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Written by: Richard Frykberg

The capital allocation dilemma is deciding what to do with your hard-earned profits. Should you provide an immediate return to your stakeholders, or reinvest for an even more profitable future?

This decision is a critically important responsibility of executive management and will have fundamental implications for all stakeholders including employees, owners, financiers, customers, governments, and the broader community. Unfortunately, many organizations lack a rigorous framework for effective capital allocation.

This article considers your capital allocation choices, identifies the imperative for urgent action, and provides a recommended framework for a more effective capital allocation process.

Capital Allocation Choices

Executive managers are responsible for deploying human and financial capital resources appropriately. Financing and operational activities will generate free cash flow that can be applied either towards repaying investors today, reinvesting for the future, or providing a balanced allocation of capital between the short and long-term.

How to balance capital allocation

An investor’s preference will be determined by risk and return. If the management team can confidently forecast a quantum of future return commensurate with the level of risk to be assumed, investors would logically prefer to see available resources re-invested. Alternatively, if industry trends forebode a challenging future due to technological, market, or regulatory upheaval, investors will prefer a higher return today, so that they can diversify their own capital allocation accordingly.

Executive management’s preferences may not always fully align with that of investors. Frequently, incentive plans motivate management, at both executive and business unit level, to maximize short-term results. This may lead to an undue focus on cost-saving and low-risk initiatives that can constrain an organization from achieving its full potential.

Short-term investment returns are achieved by maximizing short-term profitability by cutting-back on research and development and resisting transformational technological improvements. These short-term gains can be distributed to investors by way of increased dividends and share buy-backs.

Long-term reinvestment requires management to actively seek out, assign resources, and allocate capital to initiatives for growth. These growth opportunities may come from mergers and acquisitions or organic growth.

Growth through mergers and acquisitions is an effective strategy only when an organization is experienced in and effectively prepared to mitigate the significant risks inherent with such transactions including the cost and distraction of integrating people, processes, systems, products, and customers. It is imperative that significant synergies are achieved by consolidating organizations, as investors can themselves directly diversify their investments by acquiring shares in both organizations.

Long-term growth is achieved organically when an organization focusses its efforts in a domain of sustainable competitive advantage. This requires an organization to have a clear strategic purpose, and for management to actively pursue initiatives that extend its competitive differentiation through ongoing technological innovation and market penetration.

For many organizations in steady state industries and with successful operating histories, the capital allocation process has become routine. Dividend rates are sustained, and capital allocations are doled out to operating units for sustenance of their business-as-usual activities on a predictable basis. There is no formalized process for identification, evaluation and ranking of initiatives, with much of the top-down capital budget allocation left to departmental heads. Unfortunately, once this sclerosis sets-in, these are the organizations destined for the annuls of history, as new, global, and more innovative competitors spring-up with better and cheaper products leveraging the latest technologies to replace the lumbering behemoths of old.

So, how can organizations transform their capital allocation process with an emphasis on organic growth, and why is this change so important right now?

Capital Allocation Transformation Imperatives

Several factors are driving leading organizations to transform their capital allocation process, realizing that informal, spreadsheet-based processes are inadequate to meet the existential challenges of the moment.

Technological Advances

Technological advances impact all organizations, all the time, and always have. But, perhaps, never has the pace of technological change been as frenetic as it is today. Fanned by Artificial Intelligence and machine learning we’re experiencing massive disruption in every human endeavour from bio-chemical engineering through to the care economy. Whilst AI may not replace humans any time soon, it is inevitable that organizations that fail to adapt to and adopt the breakthrough opportunities being presented by this new technological wave will certainly be displaced by those that do.

Cost of Capital

From a time not so long ago, when very low interest rates made capital almost free, rising inflation and interest rates now dominate financial market concerns. With low-risk investments providing more attractive returns, and market-uncertainty raising project discount rates, the Net Present Value of all projects requires recalculation and re-assessment.

Agility

The pandemic, wars, and supply chain disruptions have re-emphasised the need for capital allocation agility. Once-a-year project evaluations and budgeting processes are no longer nimble enough to ensure the timely and effective allocation of human and capital resources to the initiatives that will matter most.

Governance

Governments and consumers are demanding a higher standard of governance. From activist shareholders to social media influencers, management decisions are under the spotlight. Management teams are expected not only to apply the highest level of competency and ethics in their decision-making processes but be able to demonstrate the probity of their actions.  In a hyper-connected operating environment, transparency and trust are the values that will underpin the successful enterprises of the future.

Environmental and Social Objectives

Societal demands have required management teams to respond with initiatives that address environmental sustainability and social concerns such as diversity, equity and inclusion. Far from being simply costs, increasingly evidence is mounting that such initiatives are producing substantial long-term benefits including attracting top talent, winning new business, and accessing low-cost capital. Unfortunately, most organizations have not incorporated these non-financial dimensions within their initiative evaluation and prioritization processes.

Capital Allocation Framework Techniques

Given the tricky balancing act between short-term profit and long-term capital returns, and the urgency for an enhanced capital allocation process, it is remarkable that nearly 60% of major enterprises consider their capital allocation process to be less than mature*. The following techniques are proposed as a method for enhancing the effectiveness of your capital allocation process.

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The Capital Allocation Framework and Techniques - Infographic

Align to Strategy

To be effective and successful in the long-term, all key stakeholders in the organization should be aligned towards the strategic goals and objectives. To ensure this alignment, strategy must be clearly articulated and communicated, allowing misaligned individuals to realign or exit. The strategy will help articulate the expected timing of returns, and risk profile assumed. These strategic objectives should be respected throughout the capital allocation process so that every growth initiative can be clearly related to these strategic goals as a basis for effective prioritization.

Respect and Support CEO Responsibility

The ultimate responsibility for capital allocation lies with the Chief Executive Officer (CEO) of the organization. In fulfillment of this important responsibility, the CEO will consult their executive team for guidance and insight, but it must be acknowledged that ultimate responsibility is exclusively theirs, and not the subject of a vote or unanimous agreement.  In support of this decision-making process, a capital committee is a highly beneficial mechanism for facilitating the necessary review and debate of proposed initiatives. Key members of the capital committee should include the Chief Financial Officer, Chief Technology Officer, business unit heads and Project Portfolio Manager. The capital committee should meet regularly (at least quarterly) to review both new applications and to monitor progress of key in-progress initiatives. It is recommended that the CEO has line-of-sight visibility of the most significant initiatives (normally circa 20) at an appropriate degree of granularity.

Apply Zero-Base Budgeting

The surest way to technological obsolescence and irrelevance is to rely on historical capital allocations to drive future investment decisions. Simply apportioning budget buckets to existing business units for independent capital allocation to initiatives invariably misses out on transformational opportunities. Instead, all capital allocation decisions should be based on a granular and strategically aligned evaluation of candidate initiatives.

Structure by Investment Area

Capital allocation responsibility areas should align with future strategic emphasis not merely existing business units. Breakthrough initiatives are more likely to derive from innovation skunkworks than traditional product development departments within existing departments. Your future capital allocation responsibility areas should thus be liberated from current business unit structures to maximize the potential for innovative thinking to retain your competitive advantage, rather than relying simply on continuation of legacy products and processes.

Transition to Online Business Case Templates

The inherent risks of standalone, often spreadsheet-based, business case templates are that they lack the depth, quality and consistency for effective evaluation and ranking. As your future strategic success is reliant on picking the initiatives that will most quickly, cost effectively and at least risk, deliver your strategic goals, it is essential that executive management has confidence in the accuracy and completeness of proposals presented for effective decision making. Online business case templates provide a reliable single source of truth for collaboration and analysis to ensure that all initiatives are evaluated fairly and are not unduly influenced by pet-project submissions from vocal sponsors. Calculations of key metrics (including Net Present Value, Internal Rate of Return, and Payback Period) should be fully automated and based on common planning assumptions.

Incorporate Environmental, Social and Governance Assessments when Evaluating Initiatives

Whilst it is legitimate to have a class of initiatives that are explicitly targeted towards addressing these non-operational objectives, studies have shown that organizations that consider these aspects when making all significant capital allocation decisions achieve superior long-term outcomes. Talented staff want to join organizations with purpose, customers want to engage suppliers that share their values, investors make more funding available, and governments increasingly demand action on these worthy ambitions. Many legacy project evaluation and scoring approaches, however, rely heavily on simple financial metrics for ranking purposes. To provide a more holistic evaluation of initiatives, it is, therefore, beneficial to adopt a scoring model that supports multi-dimensional evaluations incorporating financial, non-financial, and qualitative assessments.

Provide Ranged Estimates

Nobody can accurately predict the future: but they can make educated estimates regarding likely outcomes. Incorporating an understanding of the likely range of outcomes helps executives assess the inherent risk of alternative projects. Two nominally similar initiatives may expect similar results, however a closer examination of the potential variability of underlying assumptions will typically favour the initiative with a narrower range of projected outcomes.

Perform Sensitivity and Scenario Based Assessment

All organizations have finite resources that shareholders are willing to risk. When determining project portfolio selections, it is therefore necessary to model the potential for catastrophic loss. This is achieved by modelling outcomes based on common assumptions and evaluating the projected outcome across a range of probable future scenarios. These scenarios should include assumptions about macroeconomic factors (for example, interest and exchange rates) as well as regulatory changes, market demand, and competitor reactions. A common method of evaluating portfolio performance is to conduct Monte Carlo simulations to identify the overall impact of random variations in underlying drivers.

Apply Scoring Models to Rank Initiatives Objectively

Typically, there are more good opportunities and higher demand for funding and resourcing than capacity available. Therefore, to optimize capital resource allocation, it is essential to effectively prioritize and rank candidate projects. The basis for evaluating and scoring projects should be clearly defined and consistently applied. Key dimensions that should be considered in the ranking should include:

  • Urgency of the initiative to mitigate operational risks and opportunity costs
  • Degree of strategic alignment
  • Expected benefits to be derived
  • Implementation risk

The applicable scoring model and method should be tailored to class of project, with low-value asset replacements subjected to a less onerous assessment than high-value strategic initiatives.

The value of applying a scoring model is to expedite the decision-making process. Typically, high-scoring initiatives are quickly progressed, and low-scoring initiatives shelved. This allows the focus of management attention to be on the middle-ground. Whilst any scoring methods help provide rigour, ultimately all capital allocation decisions must be made by people.

Encourage Collaboration & Debate

A key part of initiative evaluation is to glean the insight and endorsement of technical, market and financial specialists. A key enabler of broad collaboration and input of diversified perspectives is an automated workflow process. By applying automatic routing of initiatives during the business case evaluation phase, the involvement of critical roles can be facilitated. Formal delegation of authority approval policies can be enforced, and the probity in the decision-making process evidenced.

There is, however, no substitute for compelling debate. To avoid group-think, it is extremely valuable to include contrarian perspectives in the qualitative evaluation process. The strategic success of most organizations ultimately relies on the knowledge, experience and aptitude of decision makers in picking winners, and in identifying potential pitfalls before wasting resources on failed initiatives.

Risk Management

All endeavour attracts a degree of risk. But so too does inaction. In the face of a rapidly evolving operating environment with new opportunities and competitors constantly emerging, decisions must be made, and action taken pro-actively.

The art of effective capital allocation is to identify and effectively manage inherent risk. Tools and systems can help quantify this risk, but ultimately, effective risk management relies on a culture of risk management.

Effective risk management is not about seeking to eliminate risk. Its rather about ensuring that the potential returns justify the level of risk assumed. Risk management includes establishing effective risk monitoring controls and preparing contingency plans. This means that project portfolio management and analysis should focus on both tracking costs to plan, as well as monitoring ongoing benefit realisation projections. Delivering a project ‘on budget’ once the potential benefit has evaporated due to changes in the operating environment is indeed a waste, and an opportunity cost, where the capital could have been more effectively deployed elsewhere.

Conclusion

The fiduciary duty of executives is to wisely steward the capital and human resources of an organization. But this does not mean simple perpetuation of the status-quo. Failure to actively seek out new growth opportunities is indeed a misallocation of funds. If a management team cannot successfully generate high-quality organic growth, it should consider returning capital to investors who can themselves seek out more attractive propositions.

The most crucial step to ensuring successful growth is to ensure strategic objectives are aligned amongst key holders, and to make bold decisions to seek out and allocate capital to initiatives that will help achieve these strategic goals soonest, at lowest cost and least risk.

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