540  Corporate Portfolio Strategy in Chapter 31, “Mergers and Acquisitions,” high-performing conglomerates continually rebalance their portfolios by purchasing companies whose perfor- mance they can improve. Second, high-performing conglomerates aggressively manage capital allo- cation across units at the corporate level. All cash that exceeds what’s needed for operating requirements is transferred to the parent company, which de- cides how to allocate it across current and new business or investment oppor- tunities, based on their potential for growth and returns on invested capital. Berkshire Hathaway’s business units, for example, are rationalized from a capital standpoint: excess capital is sent where it is most productive, and all investments pay for the capital they use. Finally, high-performing conglomerates operate in much the same way as better private-equity firms: with a lean corporate center that restricts its involvement in the management of business units to selecting leaders, allo- cating capital, vetting strategy, setting performance targets, and monitoring performance. Just as important, these firms do not create extensive corporate- wide processes or large shared-service centers. For instance, you won’t find corporate-wide programs to reduce working capital, because that may not be a priority for all parts of the company. At Illinois Tool Works, business units are primarily self-supporting, with broad authority to manage themselves as long as managers adhere to the company’s 80/20 rule (80 percent of a com- pany’s revenue is derived from 20 percent of its customers) and innovation principles. The corporate center largely handles taxes, auditing, investor rela- tions, and some centralized human resources functions. Conglomerates in Emerging Markets As mentioned earlier, the economic situation in emerging markets is distinct enough that we are cautious in applying insights gleaned from developed- world companies. Some preliminary, unpublished McKinsey research shows that more diversified companies in emerging markets outperform their less diversified peers. That is not the case in developed markets. While we expect the conglomerate structure to fade away eventually, the pace will vary from country to country and industry to industry. We can already see the rough contours of change in the role that conglomer- ates play in emerging markets. Infrastructure and other capital-intensive busi- nesses are likely to be parts of large conglomerates as long as access to capital and connections is important. In contrast, companies that rely less on access to capital and connections tend to focus on opportunities that differ from those of large conglomerates. These companies include export-oriented ones such as those in information technology (IT) services and pharmaceuticals. The rise of IT services and pharmaceuticals in India and of Internet com- panies in China shows that the large conglomerates’ edge in access to mana- gerial talent has already fallen. As emerging markets open to more foreign Constructing the Portfolio  541 investors, these companies’ advantage in access to capital may also decline. That will leave access to government as their last remaining strength, further restricting their opportunities to industries where its influence remains impor- tant. Although the time could be decades away, conglomerates’ large size and diversification will eventually become impediments rather than advantages. Constructing the Portfolio Executives can apply the principles discussed in this chapter to construct a portfolio of businesses for their company. A typical large company already owns enterprises in a single business or has an existing collection of diverse businesses. While there’s no single right way to think through this task, we’ve found over the past 30 years that a systematic approach to constructing a com- pany’s portfolio of businesses is helpful. This section describes that approach. Assessment of Business Units The process starts with analyzing the value creation characteristics of each business unit. The following questions can direct the analysis: • Is the unit in an attractive market—specifically, a market with attractive ROIC and growth opportunities? • Does the unit have a competitive advantage over peers, as evidenced by higher growth or ROIC? What are the sources of advantage? Are they sustainable? • Why is the parent company a better owner of the unit? What advan- tages does it bring? • Does the unit provide the company with the option of expansion? • Are there inflection points ahead in the unit’s product market (either positive or negative) that affect its value? In addition, you should evaluate the following secondary factors: • Does the unit have any risk impact on the rest of the company? • On a net basis, does the unit provide or consume cash? • Is the potential to create value large enough to have a meaningful im- pact on the entire company’s value? • Does the unit consume much more management time than others, rela- tive to its value creation potential? Once you have conducted these analyses, you could lay them out in sum- mary form, as in Exhibit 28.2.