McKinsey: Best practice in core business diversification creates value

Core business diversification allows a business to, among others, create new revenue pools, strengthen portfolios, secure competitive advantage, and acquire skills and capabilities that were previously lacking in the core business. Expansion come with risks however, with more than 70% businesses embarking on the journey finding that it creates little value or underperforming on their expectations. New research highlights that utilising best practice in the scanning, evaluation and integration of diversification efforts reaps benefits.

Expanding and diversifying a business beyond its core business proposition comes with considerable opportunities, if done right; but also with considerable risks. New research from McKinsey & Company, titled ‘Growing beyond the core business’, explores in how far businesses that expand their businesses outside of the core are able to create value, and what best practices set those that do create significant value out from the rest

According to the research, which involved 1,143 executives at companies with revenues above $500 million, only around a third of businesses are able to create value of more than 10% of their total business through diversification efforts. In total, around 50% of respondents said that the biggest revenue-generating move has created some financial value, while 28% say it has created significant value. 9% say that it added no value, 8% say it destroyed value and 2% say it destroyed significant value.

Reasons to make the move

The reasons cited by respondents for expanding their respective businesses beyond their core businesses differ across respondents. 61% however, cite that it provides them with access to new profit pools, whereby 49% say that it secures long-term growth options outside their core industry and 23% say that it is to diversify risk and exposure to business cycles within their core industry.

The research also found that 60% of respondents, justify their expansions outside the company’s core business on the basis of it strengthening their core business. Around 28% said that it secured a competitive advantage for their core business, 25% said it allowed them to acquire skills and capabilities that were lacking in their core business and 20% said it allowed them to acquire technology or R&D assets to leverage in their core business.

For most companies, the move to diversify their offering is aimed at creating long-term value. Around 10% of businesses said that they expanded their business as a source of short-term growth.

The research also considered in how far home-market companies in emerging markets prised their ability to diversify business practices beyond their core market, relative to developed market companies diversifying offerings in an emerging market. The research found that emerging market players were 1.4x more likely to have their diversification efforts generate significant value for their companies.

The study shows that 45% of emerging-economy companies believe that they are better position, due to them having more opportunities to reinvest retained earnings into new businesses, while 37% said that they are advantaged because it is easier for them to leverage relationships with local stakeholders. Respondents also said that they felt better positioned to attract talent, cited by 24%, and better positioned to attract investors, cited by 19%. 11% said that they felt that they would have no advantage.

The firm sought to identify the ‘best practices’ employed by companies that were able to improve the likelihood that a company expanding its business beyond its core business is able to generate significant value.

The research notes that three key best practices were identified, ‘scanning for expansion opportunities’, ‘evaluating expansion opportunities’ and ‘integrating new activities into core business’. Mastering these three key steps in the diversification process, has a 1.9x, 2.1x and 2.0x chance of improving the diversification outcomes respectively, even while the % of respondents found to be following best practice came in at 27%, 29% and 22% respectively.

A number of other factors were found to be important in the diversification process, including executing the move, through acquisitions, partnerships, allocating organic-growth resources, which was found to make a positive outcome 1.7x more likely, while clear management of new activities was found to be particularly effective, increasing the chance of success by 2.7x.

The effect of the three key ‘best practices’, scanning, evaluating and integrating, identified by McKinsey as inherently able to boost diversification outcomes, were considered in more detail.

When it comes to scanning for expansion opportunities, around 40% agreed that having a clear strategy for expanding into activities in new product/service categories was about to create significant value in their biggest move outside their core bussiness, compared to 10% that disagreed. Around 36% of companies said that the use of a wide variety of sources to identify extension opportunities created significant value, compared to 23% that disagreed. Companies that have a clear process to scan for opportunities in new categories too, the research found, agreed more than disagreed that it allowed them to drive significant value creation.

Around 37% of companies evaluating expansion opportunities said that they agreed that, a clear process to evaluate opportunities in new categories created value, compared to 19% the disagreed. 36% of respondents also said that clear criteria to evaluate whether opportunities would be worthwhile to pursue created value, compared to 14% that disagreed.

Finally, 42% of companies that have an institutionalised approach to, and processes for, integrating acquisitions agree, compared to 17% that disagree.