Executive Summary
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The principal job of management is the allocation of scarce resources—people, time, and money—to opportunities that yield the greatest returns.
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There is always a shortage of capital and an excess of worthy projects. There are many methods of capital allocation, but most do not fund the best opportunities.
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The key task is to allocate capital to support the greatest opportunities, those that match strategic objectives.
Introduction
The appetite of organizations for capital is insatiable. Understanding the nature of capital and its effective allocation is essential to organizational success. Classical economics defines land, labor, and capital as the determinants of wealth, each being exclusive to its owner. Now there is a fourth determinant of wealth—information—and it is nonexclusive. The more information is shared, the more valuable it becomes. Business is a competition in which the score is kept in money, and thus allocation of capital, in all its forms, is a critical success factor.
The challenge is to decide which division, project, or acquisition gets the scarce capital. The challenge varies with the source of capital. Venture capitalists’ and hedge funds’ tolerance for risk is offset by their high return expectations. The low risk of municipal bonds and banks is matched by low returns. Hedge funds make increasingly larger “bets,” while equity investors carefully consider exit strategies in capital allocation decisions. Privately owned companies strive to enhance shareholder value, matching investment choices to their investors’ expectations. Public companies are servants of the public stock markets and investment analysts. Each master has different expectations, and thus capital allocation must vary accordingly.
Allocating Capital
If capital is allocated foolishly, or to poorly defined projects, it is wasted. The game is a simple one: invest the least possible amount, borrow the rest, and put it in projects with the greatest potential return (or occasionally the lowest risk). Deciding which ventures to invest in has always occupied management attention. There are many quantitative methods for allocating capital. Most of these remain valid, but they share one problem: they all depend on a forecast of future events, which is uncertain. The challenge is to allocate capital to the best opportunities, given the risk-reward profile of the investors, and to choose projects that have the best chance of earning good returns.
The Typical Plan: Allocation for Strategic Purposes and Objectives
Capital allocation must be aligned with the strategic purposes and objectives of the investor. The implication is that these are well defined and clearly understood. However, this is frequently not the case. Often the strategies and goals are unclear or poorly understood.
The Typical Practice: An Artifact—The Capital Budget
Organizations develop capital expenditure budget needs for annual review by boards and lenders. A common breakdown of a capital budget is by category or type of expenditure—for example, new products, new facilities, maintenance of existing products or facilities, and infrastructure needs. This is a theoretically sound method since each category has a different strategic purpose: for example, sustaining current activities or revenue streams, creating new revenue streams, or providing infrastructure to support current or new business needs. These category splits are intended to allow senior management and boards to allocate capital fairly according to the company’s strategic needs. The problem is that there is an enormous gap developing those artifacts of bygone eras—capital budgets—and the actual intent of the investments. This traditional route is a sure path to sustained mediocrity or steady decline.
Making It Happen
The Capital Appropriation Process
When management has determined what it believes is an effective use of capital, it must find a means to communicate that need and its worthiness relative to other needs. Larger organizations use a formal capital appropriation process. This process involves documentation of the intended use, description of the assets to be acquired, time frames for the investments, and benefits to be gained. A financial analysis is a required part of the capital appropriation request
The methods used to compare and evaluate capital investments are based on projections of future revenue streams and a calculation of some combination of:
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internal rate of return (IRR)
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net present value (NPV)
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breakeven
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economic value added (EVA)
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economic profit created (EP)
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risk-adjusted return on capital (RAROC)
This approach rewards the best analysts, politicians, and sycophants, but not the best projects. The most innovative, high-potential projects are seldom easy to analyze and quantify. Yet these are the very ideas that turn out to be outstanding—but only in retrospect—and only if they ever get funded. In traditional allocation, the capital tends to be spent either protecting the past or perfecting the present, with precious little left for funding the future. For reasons of personal or organizational pride, differing goals, or political power, appropriation requests often do not match corporate goals. Competing executives or organizations will scuffle for scarce capital, and even if their intentions are good (which they usually aren’t) the resulting conflicts can be ugly. Who is to resolve these conflicts
Approvals and the Capital Appropriation Committee
In some companies the authority level for heads of business units is high—assuming funds have been budgeted—in the category needed. This means there is a chance that good, innovative ideas might receive financing. In central-control-oriented companies spending approval levels are kept low, forcing corporate reviews of most investments.
Appropriation requests go up the ladder to be approved by successively higher levels of management, and the higher one goes, the less informed the management tends to be. The originator’s chain of command includes gatekeepers from finance and accounting. Other functions affected often have sign-off rights, too. This creates a time-consuming, bureaucratic, and often contentious process that wrings the creativity out of any proposal, replacing it with conservatism, caution, and capital “constipation.”
After running the divisional bureaucratic gauntlet, the appropriation goes to the corporate capital appropriation committee, where it is subjected to more scrutiny by even less informed people. This review is supposedly based on alignment with corporate strategies, return versus competing capital needs, and the requesting unit’s budget. The larger the organization the more levels there may be, but the process varies surprisingly little from company to company.
When small companies grow rapidly, capital allocation is efficient and effective—and involves only a few well-informed people. As the company gets larger or is acquired by a larger entity, it implements a more formal capital approval process. This process now includes approval at higher authority levels. While this is considered necessary, it is noticeably slower and less efficient. The successive layers of capital appropriation processes and committees can slow down or even kill most creative projects and divert capital to safer, less rewarding uses.
Historically, depreciation was designed to fund the replacement of assets by expensing non-cash charges, thereby reserving the cash (capital) for new expenditures. Thus the norm was for capital allocation to equal depreciation. To spend more is equivalent to putting in new money, and to spend less is in effect using up the business. Many lending agreements also contain restrictive covenants that limit capital spending to formulae—the right spending level is a function of what happened in the past adjusted by management’s or investors’ wishes. The obvious corollary is that, if the company is struggling, it is often starved of the necessary capital to rebuild itself.
Other Challenges in Capital Allocation
Cash-rich companies also have a problem. A low return on conservatively invested cash reduces overall returns. Companies are expected to earn higher returns than banks. A common alternative is to repurchase stock, a less than exciting capital allocation. In other cases, company treasurers are tempted to use high-risk investments like derivatives to elevate returns on excess cash. Multinational companies encounter another issue: currency exchange rate fluctuations, which can negate the best analyses. Hedging currency by buying futures can protect the downside, but, like all insurance, this too comes at a cost. Then there are fiascos in which capital allocation is based on equity markets and stock prices. The dot-com deals involving stock swaps quickly revealed the flaws here: huge profits disappeared overnight, replaced by unexpected write-offs. Misadventures like Enron illustrate how easily a bogus capital structure can tumble like a house of cards.
Furthermore, what happens to budgeted but unspent money? The government model—use it or lose it—is often used. The rush to spend unused budgeted capital results in waste, misallocation, or both. Alternatively, a passive indecision deprives the enterprise of funding for its growth or rejuvenation.
Nonmoney “Capital”
Finally, there are critical non-capital resources to be allocated—people, knowledge, or time. The people part is often called “human capital,” an appropriate name. If this human capital is in short supply, all the monetary capital in the world will not help. Capital must be spent wisely or allocating it well is useless. People spend the capital, and thus the most important question to ask is not what it will be spent on, but who will be spending it and what is their track record? Choosing the right people to bet on is the critical decision.
An Alternative to Allocation?
In the bubble era of 2000–2001 capital flowed freely to those perceived to deserve it; those perceived as undeserving were starved. Many decisions were bad, but consider the concept. Instead of allocating capital, think of “earning it and/or deserving it.” Innovative ideas seldom survive bureaucratic battles, particularly if they threaten to cannibalize existing businesses. Harvard’s Clayton Christensen has written at length about “disruptive technologies” and their impact on markets. In the real world, an idea should either be able to attract capital or not. No corporate committee says yea or nay. The idea must prove that it deserved the capital by being successful. That is capital allocation’s model for the 21st century.
Conclusion
Companies usually allocate capital on the basis of one of three mindsets:
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The first is protecting the past, in which case they will always be following the competition and reacting to a leader’s moves, simply trying to hang on to past glories.
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The second mindset is the attractive trap of perfecting the present. Such moves are always easier to analyze, and make short-term goals, except when new, disruptive technology or a competitor enters the fray, upsetting the applecart.
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The third mindset is the critical one—to allocate capital by investing in funding the future. This is harder and riskier, but it is the only true path to success. The capital need must attract the needed capital based on its potential success.
Few traditional appropriation processes accommodate this approach, which is why so few companies succeed over the longer term. Companies trying to fund the future are often led by “escapees” from the other kind of companies—people seeking outlets for creative brilliance and thwarted by bureaucratic, inwardly focused capital appropriation processes, policies, and committees. The best rule for capital allocation is to allocate very little to protecting the past and just enough to perfecting the present, leaving plenty to spend on funding the future. That is where real wealth and excitement lies—if only management and boards will finance it.
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