Successful capital allocation strategies

According to Harvard Business School, companies are holding more cash than ever before and there are many ways to allocate capital successfully — and many potential pitfalls. Decisions, decisions.

The increasing likelihood of an economic slowdown and ongoing digital disruption have raised the stakes for companies when directors and executives decide how they should best deploy their capital. 

The consequences of a misstep in capital allocation can be much more severe when the company is being buffeted by economic headwinds. At the same time, a downturn and resulting fall in asset prices can present opportunities for companies in a strong capital position. 

Environmental, social and governance (ESG) considerations are also playing a more central role in capital allocation decisions, with directors and executives paying more attention to non-financial metrics in their deliberations. 

The phrase “capital allocation” is often used interchangeably for M&A or capital expenditure, but it can also encompass operating expenditure, R&D, returning cash to shareholders or paying down debt. In fact, doing nothing is in its own way a capital allocation decision. 

“Every day, an organisation is making a capital allocation decision by continuing to remain invested in its existing businesses,” says Aleks Lupul, a partner in Deloitte’s financial advisory practice. 

In the current environment, directors and executives need to run robust downside scenarios and consider “almost what does it take to break this”, says Leanne Buck GAICD, a non-executive director at AusNet Services and Argo Investments, where she is also chair of the audit and risk committee. 

“The one thing I know from my career is that it never works out exactly how you thought it would — hopefully better, but there are always going to be changes in variables that come along with the actual investment.” 

Boards can be comfortable about their capital allocation decisions in a softening economy if they have a plan in the event that acquisitions don’t transpire as anticipated. 

Even without a specific investment in mind, boards should consider their company’s potential scenarios in funding markets and maintain the flexibility to take advantage of opportunities. 

They should ponder a deeper slowdown where funding markets aren’t accessible or affordable for the company and consider what sort of position that would leave the company in. 

Strategy is core 

Directors say that regardless of the economic conditions, the company’s strategy should lie at the centre of any capital allocation decision. 

When Buck is presented with a capital allocation strategy in the boardroom, she wants to see how it fits in with the organisation’s overall strategy. 

The process usually begins before the consideration of acquisitions, when a strategic imperative is identified and the organisation goes hunting for opportunities and looking at the relativities between different opportunities. 

Considerations of an acquisition include what the company is trying to achieve, the financial and non-financial benefits of the opportunity, and factoring the objectives of shareholders and investors into the assessment. 

“Then you get down to the nitty-gritty of the actual opportunity,” says Buck. “Does it stack up from a shareholder and an investor perspective? Does it stack up from strategy? Does it stack up in terms of [being] the best relative opportunity? Then you start looking at the detailed funding plan. What is the business plan?” 

Ongoing digital disruption and the upending of established business models present boards and executives with another decision about how to deploy capital — should the organisation invest in its existing business to turn it on its head or is it better placed to acquire another business to help reinvent its business model? 

As with all capital allocation decisions, the starting point should be clarity over the strategic objective the board is seeking to fulfil with the allocation. 

As the custodians of shareholders’ capital, management and boards will generally seek growth if they believe it’s possible. 

Suzanne Ewart FAICD, chair of fintech Butn, says CFOs and CEOs should present a range of alternative capital allocations to the board, and not “fall in love” with a transaction that might not necessarily be in the best interests of shareholders. 

They almost need to anticipate board questions and present a range of different scenarios. 

“For example, if you’re looking at an M&A transaction that the cash flows indicate is going to add X amount of profits to your bottom line, how does that compare? Or would we be better off increasing our dividends or doing a share buyback?” she says.

According to Ewart, the absence of alternative capital options is a red flag and directors need to be strong enough to ask the right questions and put the counterargument. 

She says a lot of businesses make a capital allocation and then “set and forget”. 

They become wedded to the allocation without going back and considering whether it is actually producing the anticipated results. 

Karen Moses FAICD, a director of Charter Hall, Orica, Boral and Snowy Hydro, agrees that capital allocation decisions need to be monitored over time. 

In her experience, it’s rare for a company to make an acquisition that isn’t strategically sensible. 

The most common pitfall in capital allocation, specifically with acquisitions or spending on projects, is implementation rather than the strategy, when executives fail to consider if the company is equipped and able to bed down the acquisition. 

“Sometimes, there’s an underestimation of the breadth of change you’re asking existing people to be able to step into,” says Moses. “It’s easy on paper to say, yes, we can do this, we can do that, but when you actually have to do it, people are overly optimistic of how much change they can drive.” 

The board can ensure the management has a good plan for an acquisition and that there is assurance over its performance — this includes the right KPIs. 

Hostage to change 

Sometimes, events move against a capital allocation decision, but this doesn’t necessarily make them bad decisions. 

Investment decisions are often judged by how they performed in the first few years, but if commodity prices for a mining acquisition, for instance, are 40 per cent lower in the first two years, the investment will be viewed as a failure.

But just because a capital allocation project or acquisition missed the mark in the early years doesn’t mean it is necessarily a failure over its lifetime. 

In general, management needs to find the best opportunity for the company’s capital, but that might not be the best opportunity for investors. 

“The better opportunity for investors may well be to return the money,” says Moses. 

That consideration is an important role for the board to play, because management will generally seek the best choice within their industry and look for the opportunities to build the resources under their care. 

CFOs and boards are making capital allocation decisions in a complex environment of accelerating change, business transformation, economic shocks and disruptions — as well as ESG considerations, a broader range of stakeholders and investor expectations around sustainable growth. 

As such, says Deloitte’s Lupul, they need a capital allocation framework to provide guiding principles. 

This includes an understanding of the organisation’s existing capital portfolio and the return on capital that they’re generating. 

“One thing we often advocate to clients is the need to have that really unwavering focus on return on capital,” says Lupul. “It’s not about topline growth. It’s not about EBITDA (earnings before interest, taxes, depreciation and amortisation) growth. Ultimately, as custodians of capital, you need to be generating a return on that capital and doing it in the right way. It’s developing sustainable business models through the execution of your capital allocation strategy.” 

Organisations are typically adept at making individual investment decisions, but they should consider exactly what an acquisition means for the entire portfolio of assets. 

They should evaluate the emerging and external risks, as well as the resilience of the portfolio, and then decide how a potential acquisition could alter that. 

Directors can usefully step back and consider an acquisition in the context of the overall portfolio. In recent years, ESG considerations have moved from not even factoring in decisions to being front and centre in capital allocations. 

It can change the valuation of a potential acquisition if the organisation has an opportunity to improve its ESG credentials — for example, by being more green or by improving governance. 

“ESG helps create return on capital for the long term,” says Lupul. It’s not about generating one-year returns. It’s actually developing sustainable business models through the execution of your capital allocation strategy.” 

NFP considerations 

According to Annette Carruthers AM FAICD, a non-executive director of Calvary Healthcare, Headspace and Cater Care, capital allocation decisions in NFPs require the same rigour as those at for-profit companies, but can have a slightly different focus. 

“At ASX-listed companies it’s about maximising profits, compounding shareholder wealth and value creation, whereas in an NFP, it might be more about fulfilling your mission,” she says. 

NFP directors need to find a balance between allocating for growth or expansion and spending to meet current needs. 

“Sometimes, these expenditures are necessary, but then there’s the nice-to-have, which requires more consideration and judgement of alternative ways to expend what funds you have,” says Carruthers. 

“You want a sound business case, to understand the hurdle rates, the proposed return on investment. You still have to give it the same level of inquiry as a for-profit company in making a rational decision about the value to stakeholders in what you’re going to expend.” 

NFPs are currently directing a lot of expenditure on technology and digital, because that is the way many of their customers want to interact with them. 

“You’ve got to make sure that you’ll be very clear on what the system’s going to deliver,” she says. 

“Do lots of research about other companies’ experience with a product and make sure that you have the skills in your staff to manage the implementation of that new system.” 

This article first appeared under the headline ‘Where to Stash the Cash’ in the July 2023 issue of Company Director magazine.