McKinsey on Finance

Private equity’s new challenge 1

Perspectives on
A changed competitive landscape calls for a different business model.
Corporate Finance
and Strategy
A new era in corporate governance reform 6
Directors and investors want deeper change. Executives should
Number 12, Summer
get ready for it.
2004
Can banks grow beyond M&A? 10
US banks will need to look beyond mergers for growth. Better earnings
will have to be won from improved value propositions and productivity.

Internal rate of return: A cautionary tale 16

Tempted by a project with a high internal rate of return? Better check
those interim cash flows again.

Taming postmerger IT integration 20

Lessons from the IT-heavy banking sector can bring balance to this
critical task.
McKinsey on Finance is a quarterly publication written by experts and practitioners in McKinsey & Company’s
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McKinsey & Company.

Private equity’s
new challenge
A changed competitive landscape calls for a
different business model.
Neil W. C. Harper and For more than two decades, buyout
Antoon Schneider
funds—or nonventure private equity
funds—have been an important force in
global corporate finance and restructuring.
Top-quartile funds, in particular, have
turned in consistently strong performances,
generating attractive returns for their
investors (Exhibit 1). In the 1980s the
sector led a revolution in value creation and
corporate restructuring that continues to
reenergize economies in the developed and,
increasingly, the developing world. Viewed
from corporate suites, buyout players have
alternately been willing acquirers of
underperforming businesses, formidable
competitors, and, under the right
circumstances, valued partners. Storied
firms such as Clayton, Dubilier & Rice,
Kohlberg Kravis Roberts, and The
Blackstone Group may be emblematic of the
sector, but its ranks also include many other
private limited partnerships, investment
banks, and public-investment vehicles that
follow a similar business model.
That model, however, may soon look quite
different. A convergence of market forces
has altered the competitive landscape in
Private equity’s new challenge | 1
which private equity firms have thrived.
More and more, they are encountering
heavier competition for opportunities to
invest, often against new competitors. The
rise of the auction sales process is eroding
the buyout players’ ability to gain
privileged access to investments from their
once-legendary networks of relationships.
The creative financial-engineering skills
once guarded by a few top practitioners
have become commodities, and a tougher
stock market has worked against players
looking to purchase, restructure, and then
quickly sell a company. Taken together,
these changes threaten to lower median
returns over the next five to ten years,
compared with the public equity markets,
and could make standout performance
considerably more difficult.
Of course, as long as there are attractive
buyout opportunities—and there will be,
particularly in the European industries that
are restructuring and in less financially
developed markets—the top buyout fund
managers will continue to generate attractive
returns for investors. But the most successful
exhibit 1
Private performance
Comparison of private equity funds with public equity market: average
annual net returns to investors, 1986–2003, %
Europe United States
Private equity
Overall average1 19.0 12.4
Minimum return
for top quartile1 23.0 17.5
Public equity2 12.3 17.1
1 Through 2003, for investments initiated from 1986 to 1998; excludes
returns for investments initiated in more recent years, as substantial
portion of returns are still unrealized.
2 5-year forward rolling average of returns for investments initiated
from 1986 to 1998.
Source: Thomson Financial; McKinsey analysis
2 | McKinsey on Finance | Summer 2004
exhibit 2
Money to burn
Estimated total amount of private equity capital awaiting deployment1
Europe, € billion2 United States, $ billion
122
90
62
39
30
10
1997 2000 2003 1997 2000 2003
1 6-yearcumulative total of capital committed to private equity funds
minus amount deployed; for buyout funds only.
2 Averageexchange rate: €1 = $1.13 in 1997, $0.92 in 2000,
$1.14 in 2003.
Source: Thomson Financial; European Private Equity & Venture
Capital Association (EVCA)
fund managers will be those willing to
change significantly their historical
investment and value-creation models. For
the rest, recent trends will likely lead to
something of a shakeout as well as
increasingly differentiated performance
between top buyout funds and the median.
Diminished advantages
Our research and work with clients highlight
a series of changes in the landscape where
private equity firms have thrived.
An excess supply of capital. Throughout
the 1980s and most of the 1990s, well-
positioned players could rapidly deploy their
capital because the demand for private
equity financing generally exceeded the
available capital. That situation has reversed
dramatically, however. In the late 1990s,
buyout funds collectively raised as much as
$50 billion to $60 billion per year. Yet by
the early 2000s, annual deployment had
fallen to the $30 billion to $40 billion
range,1 and today a significant pool of
capital—some $90 billion in the United
States and €39 billion in Europe—is
awaiting deployment (Exhibit 2). The result
is more competition for each new
investment opportunity, more marginal or
high-priced deals, and greater pressure from
institutional investors to return some
previously invested capital.
Privileged access is less important.
Discussions with fund managers and
investors indicate that the privileged deal is
a thing of the past. Historically, the
relatively limited number of fund managers
(primarily experienced investment bankers)
had unique networks of relationships that
provided access to investment opportunities
that other, less well-connected buyers
couldn’t match. Indeed, fund managers
could sometimes consummate buyouts
without a competitive bid process.
This situation has changed gradually over
the years; today there are many more well-
networked participants with much better
information. Almost all significant deals
today are subject to a visible and public
auction process as sellers seek the maximum
price. In many large deals, the number of
bidders, both alone and in consortia, can
reach double digits. The recent auction of a
US newspaper publishing business, for
example, attracted almost all of the large
active US buyout funds.
Commodity financial-engineering skills. For
years, the ability to create value through
financial engineering was important. At its
simplest level, a buyout fund would
restructure and increase the debt of
companies with too much equity. In this way,
the fund reduced the companies’ exposure to
corporate-income tax, used heavy interest
payments to manage cash flows, and
encouraged management performance with
levered equity-based incentives.

Such skills remain important, but today
they are broadly available. Vendors are
beginning to use so-called stapled finance,
where assets and businesses are auctioned
with aggressive buyout leverage already in
place or preapproved by the financing
banks, for instance. Even the sales of
businesses with lower leverage tend to
attract multiple bidders, each with its own
access to similar sources of debt through
the financial sponsors’ groups of large
investment and commercial banks.
Acquisition prices therefore tend to reflect
most of the upside from leverage.
Cyclical difficulties in ensuring attractive
exit. Particularly during the 1990s, strong
equity markets frequently permitted buyout
firms to use initial public offerings (IPOs) to
divest their interests. Beginning in 2000 that
became more difficult, as markets
plummeted, and even today this approach is
a harder sell. As a result, buyout firms
increasingly are changing their divestment
strategies. Some are selling via secondary
buyouts, while others are holding onto their
investments longer. Indeed, Initiative Europe
has reported that average holding periods
increased from 37 months in 2002 to
52 months in 2003.2
While some will argue that the current
situation merely reflects the cyclical nature
of the IPO market, it may well signal a
fundamental change in the way that
investors, markets, and regulators think
about the characteristics of an IPO as well
as the track record necessary for a
successful listing.
Emergence of new types of competitors.
Several categories of new competitors have
emerged, further complicating the buyout
world. An increasing number of buyout
Private equity’s new challenge | 3
firms now raise funds for each individual
transaction from investors who can choose
to participate on a case-by-case basis, for
example. A few have used this model for
years, but others are attempting to copy it.
Such funds may be more flexible in
responding to market conditions than those
that engage in significant fund-raising
activities only every few years and may feel
less pressure to rapidly put money to work.
Another example involves the accelerated
IPO, whereby businesses being auctioned
are offered a rapid route to IPO,
circumventing the typical intermediate step
of buyout-fund ownership for a three- to
seven-year period. Undoubtedly, we will see
additional categories of competitors,
further increasing the competition for
available transactions.
Fewer pull-through opportunities for
banks. Buyout funds within financial
institutions can create value both by earning
a basic investment return and by creating
opportunities to pull through fee-based
business such as M&A advisory and
underwriting fees. Indeed, much buyout
activity has been carried out within broader
corporate-form financial institutions
(predominantly investment banks) using
both their own capital and that of third-
party investors. A number of such bank
funds historically have been very strong
performers, although investors, unlike those
in partnership-form peers, have suffered
from double taxation of fund returns.
Recent market conditions, however, have
severely limited pull-through business: few
significant IPOs have been completed, and
the fees per deal related to debt financing
have continued to fall. Hence, while some
banks will likely continue to create value
from buyout activity, it may be worthwhile
4 | McKinsey on Finance | Summer 2004
for all banks to reconsider carefully how
much of their own capital they must invest
to optimize total returns—including the
pull-through of fee-based business.
Changing the model for success
Some forward-thinking fund managers have
already begun to respond to this
dramatically changed environment, but so
far few have embarked on a broader effort
to redesign their historical investment and
value-creation model.
In a new environment for private equity
firms, a logical first step would be to begin
investing more aggressively in due diligence.
Funds traditionally have been reluctant to
invest heavily up front to really understand
what is needed to realize the upside
potential in a proposed buyout. This
pattern may be partially due to the incentive
structure of most funds, where up-front
investment in incomplete deals effectively
reduces the cash available for the
compensation of fund managers and other
professionals. The likely result, however, is
too many deals being taken too far through
the process. Early, detailed, and rigorous
transaction screening can yield significant
dividends in the appropriate deployment of
fund professionals’ time and the ultimate
success of each deal.
Another likely source of competitive
advantage in this new landscape is the
development of a more hands-on approach
to ownership and management. Several
buyout firms now recognize that they can
create value (in conjunction with
management teams) by participating more
in managing the companies in their
investment portfolio and by developing
cross-industry functional skills—including
marketing, pricing, lean manufacturing,
and procurement and supply chain
management.
To develop these sources of competitive
advantage, fund managers must add to their
teams more professionals with deep
strategic and industry insight, operational-
improvement expertise, and other functional
skills. Several firms have begun to build
groups of strategists, former operating
executives, and turnaround specialists, while
others have entered into alliances with third
parties to provide such services. Success
will require extending this effort further;
to attract the highest-quality operating and
strategic talent, leveraged-buyout firms will
have to cast aside past practices and
increasingly offer up a share of the carry
to such professionals.
Some firms will want to focus on a limited
number of industry segments. Truly superior
strategic and operational insights and the
development of potentially privileged
networks for sourcing require deeper
industry knowledge in today’s environment.
Firms that quickly develop their knowledge
of a few narrowly defined industry segments
and geographies will be better positioned to
translate this expertise into a perspective on
value-creation potential, transaction price,
and potential returns.
Last, another competitive edge will likely
come from the better sizing of funds to
targeted investment opportunities.
Successful fund managers have tended to
raise funds as large as the market will allow.
While there is nothing inherently wrong
with large funds—some of the top
performers have been large, and there are
some deals that are so large that only a few
funds can compete—size has several
unfortunate and unintended consequences.

First, in the United States and Europe,
competition for big deals is often fierce, with
multiple funds and consortia chasing most
deals. Second, very large funds force buyout
firms to “institutionalize” as organizations
grow, and many fund managers feel a threat
to their entrepreneurial culture—a key to
success. Finally, as the size of deals increases
with fund size, so does the difficulty of
ensuring that fund managers have the
appropriate skills to effect multidimensional
change in organizations with substantial
portfolios. Although large funds should not
necessarily be avoided, fund managers
should think carefully about their firm’s
focus and the nature and scale of its likely
opportunities and then adjust their fund-
raising accordingly.
Corporate connections
The trends altering the private equity
landscape can offer opportunities to CFOs
and other corporate strategists. Because of
the surplus of capital in the current market,
corporations looking at acquisitions are
seeing more and more competition from a
broader set of financial buyers in addition
to the anticipated strategic buyers.
However, buyout firms are increasingly
willing to partner with corporations that
bring complementary industry knowledge
and managerial and operating skills. These
partnerships create new strategic
opportunities for public companies—and
might even reassure some shareholders that
they are investing alongside smart money.
What’s more, corporate buyers often bring
assets that can be combined attractively
with the target business. While preparing a
bid for a technology company during a
recent auction, one corporation was
approached by four buyout funds, for
example, each with varying complementary
Private equity’s new challenge | 5
assets and strikingly different proposals for
alternative forms of partnership.
Many buyout firms also have increased
their interest in private investment in public
equity (PIPE). These investments are
typically minority equity or convertible
stakes in public entities that can in some
cases be linked to financing for specific
acquisitions. PIPE investments can also be
part of an attempt to broaden the available
set of opportunities beyond private deals,
to get ahead of the competition for
privileged access to divestitures of
nonstrategic assets, or even to involve
leveraged buyouts of complete public
entities. Corporations will increasingly see
buyout firms positioning themselves as
potential minority shareholders and
strategic partners, but CEOs and CFOs
should consider carefully the true cost of
such capital infusions from these players
compared with the alternatives.
Finally, corporate executives should be
prepared to encounter more competition
from buyout firms for top managerial talent.
Not only will buyout fund managers seek to
add operational and strategic expertise to
their ever-broadening teams that evaluate,
execute, and monitor investments but also to
offer more compelling financial incentives
for such talent to accept positions in the
turnaround and ongoing management of
portfolio companies. MoF
Neil Harper (Neil_Harper@McKinsey.com) is a
principal in McKinsey’s New York office, and Antoon
Schneider (Antoon_Schneider@McKinsey.com) is a
consultant in the London office.
1
In equity value.
2
Founded in 1988, Initiative Europe is a leading independent
provider of specialist and in-depth information focused purely
on European private equity and venture capital markets.
6 | McKinsey on Finance | Summer 2004
A new era in corporate
governance reform
Directors and investors want deeper change.
Executives should get ready for it.
Robert F. Felton Seldom does an annual shareholder
meeting offer Hollywood-style drama, but
the March 3 annual meeting of the Walt
Disney Company certainly delivered. The
scene: By withholding their votes, an
unprecedented number of shareholders
delivered a stinging rebuke to the current
slate of directors. Meanwhile, board
members, roiled by recent resignations,
wondered if they should heed the
shareholders’ calls for continuing reform. By
day’s end, Michael Eisner had been stripped
of the title of chairman and had a tenuous
hold on his position as CEO. As that plot
continues to generate intrigue, CEOs and
boards at other companies should worry
about widespread syndication of the script.
Arguably, the past few years have seen more
corporate-governance reform than the
previous several decades. Yet recent
McKinsey surveys1 show that directors and
institutional investors clearly agree that too
little reform has taken place to improve
meaningfully board governance. As these
groups join forces to push for even more
substantive change, CEOs face a second wave
of reform that will prove far more intrusive
and burdensome than the accounting and
board independence reforms characterized
by the landmark Sarbanes-Oxley legislation.
The specifics of what our survey respondents
seem to be calling for existed in microcosm
in the Disney drama: a separation of the
roles of CEO and chairman, directors who
are more independent and accountable, and a
scaling back and restructuring of executive
compensation. The speed at which
executives and boards develop and
communicate credible plans in each of these
three areas will determine whether they fare
well in the next round of governance reforms
or end up in the crosshairs of angry
investors. In mid-April, the California Public
Employees’ Retirement System (CalPERS),
the biggest US pension fund, showed off its
activist roots by announcing it would
withhold support for the reelection of
directors at about 90 percent of the 2,700
US companies whose shares it owns.
It is understandable why deeper governance
reforms haven’t already happened. As high-
profile corporate abuses unfolded, boards
were preoccupied with either damage
control or implementation of the new
requirements of Sarbanes-Oxley. For their
part, few CEOs have felt the need to lead
the reform bandwagon. Not only do most
of them believe that the US model of
capitalism—with a combined chairman and
CEO and a fairly close-knit board—works
well, but few have been eager to sacrifice
any of their control. Indeed, investors and
directors expect CEOs to be most resistant
to such structural changes (Exhibit 1).
Maintaining the status quo is likely to be an
unattractive option. Investors seem intent
on pushing a reform agenda that will make
boards more responsive to their interests.

exhibit 1
Directors and investors support splitting the roles of chairman and
CEO but expect strong resistance from CEOs
Do you support or oppose splitting
board chair and CEO roles?
Directors Investors
% of respondents % of respondents
Very
Not much Not sure
Very much sure support
oppose Oppose
9 0
6 14
Some-
what 13 40 17
oppose
69
32
Somewhat
support
Given the pressure from shareholders and
the natural resistance from management and
many directors, it falls to boards to take the
lead in crafting solutions that satisfy
executives and shareholders alike. Any
failure to respond may leave boards more
exposed to the ire of investors and less
prepared to handle a more challenging
governance environment.
The highest priority of both investors and
directors is to split the chairman and CEO
roles. Investors know how CEOs have
dominated boards over the past decade and
believe that only by separating the roles will
boards have the independence to provide
much-needed oversight. Boards require a
strategy that simultaneously expresses faith
in the existing CEO and charts a clear course
toward eventually separating the roles. A
first step—one Disney had taken even prior
to the climactic confrontation in March—is
to appoint a lead or presiding director with
real authority and also draw up a plan that
details how the separation will occur during
the next CEO transition. But make no
mistake: finding a nonexecutive chairman to
A new era in corporate governance reform | 7
Which of the following would be a barrier to effectively implementing a split
in chair and CEO positions?
Directors
% of respondents
50 100
CEO acceptance/retention
CEO recruiting
Political conflict
Support Finding qualified chairs
Director acceptance
fit well with the current board and executive
team will be difficult. Given the scarcity of
good candidates, boards need to start
thinking about this now, before the best are
recruited elsewhere.
Recent rule changes at the NYSE and
Nasdaq have improved the chances for
greater board independence, but more
needs to be done to encourage director
accountability. Directors themselves would
agree (Exhibit 2). But in fact, our survey
also found that nearly a third of directors
are barely adequate in the eyes of their
peers (Exhibit 3). Board evaluations offer
one remedy. Intel, for example, requires
that all directors complete a structured
questionnaire and discuss it with the
(nonexecutive) chairman to identify ways
they can improve. As the life of boards
becomes more demanding, they will also
need to be much more deliberate about the
way that boardroom culture, recruitment,
and training contribute to their overall
quality. Finally, boards must wrestle with
the delicate subject of executive
compensation (Exhibit 4).
8 | McKinsey on Finance | Summer 2004

exhibit 2

Directors are dissatisfied with their lack of control over the board’s
agenda and desire more open discussion at meetings

To what degree does the CEO control Do you support or oppose more director Do you support or oppose more time
and shape what directors learn about control over the agenda? for open discussion?
the company?

Directors
% of respondents1

Not at all (1) Somewhat

Not oppose (1) Not
Partially (3) Completely Very much sure sure (3)
oppose (2) Very much
Moderately support
5 10
15 Somewhat 28
oppose 15 Somewhat
support 39 56
76 45 Very much
support
Largely Somewhat
support
1 Figures do not sum to 100%, because of rounding.

exhibit 3

Directors who believe that many of their peers are not performing very
well welcome changes in the composition of their boards

In your opinion, what percentage of directors on Do you support or oppose appointing outside
your board meet the following performance levels? professional directors?
Directors
Average response, % % of respondents

Poor Not sure

Adequate Very much oppose

6 11
22 Outstanding 9
35
42 Very much support
Somewhat oppose 13

37 25

High Somewhat support

The day is drawing near when executive pay
will be scaled back and compensation will
be more transparent and more tightly
linked, not just to the stock price of a
company, but also to its overall health as
measured by market share, product quality,
and customer satisfaction. As options,
loans, and other special forms of executive
compensation continue to fall from favor,
boards must develop new compensation
plans that balance what investors think is
fair with management’s expectations, which
have grown dramatically over the past
decade (Exhibit 5). In any case, shareholders
expect a significant—and not just an
incremental—recalibration of executive pay
so that investors will see satisfactory returns
after management takes its cut in what is
generally expected to be a slow-growth
equity environment.
 A new era in corporate governance reform | 9

exhibit 4

Both directors and investors are dissatisfied

with executive compensation

“Compensation plans To what degree did compensation plans lead to How would you describe executive
encourage reckless recent scandals? compensation today?
management behavior.”
—Survey respondent Directors Investors Directors
% of respondents1 % of respondents % of respondents
Not at all (3)
“CEO compensation Partially
is not performance Completely Completely Too low
Moderately Moderately/ Far too high
based; performance partially
10 5 7 5 13
goes down, pay goes 32
up . . . performance 22
goes up, pay goes 43 39
59 61
way up.” Too high
About
—Survey respondent Largely Largely right

1 Figures do not sum to 100%, because of rounding.

exhibit 5

Executive compensation will feature more cash and

fewer options or other special grants

What’s the proper mix to align the interests of executives with Do you support or oppose the following forms of special
those of shareholders? compensation for executives?

Directors Investors Directors

Average response, % Average response, % % of respondents

Unrestricted stock, Unrestricted stock, 0 25 50 75 100

Restricted unrestricted stock unrestricted stock
stock options options
Restricted Forgivable loans
options stock
12 options 6 Termination
20 bonuses
17 45 Cash
47 Cash Special retirement
26 27 plans
Signing bonuses
Restricted Restricted
stock stock Support/not sure Oppose

The coming months will require tough be serving neither management nor
choices in the boardroom. Substantial shareholders well. MoF
progress already has been made, but
investors and directors are calling clearly Bob Felton (Bob_Felton@McKinsey.com) is a

for more—and deeper—reforms. And our director in McKinsey’s Pacific Northwest office.

surveys suggest that if directors don’t

show leadership on these issues, investors 1
The surveys of 150 corporate directors and 44 institutional
investors (with more than $3 trillion in assets under manage-
will. Boards that embrace reform may well
ment) were conducted with the Directorship Search Group
reap a trust premium, while those that and the Institutional Investors Institute, respectively. The
continue to ignore the call for change will surveys are available at www.mckinseyquarterly.com.
10 | McKinsey on Finance | Summer 2004
Can banks grow
beyond M&A?
US banks will need to look beyond mergers for
growth. Better earnings will have to be won from
improved value propositions and productivity.
Kevin P. Coyne, During the 1990s, the economic rationale
Lenny T. Mendonca,
for mergers in the banking industry was
and Gregory Wilson
indisputable. Enormous gaps in efficiency
between the acquirer and the acquired
often created cost and revenue synergies
ranging from 30 to 100 percent of a
seller’s net income.1 New technology
made many of these gains possible by
facilitating the consolidation of branches.
In addition, the Riegle-Neal Act of 1994,
which allowed bank holding companies
to acquire banks in any state, opened the
door to pairings—such as Bank of America
and NationsBank or Norwest and
Wells Fargo—that previously would have
been difficult or impossible.
So successful was this wave of mergers that
the industry progressed toward a natural
endgame in which a handful of nationwide
banks began to emerge. Although curbed by
a regulation limiting an individual bank’s
share of US deposits to 10 percent of the
total, the top ten institutions increased their
share of US deposits from 27 percent in
1994 to 44 percent in 2002 (Exhibit 1). The
result? For most large banks, further
expansion won’t necessarily yield dramatic
scale-based savings in systems and product-
development costs. What potential
combinations remain among the larger
institutions present fewer geographic
overlaps, and while scale economies are
always helpful, most leading banks are
already big enough to support the systems,
branding, and product-development costs of
the next few years. Instead, executives of
large banks must look for new ways to
increase earnings.
Like the best retailers, banks must
differentiate themselves by understanding
the needs of their customers and giving
them a distinctive experience. Banks should
also boost their performance the old-
fashioned way, by improving productivity—
something that will become vital as their
payments businesses, which represent a
substantial share of industry profits and
operating expenses, shrink with the falling
use of checks. To succeed in these tasks,
banks must innovate in their formats, their
customer targeting, their approach to
lending and asset management, their
operations, and their use of electronic
payments. This agenda is challenging, and it
exhibit 1
Consolidation continues
Share of total assets held by US commercial/savings banks by size, %
100% = $5.0 $8.4
trillion trillion
Top 10 banks 27
44
Next 15 banks 15
Next 25 banks 12 14
Next 50 banks 11
10
7
All other banks 35
25
1994 2002
Source: FDIC; Sheshunoff Information Services; SNL Financial

calls for skills beyond those—such as
identifying and valuing acquisition targets
and driving integration—that have served
executives so well in the recent past.
Significant changes lie ahead for managers
who are working toward a new set of
performance priorities.
In pursuit of growth
In other industries, particularly retailing,
value-oriented companies have spent the
past two decades developing new formats
and relieving customers of the need to
balance price and selection, quality and
convenience. Banks should now do the same
by reinventing the experience they offer and
improving their customer service.
Opportunities can be found in both retail
and wholesale banking, and the current
branch-building boom makes this a good
time to act.
Reinventing the customer experience
Banks have invested heavily in efforts to
keep their customers more satisfied, and all
of them want strong relationships with their
clients. Yet some leading institutions are
poorly differentiated. What should big banks
do? Our research suggests that three factors
are particularly important to customers. The
first is ease of use. A few years ago, a bank
could stand out by having a number of
points of access—plenty of branches and
ATMs as well as online services. But
consumers now take these amenities for
granted and are more interested in what
happens at the service point: they want
banks to get them in and out quickly, with
exactly the products and services they want.
The second important factor is the accurate
opening and fulfillment of accounts, both of
which frequently give rise to errors. The
third is the ability to correct these errors.
Perhaps surprisingly, our research shows that
Can banks grow beyond M&A? | 11
customers are willing to forgive occasional
mistakes if banks fix them quickly and
transparently. When banks don’t, the level of
satisfaction plummets.
Providing the right experience goes hand in
hand with redefining relationships. Our
research shows that customers want a bank
that understands their needs and provides
timely, tailored solutions.
Many transactions—taking out a mortgage,
arranging a small-business loan, buying an
automobile—occur infrequently. Without
deep knowledge of customers, banks are no
more likely to win such business than are
specialist competitors. One problem with
customer relationship management and
other cross-selling techniques, however, is
that, for all the data they collect, they don’t
necessarily get at the most important pieces
of information (such as the age of children
destined for college, for whom financial
planning might soon be necessary).
Some of this information still comes from
personal interaction. Technology, although
no substitute for it, can help by facilitating
the capture and recording of vital data, by
routing leads to the agents best equipped to
help, and by improving the performance of
back-office analytics. Such measures have
helped some large banks make substantial
branch and call-center sales breakthroughs.
Serving the underserved
In addition to upgrading the experience
they offer, banks should simultaneously
reevaluate the customers they are—and are
not—serving. Underserved segments exist in
the retail and wholesale businesses of many
banks because for years they have focused
on bigger clients, wealthier clients, or both.
One important challenge for CEOs is
12 | McKinsey on Finance | Summer 2004
persuading their organizations to look far
enough ahead to allow new customer
segments to become growth engines.
One area that
The payments business,
banks could
accounting for 25 to consider is cheaper
retirement advisory
40 percent of the profits of
services at the
most institutions, is the lower end of the
mass-affluent
‘stealth industry’ of
market. As the baby
commercial banking. But the boomers retire and
government and
business, with its underlying
private-sector
costs and complexities, is retirement
programs come
also an expensive one.
under strain, the
accumulation of
assets will slow and investors will shift the
weighting of their portfolios from equities
to fixed-income securities. Banks are well
positioned in this respect because they have
long provided certificates of deposit and
money market investment vehicles; they are
also skilled at serving the smaller customers
some money managers shun. Further, many
people place more trust in banks than in
Wall Street brokerages or mutual funds.
Less affluent market segments beckon
too. The US Federal Deposit Insurance
Corporation estimates that 10 percent of
the US population is “unbanked.” Yet many
relatively unsophisticated vendors earn
attractive returns by focusing on
transactions—ATM withdrawals at
supermarkets, wire transfers, payday loans,
tax-refund loans, check cashing, prepaid
credit cards, used-car loans, and appliance
loans—for which unbanked customers are
willing to pay above-average interest rates.
Leading banks that leverage their scale,
technology, risk-management systems, and
delivery channels should be able to provide
this group with simple transaction, savings,
and credit products and to earn a profit.2
Meanwhile, the large and rapidly
growing Hispanic segment, currently
numbering about 40 million, works with
fewer financial intermediaries (1.5), on
average, than does the population as a
whole (2.4). Some banks, including Bank of
America, Citibank, U.S. Bancorp, and Wells
Fargo, have been targeting Hispanic people,
but it is not yet clear what approaches will
be successful.
Opportunities for experimentation
abound
In wholesale banking, the corporate middle
market merits attention. Despite relatively
low revenues per relationship, the market as
a whole represents a $20 billion pool of
potential profit and is growing by 8 percent
a year—twice the rate for lending to large
corporations. Over the next few years, big
volumes of this business may be up for
grabs because of a proposed Basel II
provision that requires certain banks to hold
substantially more regulatory capital against
loans to companies with lower risk ratings.
Boosting productivity
To finance these customer initiatives,
banks must wring more value from
operations. Opportunities remain to
generate revenues and cut costs by
improving productivity. The payments
business deserves special examination.
Upheaval in payments
The payments business, accounting for
25 to 40 percent of the profits of most
institutions, is commercial banking’s stealth
industry. But the business is also an
expensive one, with banks spending

$50 billion a year servicing consumer and
corporate accounts through a growing array
of channels (branches, ATMs, telephones,
the Internet, and point-of-sale devices) and
of payment instruments (checks, cards,
electronic fund transfers, bill-payment
services, and account-to-account transfers).
As the variety of channels, transactions, and
payment types multiplied, so too did the
underlying costs and complexities of
servicing direct-deposit accounts.
The economics of payments are under
pressure on several fronts. Customers’ cash
balances have migrated to higher-yielding
(and so, for banks, lower-margin) savings
and investment vehicles. Rock-bottom
interest rates have compressed banks’
spreads from lending. Finally, the fee
income from demand-deposit accounts has
come under attack. Debit card fees fell by a
third following the success of a recent
class-action lawsuit brought by retail
merchants against Visa and MasterCard,
and in several states overdraft and other
account-based fees have attracted
regulatory scrutiny.
A glimmer of hope is held out by the
Check 21 legislation passed in October
2003, which will allow banks to provide
check images with their customers’ monthly
statements rather than sort and return the
actual checks. Truncating the process in
this way could knock $2 billion to
$3 billion off the estimated annual cost—
$8 billion—of processing checks. Check 21
does, however, have potential drawbacks.
Electronic migration will alter the strategic
dynamics in payments by making today’s
value drivers in checks—geographic
proximity, efficient manual labor, and the
ability to maximize clearing balances—
increasingly irrelevant. Furthermore, the
Can banks grow beyond M&A? | 13
unit costs of processing paper checks will
escalate rapidly as the electronic shift
progresses, leaving behind large fixed
infrastructure costs.
The shift to electronic payments creates
opportunities for banks to develop new
payment propositions with economics
superior to those of cash and checks. Low-
balance customers, traditionally unprofitable
to serve, might look more attractive if their
cash and check usage could be moved to
debit or credit cards or to ATMs. As with
credit cards, competitors will probably
develop new products and services, from
prepaid cards for the unbanked to
sophisticated payables-processing algorithms
for large corporations.
Broader productivity opportunities
In the absence of “big-bang” opportunities
such as back-office automation, more banks
will need to pursue the kind of lean
techniques that pioneering institutions
have employed to enhance service quality
and efficiency ratios. Working both the
numerator and the denominator of the
efficiency ratio, banks could improve the
performance of their operations more
quickly than they have in recent years
(Exhibit 2). Initial improvements would
be on the order of 2 to 5 percent, with
the potential for more if systems were
fully developed.3
Productivity gains can also be had from
reducing the number of wasted customer
leads, refining treasury management and
custody controls, and speeding up the
processing of applications for credit or
insurance. To capture such gains, banks
must continue to strike the right balance
between cost efficiency and revenue
generation in their branches and call
14 | McKinsey on Finance | Summer 2004

exhibit 2

How low can banks go?

Distribution of top 50 US banks by revenues

120

Efficiency ratio1 (lower = more efficient) 100

80

60

40

20

0
0 25 50 75 100

Share of industry revenues, %

Banks in 1994: A B C . . . (100% = $143 billion)

Banks in 2002: A B C . . . (100% = $331 billion)

1Common operational-efficiency measure defined as noninterest expense ÷ (net interest income + noninterest income).
Source: SNL Financial; McKinsey analysis

centers. A few companies, such as the main pressure to perform at all levels, addressed
credit card players, are moving in the right capabilities in areas such as capacity
direction, but it’s not easy. Key challenges management, or changed the way frontline
include redefining the roles of frontline managers and employees are hired,
sales, service, and supervisory jobs and motivated, and rewarded.
redesigning processes and the supporting
infrastructure so that decisions can be made Productivity initiatives interact in
on the spot. important ways with banks’ offshoring
efforts. The wage savings made possible by
These opportunities are not new. But moving jobs to countries such as India are
realizing value from them has been so attractive that offshoring is a
extremely difficult because the cost base of competitive necessity; over time, many
most banks is highly fragmented, which financial institutions will offshore 20 to
makes leveraging improvements across the 40 percent of their cost base, thereby
organization tricky and time-consuming. saving as much as 15 percent of their total
Broad-based progress requires changes in noninterest expenses. Yet as banks evaluate
the outlook and behavior of employees at offshore options, they will have to
all levels.4 Many programs have so far failed recognize the relationship between what
to realize these kinds of changes because they move abroad and the productivity of
the banks adopting them haven’t created their operations at home. Banks often send

easier, base-load calls offshore, for example,
reserving domestic call centers to handle
more complex requests and to cope with
surges in demand. This approach can help
domestic call centers improve the way they
meet the needs of customers, but it also
demands first-rate management of
capacity.5 In fact, sending functions to low-
wage countries does not relieve banks of
the need to make their operations back
home truly hum.
M&A among smaller banks
Although the banking industry’s structure
and regulatory framework will permit more
mergers in the future, the reduced potential
for synergies means that the results could
disappoint CEOs who make deals their
primary strategic focus. Some obvious
pairings will realize worthwhile cost
savings, especially among second- and third-
tier banks, but for most large institutions
the opportunities for consolidation are not
what they were a few years ago.
Nonetheless, announcements of recent
mergers of second-tier institutions bear
witness to the continuing consolidation
among banks that aspire to be truly national
in scope. Many developed markets have such
institutions, four or five of which might
command a market share of 75 to
80 percent. We expect this trend to continue
as long as management believes that mergers
can generate value through costs savings or
through new offerings for customers.
Banking consolidation will continue, but
growth and productivity initiatives will
replace megadeals as the cornerstone of
most strategies to create value—thus
Can banks grow beyond M&A? | 15
producing a more diverse and complex
agenda for executives. Increasingly, CEOs
will be orchestrating a number of initiatives
that cut across businesses and involve
frontline employees throughout the
organization instead of making a few
big portfolio decisions and then driving
their execution. MoF
The authors wish to thank Andrew Appel, Andy
Eichfeld, Jack Stephenson, and Corey Yulinsky for
their contributions to this article.
Kevin Coyne (Kevin_Coyne@McKinsey.com) is a
director in McKinsey’s Atlanta office, Lenny
Mendonca (Lenny_Mendonca@McKinsey.com)
is a director in the San Francisco office, and Greg
Wilson (Greg_Wilson@McKinsey.com) is a principal
in the Washington, DC, office. This is an excerpt
from their article “Can banks grow beyond M&A?”
The McKinsey Quarterly, 2004 Number 1, pp. 72–81
(www.mckinseyquarterly.com/links/13467).
1
Madeleine James, Lenny T. Mendonca, Jeffrey Peters, and
Gregory Wilson, “Playing to the endgame in financial
services,” The McKinsey Quarterly, 1997 Number 4,
pp. 170–85 (www.mckinseyquarterly.com/links/13461).
2
For an international perspective, see David Moore,
“Financial services for everyone,” The McKinsey Quarterly,
2000 Number 1, pp. 124–31 (www.mckinseyquarterly.com/
links/13462).
3
Anthony R. Goland, John Hall, and Devereaux A. Clifford,
“First National Toyota,” The McKinsey Quarterly, 1998
Number 4, pp. 58–68 (www.mckinseyquarterly.com/
links/13463).
4
For details on how to effect changes of this kind,
see Emily Lawson and Colin Price, “The psychology of
change management,” The McKinsey Quarterly, 2003
special edition: The value in organization, pp. 30–41
(www.mckinseyquarterly.com/links/13464).
5
For details on offshoring models, see Gautam Kumra
and Jayant Sinha, “The next hurdle for Indian IT,”
The McKinsey Quarterly, 2003 special edition: Global
directions, pp. 42–53, particularly Noshir Kaka’s sidebar,
“A choice of models” (www.mckinseyquarterly.com/
links/13465).
16 | McKinsey on Finance | Summer 2004
Internal rate of return:
A cautionary tale
Tempted by a project with a high internal rate
of return? Better check those interim cash
flows again.
John C. Kelleher Maybe finance managers just enjoy living
and Justin J.
on the edge. What else would explain their
MacCormack
weakness for using the internal rate of
return (IRR) to assess capital projects? For
decades, finance textbooks and academics
have warned that typical IRR calculations
build in reinvestment assumptions that
make bad projects look better and good
ones look great. Yet as recently as 1999,
academic research found that three-quarters
of CFOs always or almost always use IRR
when evaluating capital projects.1
Our own research underlined this proclivity
to risky behavior. In an informal survey of
30 executives at corporations, hedge funds,
and venture capital firms, we found only 6
who were fully aware of IRR’s most critical
deficiencies. Our next surprise came when
we reanalyzed some two dozen actual
investments that one company made on the
basis of attractive internal rates of return.
If the IRR calculated to justify these
investment decisions had been corrected for
the measure’s natural flaws, management’s
prioritization of its projects, as well as its
view of their overall attractiveness, would
have changed considerably.
So why do finance pros continue to do
what they know they shouldn’t? IRR does
have its allure, offering what seems to be a
straightforward comparison of, say, the
30 percent annual return of a specific
project with the 8 or 18 percent rate that
most people pay on their car loans or
credit cards. That ease of comparison
seems to outweigh what most managers
view as largely technical deficiencies that
create immaterial distortions in relatively
isolated circumstances.
Admittedly, some of the measure’s
deficiencies are technical, even arcane,2 but
the most dangerous problems with IRR are
neither isolated nor immaterial, and they can
have serious implications for capital budget
managers. When managers decide to finance
only the projects with the highest IRRs, they
may be looking at the most distorted
calculations—and thereby destroying
shareholder value by selecting the wrong
projects altogether. Companies also risk
creating unrealistic expectations for
themselves and for shareholders, potentially
confusing investor communications and
inflating managerial rewards.
We believe that managers must either avoid
using IRR entirely or at least make
adjustments for the measure’s most
dangerous assumption: that interim cash
flows will be reinvested at the same high
rates of return.
The trouble with IRR
Practitioners often interpret internal rate of
return as the annual equivalent return on a
given investment; this easy analogy is the
source of its intuitive appeal. But in fact,
IRR is a true indication of a project’s
annual return on investment only when the
project generates no interim cash flows—or
 Internal rate of return: A cautionary tale | 17

exhibit 1

Identical IRRs, but very different annual returns

Internal-rate-of-return (IRR) values are identical for 2 projects . . .

Project A IRR Project B IRR

Year 0 1 2 3 4 5 Year 0 1 2 3 4 5
Cash flows, $ million –10 5 5 5 5 5 41% Cash flows, $ million –10 5 5 5 5 5 41%

. . . however, interim cash flows are reinvested at different rates

Key assumption: reinvestment rate = IRR Key assumption: reinvestment rate = cost of capital
Project A CAGR1 Project B CAGR1
Year 0 1 2 3 4 5 Year 0 1 2 3 4 5
Value of cash flows 5 20 41% Value of cash flows 5 7 8%
at year 5 if at year 5 if
5 14 41% 5 6 8%
reinvested at 41% reinvested at 8%
5 10 41% 5 6 8%
5 7 41% 5 5 8%
5 5

Year 5 value of $10 million investment = $56 41% Year 5 value of $10 million investment = $29 24%
million CAGR1 million CAGR1

True return is nearly 50% less

because of lower reinvestment rate

1 Compound annual growth rate.

when those interim cash flows really can be Consider a hypothetical assessment of two
invested at the actual IRR. different, mutually exclusive projects, A and
B, with identical cash flows, risk levels, and
When the calculated IRR is higher than the durations—as well as identical IRR values
true reinvestment rate for interim cash flows, of 41 percent. Using IRR as the decision
the measure will overestimate—sometimes yardstick, an executive would feel
very significantly—the annual equivalent confidence in being indifferent toward
return from the project. The formula choosing between the two projects.
assumes that the company has additional However, it would be a mistake to select
projects, with equally attractive prospects, in either project without examining the
which to invest the interim cash flows. In this relevant reinvestment rate for interim cash
case, the calculation implicitly takes credit flows. Suppose that Project B’s interim cash
for these additional projects. Calculations of flows could be redeployed only at a typical
net present value (NPV), by contrast, 8 percent cost of capital, while Project A’s
generally assume only that a company can cash flows could be invested in an attractive
earn its cost of capital on interim cash flows, follow-on project expected to generate a
leaving any future incremental project value 41 percent annual return. In that case,
with those future projects. Project A is unambiguously preferable.

IRR’s assumptions about reinvestment can Even if the interim cash flows really could
lead to major capital budget distortions. be reinvested at the IRR, very few
18 | McKinsey on Finance | Summer 2004
practitioners would argue that the value of
future investments should be commingled
with the value of the project being
evaluated. Most practitioners would agree
that a company’s cost of capital—by
definition, the return available elsewhere to
its shareholders on a similarly risky
investment—is a clearer and more logical
rate to assume for reinvestments of interim
project cash flows (Exhibit 1).
When the cost of capital is used, a project’s
true annual equivalent yield can fall
significantly—again, especially so with
projects that posted high initial IRRs. Of
course, when executives review projects
with IRRs that are close to a company’s
cost of capital, the IRR is less distorted by
the reinvestment-rate assumption. But when
they evaluate projects that claim IRRs of
10 percent or more above their company’s
cost of capital, these may well be
significantly distorted. Ironically, unadjusted
IRRs are particularly treacherous because
the reinvestment-rate distortion is most
egregious precisely when managers tend to
think their projects are most attractive. And
since this amplification is not felt evenly
across all projects,3 managers can’t simply
correct for it by adjusting every IRR by a
standard amount.
How large is the potential impact of a
flawed reinvestment-rate assumption?
Managers at one large industrial company
approved 23 major capital projects over five
years on the basis of IRRs that averaged
77 percent. Recently, however, when we
conducted an analysis with the reinvestment
rate adjusted to the company’s cost of
capital, the true average return fell to just
16 percent. The order of the most attractive
projects also changed considerably. The top-
ranked project based on IRR dropped to
the tenth-most-attractive project. Most
striking, the company’s highest-rated
projects—showing IRRs of 800, 150, and
130 percent—dropped to just 15, 23, and
22 percent, respectively, once a realistic
reinvestment rate was considered (Exhibit 2).
Unfortunately, these investment decisions
had already been made. Of course, IRRs this
extreme are somewhat unusual. Yet even if a
project’s IRR drops from 25 percent to
15 percent, the impact is considerable.
What to do?
The most straightforward way to avoid
problems with IRR is to avoid it altogether.
Yet given its widespread use, it is unlikely to
be replaced easily. Executives should at the
very least use a modified internal rate of
return. While not perfect, MIRR at least
allows users to set more realistic interim
reinvestment rates and therefore to calculate
a true annual equivalent yield. Even then,
we recommend that all executives who
review projects claiming an attractive IRR
should ask the following two questions.
1. What are the assumed interim-
reinvestment rates? In the vast majority of
cases, an assumption that interim flows can
be reinvested at high rates is at best
overoptimistic and at worst flat wrong.
Particularly when sponsors sell their projects
as “unique” or “the opportunity of a
lifetime,” another opportunity of similar
attractiveness probably does not exist; thus
interim flows won’t be reinvested at
sufficiently high rates. For this reason, the
best assumption—and one used by a proper
discounted cash-flow analysis—is that
interim flows can be reinvested at the
company’s cost of capital.
2. Are interim cash flows biased toward
the start or the end of the project? Unless

exhibit 2
A rude surprise
850
800
200
150
100
50
0
Project1 1 2 3 4 5
1 Disguised example of large industrial company.
the interim reinvestment rate is correct (in
other words, a true reinvestment rate rather
than the calculated IRR), the IRR distortion
will be greater when interim cash flows
occur sooner. This concept may seem
counterintuitive, since typically we would
prefer to have cash sooner rather than later.
The simple reason for the problem is that
the gap between the actual reinvestment
rate and the assumed IRR exists for a longer
period of time, so the impact of the
distortion accumulates.4
Despite flaws that can lead to poor
investment decisions, IRR will likely
continue to be used widely during capital-
budgeting discussions because of its strong
intuitive appeal. Executives should at least
cast a skeptical eye at IRR measures before
making investment decisions. MoF
The authors wish to thank Rob McNish for his
assistance in developing this article.
Internal rate of return: A cautionary tale | 19
6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
Standard IRR calculation Modified IRR with reinvestment at cost of capital
John Kelleher (John_Kelleher@McKinsey.com)
and Justin MacCormack (Justin_MacCormack@
McKinsey.com) are consultants in McKinsey’s
Toronto office.
1
John Robert Graham and Campbell R. Harvey, “The theory
and practice of corporate finance: Evidence from the field,”
Duke University working paper presented at the 2001
annual meeting of the American Finance Association, New
Orleans (available at http://ssrn.com/abstract=220251).
2
As a result of an arcane mathematical problem, IRR can
generate two very different values for the same project
when future cash flows switch from negative to positive (or
positive to negative). Also, since IRR is expressed as a per-
centage, it can make small projects appear more attractive
than large ones, even though large projects with lower IRRs
can be more attractive on an NPV basis than smaller proj-
ects with higher IRRs.
3
The amplification effect grows as a project’s fundamental
health improves, as measured by NPV, and it varies
depending on the unique timing of a project’s cash flows.
4
Interestingly, given two projects with identical IRRs, a
project with a single “bullet” cash flow at the end of the
investment period would be preferable to a project with
interim cash flows. The reason: a lack of interim cash
flows completely immunizes a project from the
reinvestment-rate risk.
20 | McKinsey on Finance | Summer 2004
Taming postmerger
IT integration
Lessons from the IT-heavy banking sector can
bring balance to this critical task.
Lisa Åberg and To succeed, a merger requires the smooth
Diane L. Sias
integration of IT systems and services, but
the task often plunges the CFO responsible
for ensuring the savings into uncharted
territory. Confronted by an immediate
technical challenge, companies typically
choose one of two questionable routes.
Some, fearing costs and complexity, never
fully integrate their acquisition’s systems and
thus gain few synergies. Others focus on the
promise of synergy gains and improved
performance but, in their haste, simply
choose one system over another, often
alienating both customers and employees.
CFOs might consider looking to IT
integration in the banking sector for
guidelines that can provide a better approach
in other sectors. IT, underlying every process
a bank performs, is particularly integral to
bank operations. Moreover, banks tend to
have complex operational structures, often
with many brands, branches, and product
sets.1 Yet even amid that complexity, it is
possible to structure an approach that taps
synergies,2 serves customers at least as well
as they were served before, and achieves
suitable trade-offs among internal parties.
To merge these structures for maximal
synergy and minimal customer disruption, it
is necessary to transform the IT functions
that underpin them. We have found that this
process must include two sets of rational
compromises. First, companies must find
the middle ground between a rapid
migration that captures synergies quickly
and a slow one that focuses on a smooth
experience for customers. Second, the
merging companies must simultaneously
balance the requirements of disparate
interest groups within each company.
A question of pace
Rapid integration may garner immediate
synergies, but it also typically drives away
8 percent or more of the acquired customer
base. The customers who do stick around
can face service disruptions or lost account
information. One US bank that undertook a
fast-paced integration effort found itself in
an even worse position. The company not
only saw its customers flee, its revenues
decline, and its employees’ morale suffer but
also soon discovered that its established
application architecture could not support
planned additional product features and
functionality upgrades. The merged
company quickly met its projected cost
synergies, but the benefit was fleeting.
Because of the additional costs, the merger
didn’t meet its targets.
Slower integration may impose less stress
on customers and employees, but it can
also be expensive and delay the capture of
synergies indefinitely. Our calculations for
one company found that every month the
integration was delayed represented an
opportunity cost of up to 7 percent of the
targeted annual synergies. Even real costs
are not always immediately apparent. One
large US bank, for example, sought to
 Taming postmerger IT integration | 21

exhibit 1

An optimal migration scheme requires a systematic approach

Integration context Technology, products, and customer planning Synergy capture

• Merger aspirations Input Iteration Output • Rationalized distribution
• Brand strategy • Identify target Migration plan network
products, Net present value • Consolidated product
• Balance of power among •
product gaps, Sequencing (NPV) impact range
technology, product, and Inter-
customer sets rules
business units dependencies • Required • Scale economies in
• Determine Decision customer processing and support
• Conditions necessary to
migration routines tools communication Brand-rationalization
gain regulatory approval •

• Gap-closure economies
• Expected customer
segmentation and Trade-offs projects • Cross-selling of enhanced
destination • Migration product range
routines

What you need to know Sequencing based on

beforehand to make the
right trade-offs
+ Rigorous methodology for developing and evaluating options = enhancing shareholder
value

protect its customers and to avoid the costs way a company plans to get from today’s
of integration by keeping its own system environment to the future one. The best
separate from those of its numerous plan will explain in detail how the company
acquisitions. Yet it discovered that it was will realize every anticipated source of
actually spending more on technology—to synergy (Exhibit 1).
maintain and upgrade so many different
systems—than its competitors were and A question of leadership
was also inconveniencing the customers As difficult as it is to get the timing right,
whose service it had sought to protect. sorting out the needs of separate and
Customers transferring their accounts from powerful interest groups can be even
state to state went through the same tougher. In retailing, for example, such
rigmarole they would have faced in groups include the merchants who create
transferring to a completely new bank. promotions, the information technology
With various branches still running on staff, and the operations employees who
different systems, the bank’s acquisitions manage the customer interface—with all of
generated neither significant customer them jockeying to manage or influence the
benefits nor the optimal synergies. integration process. In banks, these groups
include business units, product specialists,
To manage the trade-offs, companies must and IT, but most banks simply relinquish
manage integration with one eye on the control to the tech specialists in IT. Not
synergies they want to realize from it. In surprisingly, tech specialists tend to push for
other words, they must quickly identify the best solutions from an IT perspective;
target products, systems platforms, product indeed, important business decisions about
gaps, migration routines, and specific the combined entity’s product offerings may
customer sets—and then create a detailed be based on how easy or difficult they are
and comprehensive migration plan for the to implement technologically. In contrast, a
integration team to follow meticulously. The business unit that takes the lead may
result should be a complete overview of the become overly protective of its customers
22 | McKinsey on Finance | Summer 2004
by limiting any changes that might affect
them or its business practices—and not
worrying about the enormous technology
costs it may be incurring.
At banks, we have found that product
specialists, despite their inherent biases, are
best suited to play a balancing role in this
triangle of players—not business units or
the technology staff, as others have
suggested.3 In most banking organizations,
the product units are responsible—during
business-as-usual situations—for
maintaining and developing a profitable
portfolio of products in line with the needs
of customers. These units therefore serve as
the focal point for balancing those needs
(defined by the business units) with the cost
of meeting them (dictated by the technology
side). As concerns about the cost of merging
systems yield to the benefits of customer
retention and revenues, the leadership of the
product units will be all the more beneficial
for companies.
When the technology side claims that
upgrading the IT systems will be too
complex a task, for example, the product
side can ask: “Exactly how complex will it
be?” “What resources are required?”
“What are the implications for other IT
projects?” and similar questions. When the
business units worry about the revenue
implications of failing to provide a given
product, the product specialists can demand
to know its true revenue impact and
profitability, get information about other,
similar products that are available, and so
on. Ideally, the product side mediates by
taking the group, product by product,
through the portfolio rather than allowing
the discussion to progress only on a project-
by-project basis or to become focused solely
on customers.
To combine the efforts of various
constituencies, companies should include
representatives of all key groups—in this
case, business units, product teams, and the
technology team—on both the initial
working committee responsible for
developing a migration plan and the steering
committee that implements the migration.
These committees must debate every issue,
every gap, and every routine to develop and
implement the proposed migration. The
process has four critical goals.
Confirm target product set
The first goal is to confirm the target
product set for the merged banks. As
much as possible, this process should
be undertaken from the perspective
of customers, with the ultimate goal of
giving them the same banking experience
they had before the merger or of
enhancing that experience.
Choose a system platform
Next, the committees must decide which
system platform will best support the
combined product set and any planned new
products. The chosen platform must have
technology that not only is sustainable over
the long term but also is able to handle the
additional customers a migration brings and
fit into the merged company’s goals for the
overall system architecture. At the same
time, the platform must not be so complex
that the company will lack the necessary
resources and skill sets to support and
develop it. Risk must be minimized, and so
must the impact on customers. The new
platform must also take into account the
views of the business units and be deliverable
within the overall time lines for the merger.
Migration might seem like a good time to
invest in best-practice systems and services,
 Taming postmerger IT integration | 23

exhibit 2

Product gaps must be assessed to determine which should be closed

Description
Yes Apply work- • Close gap through
around process work-around
solution, avoiding
Is an economically expensive and lengthy
Yes viable work- systems changes
around possible?
Apply retention • Change terms and
measures conditions and apply
Yes according to retention measures
Will closing of value at risk (such as reduced fees,
Yes gap significantly phone calls to valuable
delay synergy customers) within limits
capture? of budget
Does failure to close Close gap by • Close gap through
Do key No changing systems changes if
gap have significant competitors offer
potential to destroy systems economic impact of
the product nonclosure is significant
value, or do functionality to
regulators require and no alternative
No customers? Are solutions apply
that we close gap? we at risk? Will
high-value • Close gap only if doing
customers be so does not significantly
affected? delay merger synergy

No Do nothing • Do not close gap as part

of migration effort
• Apply low-cost customer
retention measures
No (such as client
communication)

perhaps by replacing existing systems with
more efficient or modern ones as gaps are
uncovered. We disagree. Such an effort
distracts management from the already
demanding requirements of the merger.
Instead, in the absence of strong reasons to
the contrary, the merged bank should choose
the better of the two existing systems.
Identify gaps between offerings
and services
The third goal is to identify, in detail, all
gaps between the offerings and services of
the acquirer and the acquired companies and
then to determine whether or not to close
them. Any two banks, for example, will have
a variety of different product offerings,
access channels (the Internet, call centers,
ATMs), payment methods and terms, and
processing routines and standards (on a
technological level).
If the target product set and system
platform have been established properly,
all of these product gaps will now be
visible. One large bank discovered more
than 1,000 of them when it first began the
integration process. Since closing all of the
gaps isn’t likely to be possible, the working
committee and the steering committee
should analyze each gap to determine if it
must be addressed. For selecting gaps to
close, a detailed decision tree can be
helpful (Exhibit 2). Key questions include:
“What do we lose if we don’t close this
gap?” “Is there an alternative solution or
work-around?” “Is this product really
necessary?” “How long will it take, and
at what cost?”
Select routines for data transfer
Finally, the company must settle on the best
routines for transferring data from the
24 | McKinsey on Finance | Summer 2004
original system to the new or chosen
system. This plan is as important as
detailing the product gaps to be addressed.
It includes deciding whether to migrate
manually or automatically.
A manual
We typically recommend a
migration, which
manual system migration for involves physically
closing down a
any product with fewer than
customer’s account
10,000 accounts and an on the old system
and opening up a
automatic migration for any
new one on the
product with 10,000 or target system, will
take much time and
more accounts. We have,
many resources
however, seen successful and introduces the
possibility of
manual migrations of up to
human error.
50,000 accounts. However, an
automated
migration, while faster and more accurate,
will require the IT staff to construct
complex routines, with significant mapping
in order to address all possible account
relationship scenarios. Considering this
trade-off, we typically recommend a manual
migration for any product with fewer than
10,000 accounts and an automatic
migration for any product with 10,000 or
more accounts. We have, however, seen
successful manual migrations of up to
50,000 accounts.
Although a product-by-product conversion
may be technically appealing, the very real
risk of customer confusion demands that
any migration be broken into manageable
pieces. For a company that has unique sets
of customers and is supported largely by
independent sets of systems, managing the
migration offers a considerable advantage:
in most cases, customers can be moved in
geographic waves to allow physical
branches to be rebranded easily, with
customer sets created around typical
transaction patterns.
Once the steering committee has worked
through these four goals, it can begin to
create a detailed migration blueprint that
lists which synergies are sought, where
activities interconnect, what resources are
required, and anything else necessary to
complete the migration. This blueprint—
continually updated and revised—will allow
the committee to understand the trade-offs
and compromises it makes as it moves
through the migration process.
Integrating IT systems is complex and time-
consuming. But by involving representatives
of all the key interest groups in mapping
out an integration strategy, executives can
better meet the needs and expectations of
customers while at the same time
vigorously pursuing the anticipated
synergies of the merger. MoF
Lisa Åberg (Lisa_Aberg@McKinsey.com) is an
associate principal in McKinsey’s Stockholm office,
and Diane Sias (Diane_Sias@McKinsey.com) is a
principal in the New Jersey office.
1
We worked with one acquiring bank that had accumulated
more than 700 branches, nearly 400 product sets, and
about 300 IT systems—and was set to buy a competitor
with almost as many branches, about 250 product sets,
and close to 200 IT systems.
2
Scott A. Christofferson, Robert S. McNish, and Diane L.
Sias, “Where mergers go wrong,” The McKinsey Quarterly,
2004 Number 2, pp. 92–9 (www.mckinseyquarterly.com/
links/13267).
3
Bradford Brown and Vikram Malhotra, “Tying the knot: IT
systems in a merger,” The McKinsey Quarterly, 2003
Number 4, pp. 128–38 (www.mckinseyquarterly.com/
links/13269).
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