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I personally find corporate finance strategy studies to be interesting. They tend to have a lot at stake and the consulting teams have to be more careful in showing value on the strategy side.

That is, they are interesting not because of the supposedly scary analyses, but the thinking that is required to simplify the analyses.

The reason for this is easy to explain.

A corporate finance study that is awarded to McKinsey or BCG could just as easily have been awarded to a bank. So why is a firm like BCG doing it? There are different answers to this question.

Sometimes the board wants an independent opinion, sometimes the relationship with the consulting partner leads to a study and at other times the client feels the consulting firm is better equipped for the work.

However, irrespective of the reason, the consulting firm cannot simply replicate the work a bank could do. Some consulting firms do this, especially the audit firms, but it is path to limited differentiation in the market.

McKinsey and BCG do not have the technical modeling and market understanding expertise that a bank would have. None of the elite consulting firms compete with banks for these skills. We just do not have those skills and there is no point in replicating them.

Moreover, for a bank the modeling work or model is an actual output for which the client is paying. The modeling work is a profit center for the bank. A consulting firm like McKinsey usually leaves the model behind, but that is not why the consulting firm is hired. That is not the main purpose of our corporate finance studies.

The consulting firm was hired to use the model to answer deeper business questions for the client. The model is the means to the end and not a primary output. This is why the strategy thinking becomes more important on a corporate finance study.

The client is going to compare the consulting firms financial skills to a bank, and a consulting firm is always going to lose on that comparison. Therefore, we must be exceptional on the strategy side so that the value we bring to the client is clear and beyond any doubt. But it is a different kind of value in corporate finance.

Context

The client in this study was a government agency that managed the road network in a populous emerging markets economy preparing to host the Olympics. While the games were many years away, given the number of infrastructure upgrades required and the importance of showcasing the country’s investment potential, the upgrades to the main road arteries in and around the major cities would need to commence immediately.

I was not the partner who had built the initial relationship with the client, but I had led similar studies before and because I specialized in emerging markets and state-owned-enterprises, it seemed like an obvious choice for me to do it. It was also a nice country so I did not see any reason not to go.

The client was very polite and professional. My team worked mainly for the CFO and we had limited interactions with the CEO. The CEO was a political appointee who was going to be replaced fairly soon. Therefore, the CFO was the point of continuity in the organization as the CEO changed roughly every 2 or 3 years.

The CFO was smart, a family person and genuinely interested in the work. He did not play political games of trying to test us or protect any turf. He gave us what we wanted and stayed out of the way most of the time. However, he was clever and understood the business very well so the bar was set very high to bring him a solution.

Moreover, this client was never difficult to reach. He took my calls at all times and even stepped out of meetings to answer a question. The fact that he was so vested in the process made us all the more keen to help him succeed.

The client was concerned about the viability of the huge upgrades they planned to make. It would be the largest road works program in living memory for that country, it would cause enormous disruption to an already congested network of roads in the busiest part of the country and they were not sure of the costs or their ability to secure funding.

This was a short study to basically tell them if the project should go ahead or not.

Bringing us in was a politically smart move. If the agency had gone to the markets for funding and holes were poked in their plans, it would be hugely damaging to the incumbent political party. So the consulting study was a quiet way to vet the plan.

A rule of thumb in strategy studies for large government agencies is that there is always a political reason for bringing in the consultants.

The CFO wanted specific questions answered in the study:

1 – What were the risks of proceeding?

2 – Was the project viable?

3 – Could the project be funded?

4 – How much debt should they take on?

Of all the studies I led, the team I had assigned to the study was probably the weakest. None of them were trained within the firm but were lateral hires with no more than 9 months of experience working to our standards.

They all came from legal or accounting firms, and had a mix of legal, tax, economics and audit backgrounds, besides their MBAs. Even so, only half the team had MBAs. To have a team comprised of those backgrounds is extremely rare. I have never seen that since.

I faced some specific challenges with this team.

They loved being technical. It was deeply frustrating to review their work because they were new to strategy consulting and tried to convey their worth through complex ideas, versus simple but important findings. They liked putting complicated equations onto slides.

The engagement manager had the least experience at the firm so he still ran things the way he had been trained at his previous employee, the tax division of an audit firm. He did not encourage integration and sharing of work, ideas and findings. I had to spend a lot of time teaching him to teach the team to share ideas, and refine analyses as findings from one person impacted the other.

That is one crucial difference between the strategy firms and the non-target firms. They both do analyses but it is done in a very different way. In strategy, the teams work closely together and feed off each other, changing direction and thinking as new insights are communicated.

This team, if they are any representation of the non-target firms, seemed to take distinct pride in working in isolation and emailing the manager their slides at the end of the week. Sometimes they missed out important observations that a colleague had discovered, and blindly beavered away on the wrong track.

It surprised me when they seemed to hear information about another piece of work for the first time, only when I had them together for my updates on a Tuesday and Friday.

Corporate finance hypothesis

Unlike most strategy engagements, corporate finance studies have a lot of data in them. That does not mean there should be a lot of data analyses, but it implies that if you are not careful, you can drown in analyses.

Moreover, this client had very specific questions he wanted to answer. They would take a lot of time to answer. The question on the optimal debt level alone could be done in very complicated way. The client had seen a cost-of-capital versus percentage gearing curve and was hoping for the same analyses.

He liked pretty charts.

The curve is basically the change in cost of capital as a company takes on additional debt. Initially, the cost of capital drops as cheaper debt replaces equity, but then starts to rise as too much debt increases the probability of a debt default and breach of the company’s covenants.

That is a very theoretical curve, and would be a lot of work to do. I am not even sure if it was needed.

Outstanding strategy is about framing the right questions to be asked. It is certainly not about jumping in and doing complex analyses. Too many naïve and young consultants think strategy is about lots of number crunching. Hell, even some partners thing that way.

Most teams would jump in and start the work, but I felt the questions the client was asking were not useful to the study.

So I forced the team to work with me to think more carefully about what we were trying to do. This was what we came up with.

First insight: The optimal debt structure was irrelevant. That sounds pretty ridiculous when you say it out loud. How can the amount of debt this agency takes on be irrelevant? Surely at a certain level of debt the company would go bankrupt?

The client was also surprised when we mentioned this. The logic we used was simple but correct.

The government owned the client. The client had its own balance sheet so it was theoretically a ring-fenced financial entity and should have a debt limit.

Yet, that is not how the market perceived the company. The market viewed the company as an extension of the government and while the government had never ever publicly agreed to recapitalize the client’s balance sheet in time of trouble, the capital markets priced the clients bonds as if that would happen.

That is a great insight, but not the main insight.

There are many financial calculations that can be completed by using a set of equations or some combination of equations. Those equations are built on assumptions about the way the market will react to a set of events.

If the market does not react according to the assumptions in the equation, the equation must be adjusted or discarded.

So, there was no point in finding the optimal debt the balance sheet could hold, since their was no limit, because the market would always price the debt like it was not at risk of default.

Therefore, there was no reason to complete that funny looking curve measuring how cost of capital changed as the debt changed, because the costs would not change much. That saved us a lot of work.

As an aside, obviously there is a limit at which the market would decide the debt was too much. However, this agency was not even going to get close to this number for us to worry about it.

Second insight: It is logical to assume that the market would finance a large capital project generating meaningful returns. So, while we would calculate those returns, it did not seem to be adding any value to the study beyond doing something any bank would do.

So we flipped the question around and asked why would a set of rational investors not choose to invest in an infrastructure project with attractive returns in a fast growing emerging economy?

Now that is a far more interesting and useful question.

Front-line interviews

I mentioned earlier that the analysis is not the most important part of a strategy study. The framing or asking of the right questions is.

There is another important requirement in a good strategy study.

If you are not interviewing the primary users, than you might as well not do the study at all. To this very day, it baffles me when consulting teams build their findings around desktop analyses, review of benchmarks and discussions with internal experts like partners.

All those sources are filtering through their thoughts based on a different past study, with different issues and a different context. If you do studies in this manner, you are simply falling for the horrible trap of applying best practices by ignoring the context under which those best practices work.

Context matters.

You must interview the primary users to get their view on what is required at the current client. How you run this interview is equally important but for a different piece.

So, off we went to speak to the likely buyers of bonds issued by this government agency. That generated more useful findings than anything else, and it always does so. Because by speaking to these large funds we could deconstruct how they made an investment decision.

In simple terms, we figured out the purchasing behavior of the customers.

From that point we worked backwards and said, if these are the customers and they could make any other investment, why would they pick our client’s infrastructure project to make an investment?

So, you can see how the question we end up answering in this study is very different from what the client wanted. Yet, our refined question is more useful for the client to meet their overall objectives.

Corporate Finance Strategy Findings

I will only talk through the useful and unique findings. The returns from the infrastructure upgrades, financing requirements and risks are easy to do. They are not insightful to produce. Providing them, alone, to the client does not allow us to demonstrate why they were right to hire us.

We found one interesting finding to this question:

“Why would a set of rational investors not choose to invest in an infrastructure project with attractive returns in a fast growing emerging economy?”

What we found is that these institutional investors did not want idle cash on hand. It would be absolute failure for them to have billions of dollars of assets not invested. So asset deployment was of a critical concern to them. Moreover, they planned their investment cycles years in advance.

That means, they knew that in 2, 5 or even 6 years, they would take the cash from one investment and consider going into a new investment. So that ability to move cash from one investment to another was critical insight.

A deeper insight is that investors like to have one or two investments in each year ending so that they can logically have cash freed up to move to another investment that may come up. Ideally they wanted this to be about 10% of their total fund.

We studied similar projects around the world with similar risk adjusted returns and we noticed that for a 7 year window between, for example, 2023 and 2030, none of the bonds issued for these projects would mature.

In other words, the likely investments that competed with our client’s project for institutional funds, was not offering clients something they really wanted – maturity between 2023 and 2030.

Therefore if our client released a bond to mature in this window, the paper would be even more attractive to institutional investors since it gave them the investment transfer window they sought.

And that is what the client did.

That was the unique value we brought to the study. We altered the question in the study to find out the conditions under which the financing would be successful, and gave the client a recommendation.

We did all the usual analyses looking at how inflation and construction delays would alter the economics of the study, but really none of that gave the client anything new.

Knowing the unique ingredients to make the bond attractive was enormously useful to provide the go ahead for this study. That is why were we hired.

Michael

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