, and the executives with the best-in-class technologies that support performance management’s methodologies can just push or pull the levers and pulleys and watch the dials. To achieve superior results, executive leaders must exhibit vision and inspiration. That is what a workforce responds to.

However, to fully achieve the highest potential in the lower-right side of Exhibit 28.1—Value of New Company—an enterprise cannot rely on a rudder-and-stick approach to get there. The executive team and their workforce need integrated business intelligence and performance management software for those gears to mesh and revolve at faster speeds. The premier software technology integrates performance management’s suite of methodologies. Its underlying architecture is on a common data platform and its compute power is optimized for analytics—particularly predictive analytics. The resulting benefit is better, faster, cheaper—and smarter, by not just making processes more efficient but also prioritizing the ones most critical to creating higher value.

Enterprise resource planning (ERP) software is helping companies get operational control, but ERP software is not designed to transform transactional data into information needed for decision support. As the capital market firms influence (or require) their acquired companies to adopt and integrate performance management methodologies with their supporting technology, their desired ROI targets will be achieved and possibly surpassed.

NOTES

1 Deloitte Research, Economist Unit, M&A Survey, 2007.

2 Carol Bailey and Trevear Thomas, Deloitte Consulting LLP, “Mergers and Mergers and Acquisitions: What CFOs Should Consider Asking Before the Deal Is Done,” March 18, 2008, webinar.

3 David Norton, coauthor of The Balanced Scorecard: Translating Strategy into Action, at the Balanced Scorecard Collaborative Summit on November 7, 2006.