by Brian Pitman
From the Magazine (April 2003)
The turning point for the executive team at Lloyds Bank came in 1986, when we decided to sell our retail banking operations in California. Our acquisition of a bank there in 1974 had been hailed as healthy diversification away from our British home market, and many of our executives still viewed Lloyds Bank California as a crucial foothold in a state with one of the world’s largest, most affluent, and fastest-growing economies. The problem was that, however appealing the market, we had absolutely no competitive advantage there. Our market share was negligible. We were in no position to compete with giants like Bank of America.
Still, there was something almost cowardly about pulling out of such a dynamic growth market. It set off an enormous debate among our executive team. One emotionally charged word—“withdraw”—kept coming up: “We aren’t going to withdraw from California, are we? What will people say about that?”
But, in the end, no one could make a good economic argument for holding on to the business. We calculated that the California bank was not earning back its cost of equity, and the growth potential of the market notwithstanding, we saw no way of significantly increasing its returns. So we put the business on the block. A Japanese bank paid a small fortune for it—and our share price rose overnight.
The experience was a defining one for Lloyds Bank. It underscored the fact that managing for shareholder value inevitably entails difficult, even wrenching choices. But it also revealed that the discipline pays off. It gave us the mettle we needed to put the interests of the shareholder first—for example, by shifting the focus from growth to profitability—and it set the stage for a resurgence in the bank’s fortunes. Between 1983, when I was named chief executive of Lloyds Bank, and 2001, when I retired, Lloyds’s market capitalization grew from £1 billion to £40 billion. The compound total shareholder return during that period, including the reinvestment of dividends, averaged 26% annually—a rate that not only outpaced the returns of our UK banking rivals but put us in a league with market stars such as Coca-Cola, GE, and Gillette.
Can I take all the credit for this extended successful run? Of course not. But I did learn a few things about the challenges and rewards of focusing a company on shareholder value. The most important one is that value-based management, as it has come to be called, involves much more than putting in place some faddish new performance metric or accounting method. Getting people to concentrate on things that really create value for the company demands something else: the transformation of their beliefs.
The Single Objective
My first goal as CEO was to get our board, and ultimately our management team, to come to some agreement on what constituted success for Lloyds. If we could agree on this, we could set a single, well-defined performance measurement, one that would replace our existing array of implicit objectives: Serve shareholders, serve customers, serve employees, serve society in general. Such woolly goals get you nowhere because they aren’t specific enough to have an effect on people’s performance.
We had a cracking board, with a brilliant chairman, Sir Jeremy Morse, and highly intelligent leaders from a variety of industries. So it was an extremely stimulating discussion—a philosophical debate, really—about the nature of corporate success. It was easy to agree that we wanted to be the best financial services company. But what did that mean? In the United Kingdom? In the world? And what did “best” mean? Many sitting around the table believed that to be biggest was to be best. Some people believed that success meant having the highest level of customer satisfaction.
I want to emphasize I didn’t have a hidden agenda here; I didn’t know myself what the right answer was. But I did want to be sure we came up with a single definition of success and a single means of measuring it. Without this focus, I feared we would muddle along, our efforts diluted by the pursuit of multiple goals. I think the board probably gave me some slack in pushing so hard for this. We were still in our honeymoon period, after all.
Without a single definition of success, I feared we would muddle along, our efforts diluted by the pursuit of multiple goals.
Over the course of two meetings, I got the board to agree, somewhat reluctantly, that we would establish a single governing objective of improving shareholder value. As our performance measure, we would use return on equity, a key indicator of profitability and one investors rely on as a measure of how a company is using its money. We decided that we would seek a return on equity of 10% above the prevailing rate of inflation, which at the time was 5%.
But one board member, a senior executive from Shell, which had long used discounted cash flow techniques, argued that while ROE was the right measure, we had set the wrong target. He suggested that, rather than pegging ROE to inflation, we compare it with the cost of equity—the annual rate of return an investor would expect when buying shares in the company. At that point, none of us had ever calculated our cost of equity, which is determined in part by an assessment of a company’s business and operating risk. So the senior management team, armed with the latest academic theories, set about finding out what it was, first for the company as a whole and, later, for individual businesses.
We were horrified to discover that, whichever method of calculation we used, our cost of equity was somewhere between 17% and 19%; whatever the exact figure, we knew that there was hardly a business in the company that was generating anything near that. Yet a metric based on the cost of equity rather than on inflation was clearly the right one if we wanted to improve shareholder value. So in 1984, we not only established ROE as the key measure of financial performance but also set the demanding target of every business achieving a return that exceeded its cost of equity. ROE was reported in the management accounts, initially with separate figures for domestic and international operations and ultimately on a country-by-country basis. It was also used in determining executive compensation; before then, managers’ raises had been linked to inflation. The cry “Improve ROE” could be heard all around the organization.
We refined the goal over the years, constantly trying to come up with measures that better reflected the intrinsic value of the company and each of the businesses. But we always maintained a single overall objective: generating greater value for shareholders. In fact, we found that this objective, rather than representing an abrogation of our responsibilities to our other stakeholders, served to create value for everyone. Our customer satisfaction levels rose, our employees were better remunerated, and we contributed more to the communities in which we did business.
Note that our single-minded approach differed completely from such performance measurement systems as the balanced scorecard, which I do not find particularly useful. Systems like those rely on multiple objectives, which set up competing claims on people’s time and send confusing signals about what you are trying to accomplish. With a single governing objective, you are much more likely to get coordinated and focused action.
Stretching for Success
By the early 1990s, it became clear that we needed to be even more ambitious in pushing our top managers to create value. In calculating executive bonuses, we had set an initial standard of beating our UK competition on ROE and sub-sequent performance measures. But, according to the board, this was becoming too easy. If we wanted to be world class, we needed to benchmark our-selves against world-class corporations. We looked to banks in the United States for benchmarks, but those institutions were struggling at the time and didn’t offer appropriate targets.
Ultimately, we decided to look beyond financial services to examine some of America’s most successful companies, whatever their industry, for ideas on setting goals that would further improve our performance. One of the first things I did was to meet with Roberto Goizueta, then the CEO of Coca-Cola. He introduced me to a new performance measure: the time needed to double the value of the company, something Coca-Cola tried to do every three years. I came back and presented the idea to our top management team as a metric for determining bonuses. The general response was, “Are you stark raving mad, comparing us with a soft drinks company?”
And I countered, “You mean to say that banking is more competitive than soft drinks? I think that’s rubbish.” So we commissioned a study that looked at the competitive environment of a variety of industries. And financial services was nowhere near as competitive as soft drinks at the time; in fact, it was fairly far down the list. So everyone agreed to have a go at doubling the market value of the company every three years—which, as it turned out, we were able to do.
Setting ambitious goals, I have to admit, is not always a popular idea. I’ve heard many times—from executives at Lloyds and from CEOs at other companies where I’ve been a director—that goals “must be achievable.” My response is always, “You mean you must get your bonuses, they should be guaranteed?” So you sometimes have to be tough.
When I replaced inflation-adjusted raises with performance-based compensation at Lloyds, a business unit head—someone I’d known for years—came to me and said he wanted to opt out of the new system. He was three years from retirement, and his pension would be based on his salary when he quit working. Inflation in Britain was running around 10% at the time. He didn’t want to risk losing the raises virtually guaranteed by the inflation-based system. I told him that, while he was a first-class manager, I didn’t want anyone on my team who didn’t think we could do better than the inflation rate. He looked at me and said, “You wouldn’t fire me, would you?” Then he left in a huff. The next morning he came in and said, “I believe you would fire me.” And he decided to stay. Happily, he ended up making far more money than he ever dreamed of under the old system.
It wasn’t just top executives who benefited. We set high performance standards for people throughout the organization and rewarded them when these standards were met. The metrics varied, of course. We didn’t tell someone in check processing to improve his operation’s return on equity. We measured him on something over which he had control, like productivity and accuracy. But whatever the measure, we made sure it represented at least a small piece of the shareholder value puzzle.
And nearly everyone had stock options. I remember when we received some negative publicity for having so many millionaire executives at Lloyds—a badge of dishonor in the eyes of some people in Britain at that time. Then one of the newspapers found a Lloyds messenger who had shares worth £250,000, and that changed people’s tune! I had a branch manager come up to me once and say, “You’ve made me a rich woman. ” I replied, “I haven’t made you a rich woman. You’ve made yourself rich by what you’ve done.” Through stock incentive plans, people were able to accumulate capital hitherto impossible through savings.
Setting stretch goals changes how people perceive themselves—and how they perceive the company. You go from asking yourself, “If other banks can achieve something, why can’t we?” to “If Coca-Cola can achieve it, why can’t we?” Once people accept and meet very demanding goals, their behavior changes because they are proud of what they’ve done. They want to stay on top.
Changing Minds
For people to be truly committed to a strategy of shareholder value creation, they have to believe in it. They have to believe, for example, that profitability is more important than growth, which, pursued for its own sake, usually destroys value. They have to believe in the importance of focusing on those businesses with profit potential and getting rid of the others. If they adopt such convictions—and don’t simply pay lip service to them—it will change the way they run their operations.
Early in my tenure, we undertook a major analysis of the company to determine which of our businesses were creating value and which were destroying it. We found that a small proportion of the company’s operations were generating most of the value, while more than half of them were earning less than the cost of capital and thus dragging our share price down. This analysis led us to exit markets like California, which we calculated contributed an 8% return on equity at a time when our cost of equity was more than double that.
The analysis also started us down a path toward becoming more and more focused on UK financial services. While our traditional retail banking activities weren’t particularly profitable, we saw the distribution advantage offered by our branch network and our customer relationships. So we began selling insurance products, first as a broker and then through the acquisition of a company called Abbey Life. We also acquired Cheltenham & Gloucester, a building society that, like American savings and loan associations, specialized in home mortgages. In both cases, the companies retained their brands but sold their products through Lloyds’s branches. The merger with TSB in 1995 greatly expanded our distribution capabilities, further increasing the value of the company.
This reshaping of Lloyds Bank didn’t occur without massive resistance, both from within and outside the company. The adoption of a value creation philosophy imposes a tough discipline. People, with an eye to their bonuses, will wriggle like mad to avoid goals based on shareholder value, often arguing for alternatives that only appear to be related to it. And beliefs are hard to change. In our case, we had to abandon our conviction that Lloyds should be a global bank offering all things to all people. We had to accept that it was all right to get smaller, to stay close to home, to focus on unglamorous products like mortgages and insurance while getting out of more prestigious services such as investment banking and currency trading.
People, with an eye to their bonuses, will wriggle like mad to avoid goals based on shareholder value.
Much of the resistance centered on divestment. Getting rid of unprofitable products, getting rid of unprofitable customers, getting out of unprofitable markets are some of the most effective means of improving returns to shareholders—but they also are some of the most difficult things to get people to face up to.
Consider what happened with our merchant, or investment, banking business. In 1987, around the time of the “Big Bang” deregulation of London’s financial markets, many in our corporate banking operations firmly believed that we should boost our presence in merchant banking. Like most of our competitors, they worried that any bank would be left behind if it didn’t offer corporate customers a full range of services, including merchant banking.
So I sent one of our top corporate banking executives to Japan, a major merchant banking market. He found that big U.S. investment banks were committing massive amounts of money to developing their investment banking businesses there—whereas we were talking about investing a paltry £50 million. He concluded we were unlikely to be much more than a niche player in Japan. Not only that, further study indicated we couldn’t compete effectively against the big U.S. investment banks even in our home market.
Despite his initial opposition, this fellow had become convinced—no, he convinced himself—that shedding the business was the right thing to do. The result was that we shut down our merchant banking operation, which, though a highly unpopular decision, saved us a fortune. Pouring our resources into growth markets where we had no competitive advantage didn’t make sense, for us or for our shareholders.
Not everyone saw the light so quickly. At one point, I got so exasperated that I said to people, “I want you to start your business plan for this year with a list of the businesses we’re going to get out of. I don’t want you to tell me what we’re going to get into. If we don’t get out of underperforming businesses, we won’t have the resources to invest in the things that will guarantee us a profitable future.”
Changing beliefs is even more difficult when public perceptions are at odds with what you’re trying to do. We’d get out of an unprofitable service like tax preparation, and the newspapers would criticize us both for abandoning customers and for failing in one of our businesses. So I’d often hear people inside the company fretting about whether the papers would call us cowardly for getting out of a particular business. My response? “All the more reason you have to explain to people why we’re doing this.”
But when beliefs do change, critics within the company become converts. Even the casualties of a value-creation move may concede its wisdom. At one point, we decided to shut down our currency trading operation in one part of the world, resulting in the elimination of 20 jobs. I had a scheduled visit to this area, and a colleague said, “My God, you’re going to get a hostile reception there.” But I went anyway. And what I heard from the people on the trading desk was, “We hate you doing this, but we can see why you’re doing it.” They saw, even if grudgingly, that their operation was destroying value for the company
A Journey of Discovery
I’ll always remember coming in to work one Monday morning and finding on my desk a lengthy memo from a member of the senior management team. It was during that initial feverish effort by top management to determine our cost of equity, and this fellow had clearly spent most of his waking hours over the weekend drafting his memo. He was arguing for an alternative method of calculating the cost of equity—one that didn’t yield a figure much different from the number we had already arrived at, as it turned out. But I’ve always remembered his engagement with the task at hand.
The story illustrates a key lesson in getting people to focus on value creation—or anything else, for that matter: You can’t impose a mind-set on people. It emerges from a learning process in which they become persuaded that an objective is worthwhile and then apply their talents to realizing it. The process often involves heated debate; indeed, I found that disagreement is key to getting agreement. Without disagreement, people will simply fall into line with no real commitment to the program.
Make no mistake, the learning process includes the CEO. I certainly didn’t start out with a set of answers as I tried to make Lloyds an organization focused on value creation. I simply cultivated an environment that encouraged—no, required—inquiry. And, not surprisingly, people came up with all kinds of bright ideas for achieving our aim. Intelligent people, presented with an intellectual challenge, become deeply engaged in the endeavor.
Indeed, the intellectual journey was an exciting one for all of us. Digging down into the company and finding which products and markets created value was a fascinating process. Even the initial task of determining our cost of equity was intriguing—witness the executive who spent the weekend coming up with his own formula. We all immersed ourselves in the academic material and taught ourselves the capital asset pricing model, among others.
This culture of learning led us over the years to a constant reevaluation of our corporate and business unit strategies. People would say that a strategy was working. I would reply that there is always a better strategy than the one you have; you just haven’t thought of it yet.
One way we would galvanize such inquiry was by requiring business units to offer at least three alternative strategies for each of the major issues they currently faced. We wouldn’t accept straw men; they needed to be viable options. Creating such alternatives couldn’t be done without a great deal of thought within the business unit. It demanded learning. We would then debate which of the alternatives would create the most value for the company.
Besides generating creative strategies, this approach led to greater autonomy for the business units and the higher level of motivation that decentralization unleashes. Because they were forced to consider how the alternatives would affect value creation, unit heads became increasingly sophisticated in strategy development. That reduced the need for top management to impose strategies on the business units, which meant that implementation pretty much took care of itself. After all, people will always do better carrying out their own strategies than someone else’s.
Toss Out the Cookie Cutters
People sometimes ask what I’d do differently if I were starting over again as CEO at Lloyds. My answer: A lot, given all I learned while I was in the job. For one thing, I wouldn’t take months arguing about how to calculate the cost of equity.
But, in fact, my approach would be the same. You don’t achieve sustained growth in shareholder value through some cookie-cutter approach. The latest performance measures, though they can be helpful, aren’t enough. There are no magic methodologies.
What’s important is getting people to arrive at a meeting of the minds around a small number of central beliefs, which will determine their behavior and ultimately the company’s performance. And you don’t do this by being a dictator. You do this by leading people on a journey of learning that will reveal to everyone new insights about how to create value for your shareholders.
Shareholder value, as a corporate guiding principle, has come under fire recently. Companies with monumental market valuations have suddenly collapsed. Executives with generous stock options have been accused of trying to boost their companies’ short-term share prices for personal gain. But despite the high-profile examples of mismanagement and greed, sustained value growth is still the best long-term measure of a company’s performance and health, as well as an important driver of a society’s overall economic health. Achieving it remains the greatest management challenge—and satisfaction.