Strategic Capital Allocation

mThink Knowledge - Posted on 30 September 2003

Authored by:

Robert A. Smith;
Brian F. McCarthy, Accenture

PDF File:

CFO2_wp_smith.pdf

Accenture

Companies with highly effective capital allocation capabilities will enjoy a competitive differentiation and sustainable shareholder value.

The period from 1998 to 2001 saw a significant and well-documented consumption of readily available inexpensive capital by both startup and established companies across a broad range of industries. This was an attempt by companies to decisively distance themselves from the competition and go on to create significant sustainable shareholder value.

It seems that little attention was paid to value-management principles during this era of readily available capital, and capital investment decisions were made with seemingly tenuous justifications and new performance measures (e.g., revenue per user, page impressions, and total registered users). It was a time when the discipline of value management suddenly seemed very old-fashioned as companies believed they were in a land grab to secure leadership of the new economy and a ticket to future sustainable shareholder value.

This huge capital investment, for the most part, has not positively transformed the profitability of companies, nor has it led to significant shareholder value creation. Instead, in many cases it has led to huge capital investment write-offs and consequently some of the largest losses ever recorded by global companies, as well as a string of high-profile bankruptcies. Many of these companies continue to struggle to deliver value as they are overburdened with debt while generating lower-than-expected cash flows and consequently are suffering from depressed equity valuation.

The continuing write-offs of goodwill from this capital spend are a constant reminder to investors and managers of the consequences of poor capital-allocation decision-making.

It is fair to say that companies today find themselves in a capital-constrained environment for two primary reasons:

Debt defaults and the level of corporate debt are mounting. This drives up the cost of debt due to the increased perceived risk; and

Depressed equity valuations make access to capital less attractive due to the unacceptable equity dilution.

Corporate defaults on debt have been running at record levels, and the debt-rating agencies have reacted by downgrading the credit ratings of many issuers, forcing up the risk premiums payable on new debt issues. Though this has been offset by low interest rates, the deteriorating credit outlook of many companies will have made debt more expensive. Moodys Investors Services reported in its 16th annual study of Global Defaults and Ratings Performance that total defaults hit $163 billion in 2002, up from $106 billion in 2001. This is the highest level of defaults since the Great Depression. Many industry sectors have so much debt that they are effectively cut off from large-scale new issues. This is due to the companys inability to service higher levels of debt, coupled with financial institutions reluctance to increase their exposures to these sectors.

Additionally, the depressed equity markets have meant that IPO activity and secondary offerings have contracted sharply, and the new equity funding that has occurred has more often than usual been in the form of rights issues to help companies pay down debt. Depressed equity valuations have meant that raising new equity capital will dilute existing equity ownership by an unacceptably high level. This potential dilution of ownership has meant that raising capital by issuing new equity is also an unattractive option.

As if the sudden lack of available capital and a recession werent sufficient drivers for companies to reassess capital-allocation practices, we have also seen corporate scandals where huge consumption of capital has proved to be not only ineffective, but also less than transparent to investors. Additionally, the use of off-balance-sheet transactions as a source of capital has made investors more wary about the process surrounding the management of the sources and uses of capital.

In summary, the corporate landscape has changed as we have witnessed a movement from a period of an abundance of cheap capital to a capital-constrained environment under intense scrutiny by investors and regulators alike. As such, we believe that companies with the most effective capital-allocation capa-bil-ities will have a competitive differen-tiation and will experience sustainable shareholder value over the coming business cycles.

Figure 1: Matrix to Support a Strategic Capital-Allocation Process

Strategic Capital Allocation

Recent Accenture research followed the behavior of firms from the 1990-91 recession to today to identify companies that consistently generated sustainable shareholder value and to understand how they outperformed the market and their industry peers (see related article: When Good Management Shows). Accenture found a crash diet in investment spend during the recession was not the answer.

Accenture found these companies adopted three simple management principles that enabled them to show superior performance over the whole business cycle. The three management principles are:

Sound value-based management throughout the cycle provides the flexibility to pursue critical business objectives in an economic downturn;

Armed with a deep knowledge of their value drivers, leading companies position themselves strategically in the good times to take advantage of the bad times, not the reverse; and

Winners distance themselves from losers by expertly executing differentiating tactical moves that take advantage of the flexibility these companies retain.

All of the leading companies from this study had a differentiating capability: how they allocated capital throughout the business cycle resulted in increased flexibility during the downturn and sustainable shareholder value thereafter.

This strategic capital-allocation capability has proven to be a competitive advantage and has two key elements: selecting the business segments in which to invest and using a capital productivity framework to ensure that capital investment in these segments is efficient at driving improved cash flow.¹

Segmenting the Business

A portfolio analysis will show which business segments are creating value and which are destroying value. Value can be measured by looking at the return on invested capital (ROIC) generated by the segment in excess of its weighted average cost of capital (WACC). This is also known as the cash spread.² A positive cash spread indicates that a business segment is generating sufficient returns to cover the cost of the capital invested in that segment adjusted for the risk associated with that investment. Conversely, a negative cash spread highlights the segments of the business that are destroying value. In addition to understanding which segments of the business are creating and destroying value, the strategic significance of the segment is an important item to consider when allocating capital. The matrix in Figure 1 is a useful tool to assist companies with the thought process for allocating capital on a strategic level.

The strategic significance of a business segment can be taken as a measure of whether:

The segment is one of a few focused activities the company undertakes — a core competency;

The company has a competitive advantage in the segment compared to its peer group;

The company has distinctive skills, knowledge base, or systems in the segment; and

The segment is particularly important to customers.

Companies can use this framework as an integral part to their strategic capital-allocation process to optimize capital-investment decisions throughout the business cycle.

Strategic Value Creator

Strategic value creators are segments not only of strategic importance to the company, but are also already creating value. They should be net receivers of capital invested to drive shareholder value. Assuming the company can maintain or improve the segments cash spread, then, when more capital is invested, more value is created.

Turnaround Candidate — Invest

Where a segment has a negative cash spread but is considered of strategic significance to the business, then investments should be made to improve its cash spread by moving (in Figure 1) from point A to point B. At point B, the segment will begin to create value for the business. The ability to improve the cash spread through targeted capital investments is fundamental to driving improved shareholder value. We will discuss how this can be enabled through the adoption of the capital productivity framework in the next section.

Value Destroyer — Exit

Where segments have a negative cash spread and are not considered to be of strategic importance to the business, overall value creation within the business can be improved by sale or liquidation of the segment. The actual exit strategy depends on which is the highest-value/least-cost alternative. Where this segment needs to be retained to keep the company running (for example a support function), then it will also be a candidate for outsourcing to reduce operational costs.

Nonstrategic Value Creator

Where companies are fortunate enough to have a nonstrategic value creator, this segment should be held and invested in to the extent that it maintains the positive cash spread. This segments cash is used to grow other strategic areas of the company, a vital source of capital in a capital-constrained environment.

Figure 2: Capital Productivity Value Creation Framework

Strategic Allocation in Practice

Warren Buffet states, Im in the capital-allocation business. My job is to figure out which businesses to invest in, with whom, and at what price.³ After choosing the business segments in which to invest capital, leading companies tend to have a robust capital productivity framework to ensure that actual day-to-day capital spend is consistent with the strategic capital-allocation decisions made and that it leads to improved shareholder value.

There are three main ways to improve capital productivity: increase cash flows from existing assets, increase expected growth, and reduce the cost of financing. The constituents of this framework seem reasonably intuitive, but many companies struggle to put them into practice. Well discuss the main obstacles to implementing this framework later.

Figure 2 shows a capital productivity framework developed for a global energy company. It shows how the three main elements (on the left) are broken down into value levers that impact capital productivity (on the right).

Here are some examples of specific actions that companies can take to impact the key levers of capital productivity:

Manage working capital down by focusing on outstanding receivables and anticipating when customers will be late with payments. Identify obsolete inventory that was built up during a growth period and has little or no chance of being sold. Write it down. Negotiate extended payment terms with suppliers and defer nonessential purchases;

Renegotiate debt schedule and take advantage of lower interest rates to obtain cheap financing. By reducing financing costs, a company can increase its debt capacity and lower the risk of the equity-financing layer, thus increasing the value of the equity;

Examine the capital investment portfolio and re-evaluate all investments. Given the changed expectations around returns, many of these investments may no longer be viable;

Manage your overall risk exposure through hedging, co-financing, etc;

Evaluate asset performance to understand where value is being created and destroyed. Management then needs to take action to rectify any problems. This could necessitate divesting underperforming assets or halting any further capital investment (depending on a comparison of continuing value, liquidation value, and divestiture value);

Reduce operating risk arising as a result of the environment (customers, industry) through increased diversification in markets and customers or by making products less discretionary to customers. Increased diversification will (up to a point) reduce reliance on small numbers of customers or markets insulating the company from risk of, for example, one customer defaulting or customers having very strong pricing power. Diversification must be a balance, though, since having too many small customers would be an increasingly onerous administrative burden and would prevent economies of scale in servicing the customer; and

Reduce operating leverage (i.e., the proportion of fixed costs within a companys overall cost base) to reduce the volatility of a companys earnings, thus reducing overall risk. Where the proportion of fixed costs is high, reductions in sales have a disproportionately high effect on cash flow. If there is a bigger proportion of variable cost, then total costs will move more closely with sales, and thus margin, profit, and cash flows will all be more stable. One way of achieving a move from fixed to variable costs is through outsourcing. Outsourcing contracts are increasingly moving toward unit pricing — companies paying for each unit of service they actually consume rather than a fixed contract price — and are therefore more attractive as the cost to the company can be almost totally variable.

Challenges to Success

Making capital investments to improve the cash spread of a business segment is, of course, not easy. In practice, we have seen that the key to success is through being able to define the strategic capital-allocation strategy and, more importantly, being able to put the strategy into operation.

Implementing the strategy means aligning a companys actual day-to-day capital spending with strategy. However, our experience has shown that many investment decisions are small and incremental and thus avoid corporate capital-spending review and control. In fact, we have found that 80 percent of capital expenditures are so small that theyre under the materiality limits of the capital-allocation process, so they escape the rigor of capital-allocation verification. It is important to recognize that shareholder value is based on the combined result of thousands of decisions made by individuals in the enterprise every day. As such, it is of vital importance that the capital productivity mindset is instilled at the lowest levels of the organization where daily decisions are being made with regard to the use of capital.

To successfully implement this strategy, companies can adopt some of the following leading practices in capital allocation.⁴

Link Strategy and Capital Allocation

One of the main guiding principles of this discussion is the need to link the high-level business strategy with the day-to-day capital-allocation process and project-approval process. The use of the framework outlined here should help keep this link intact, though it must also be explicitly stated throughout the process and be included in any project appraisal summary.

Change the Management Mindset

To help drive the capital productivity framework through the organization, companies should ensure that management has the mindset that capital efficiency is a key enabler of shareholder value. Companies must identify appropriate value drivers that are linked to overall value creation, tie compensation in part to capital efficiency, and train lower-level management to understand that capital is not free.

Linking Operating and Capital Budgets

Operating and capital budgets should be linked. This will encourage management to view resource requirements together, as opposed to distinct activities, to avoid duplication of resource requests.

Corporate Control

The capital-allocation process should be controlled at a corporate level. The team should include finance, operations, and management, and its activities include: developing business cases including key financial and nonfinancial metrics; assessing risk up front; and both monitoring performance during the project and reviewing performance post-project. This will also help the company to maintain the link between strategy and capital allocation.

Multiyear Planning

Companies should use a multiyear planning horizon to avoid being constrained artificially by fiscal-year parameters.

Appropriate Hurdle Rates

Companies should use different hurdle rates for different segments to reflect the different relative operational risks of each segment. These operational risks should be decoupled from financing decisions. For example, the source of financing for a segment does not affect its operational risk, and as such it should be considered in isolation of the evaluation of operational risk. This will allow companies to synchronize risk-and-reward profiles and allocate capital accordingly.

Continuous Learning

Continuous process improvements in the capital-allocation process should not be seen as optional; theyre necessities. All projects submitted should have measurable outcomes (financial or nonfinancial) so that project progress and value realization can be tracked over time. Capital investments should be subject to a post-implementation review to ascertain lessons learned. For example, we can use post-implementation reviews to look for examples of gaming, the practice of managing the forecast cash flows of a project to get it improved.

Conclusion

In summary, a strategic capital-allocation capability is necessary not only during difficult economic environments, but throughout the business cycle. The need for such a capability sounds reasonably intuitive, but in practice many companies struggle to implement it, especially at lower levels of the organization, resulting in wasted investment spend and value destruction.

In this article we have highlighted the necessary components of a strategic capital-allocation capability:

Segment the business and perform a portfolio analysis to understand where value is being created and destroyed;

Determine the optimum approach to capital allocation by combining the portfolio-value analysis with the strategic significance of the segments of the business;

Use a capital-productivity framework to optimize capital investment aligned with strategy at lower levels of the business; and

Implement leading practices to instill the capital productivity and value mindset at all levels of the organization.

Accenture believes that companies with the most effective strategic capital-allocation capabilities will have a significant competitive advantage, resulting in sustainable shareholder value over the coming business cycles.

Case Study: Berkshire Hathaway

Berkshire Hathaway Corp. is an example of strategic capital allocation in practice. At Berkshire Hathaway, the segments described here are actually separate companies, and each has a role; nonstrategic value creators are harvested with cash returned to group where investments are made in strategic value creators and turnaround candidates. All capital decisions at the 45,000-employee Berkshire Hathaway are made by a small corporate center of 12 people. The corporate center
essentially takes cash from cash-rich companies earning a 4 to 5 percent post-tax return and invests it where returns are 8 to 10 percent. Cash generation is encouraged since managers are covered by compensation agreements in which they agree to hold capital investments to a minimum and send almost
all excess cash to corporate for further re-allocation. This simple approach to strategic capital allocation is the engine that has generated the sustained rate of shareholder value creation at Berkshire Hathaway.⁵

Endnotes

1 Business segments can refer to business units, product groups, customer groups, assets, etc.

2 We have used the cash spread for illustrative purposes in this paper since the real key to effective allocation of capital is that the return exceeds the risk-adjusted cost of that capital. For a discussion of other financial capital appraisal techniques, please see the A New View of Capital Planning, research produced jointly by Accenture and Cranfield University.

Calculation and terms;

Cash spread = [ROIC-WACC] *Invested Capital

ROIC = [EBIT — Cash Taxes] / Invested Capital

WACC = ([Cost of debt x Debt] + [Cost of Equity x Equity]) / [Debt + Equity]

EBIT = Earnings Before Interest and Taxation

Invested Capital = Net plant assets + Goodwill + Net Working Capital + Other Assets

3 Warren Buffet, Leaders of the Most Admired, Fortune, Jan. 29, 1990

4 This work is further built on in A New View of Capital Planning, research produced jointly by Accenture and Cranfield University.

5 An Owners Manual — A Message from Warren E. Buffet, Chairman and CEO, January 1999; Warren Buffet Has Been Right About the Stock Market, Rotten Accounting, CEO Greed and Corporate Governance. Fortune, Nov. 11, 2002; Berkshire Hathaway, Inc. Annual Reports (1998-2001).

About the Author

Title:

Senior Manager, Finance & Performance Management

Accenture

Robert A. Smith is a senior manager in the Accenture Finance & Performance Management service line with a focus on finance strategy. Mr. Smith is a chartered accountant and holds a bachelor''s degree in philosophy, politics, and economics.

Strategic Capital Allocation

Figure 1: Matrix to Support a Strategic Capital-Allocation Process

Strategic Capital Allocation

Segmenting the Business

Strategic Value Creator

Turnaround Candidate — Invest

Value Destroyer — Exit

Nonstrategic Value Creator

Figure 2: Capital Productivity Value Creation Framework

Strategic Allocation in Practice

Challenges to Success

Link Strategy and Capital Allocation

Change the Management Mindset

Linking Operating and Capital Budgets

Corporate Control

Multiyear Planning

Appropriate Hurdle Rates

Continuous Learning

Conclusion

Case Study: Berkshire Hathaway

Endnotes

1 Business segments can refer to business units, product groups, customer groups, assets, etc.

Calculation and terms;

Cash spread = [ROIC-WACC] *Invested Capital

ROIC = [EBIT — Cash Taxes] / Invested Capital

WACC = ([Cost of debt x Debt] + [Cost of Equity x Equity]) / [Debt + Equity]

EBIT = Earnings Before Interest and Taxation

Invested Capital = Net plant assets + Goodwill + Net Working Capital + Other Assets

3 Warren Buffet, Leaders of the Most Admired, Fortune, Jan. 29, 1990

4 This work is further built on in A New View of Capital Planning, research produced jointly by Accenture and Cranfield University.

5 An Owners Manual — A Message from Warren E. Buffet, Chairman and CEO, January 1999; Warren Buffet Has Been Right About the Stock Market, Rotten Accounting, CEO Greed and Corporate Governance. Fortune, Nov. 11, 2002; Berkshire Hathaway, Inc. Annual Reports (1998-2001).

Thought Leadership

Sponsors

Strategic Capital Allocation

Figure 1: Matrix to Support a Strategic Capital-Allocation Process

Strategic Capital Allocation

Segmenting the Business

Strategic Value Creator

Turnaround Candidate — Invest

Value Destroyer — Exit

Nonstrategic Value Creator

Figure 2: Capital Productivity Value Creation Framework

Strategic Allocation in Practice

Challenges to Success

Link Strategy and Capital Allocation

Change the Management Mindset

Linking Operating and Capital Budgets

Corporate Control

Multiyear Planning

Appropriate Hurdle Rates

Continuous Learning

Conclusion

Case Study: Berkshire Hathaway

Endnotes

1 Business segments can refer to business units, product groups, customer groups, assets, etc.

Calculation and terms;

Cash spread = [ROIC-WACC] *Invested Capital

ROIC = [EBIT — Cash Taxes] / Invested Capital

WACC = ([Cost of debt x Debt] + [Cost of Equity x Equity]) / [Debt + Equity]

EBIT = Earnings Before Interest and Taxation

Invested Capital = Net plant assets + Goodwill + Net Working Capital + Other Assets

3 Warren Buffet, Leaders of the Most Admired, Fortune, Jan. 29, 1990

4 This work is further built on in A New View of Capital Planning, research produced jointly by Accenture and Cranfield University.

5 An Owners Manual — A Message from Warren E. Buffet, Chairman and CEO, January 1999; Warren Buffet Has Been Right About the Stock Market, Rotten Accounting, CEO Greed and Corporate Governance. Fortune, Nov. 11, 2002; Berkshire Hathaway, Inc. Annual Reports (1998-2001).

Thought Leadership

Sponsors

3 Warren Buffet, Leaders of the Most Admired, Fortune, Jan. 29, 1990

4 This work is further built on in A New View of Capital Planning, research produced jointly by Accenture and Cranfield University.

5 An Owners Manual — A Message from Warren E. Buffet, Chairman and CEO, January 1999; Warren Buffet Has Been Right About the Stock Market, Rotten Accounting, CEO Greed and Corporate Governance. Fortune, Nov. 11, 2002; Berkshire Hathaway, Inc. Annual Reports (1998-2001).