Capital Allocation Framework—A Strategic Perspective to Value Creation

Vibhu Sinha - April 20, 2023

Abstract
Capital generally describes anything that grants value or benefits a business. Capital is often associated with cash deployed for investment or growth purposes (new initiatives and projects, etc.) as well as operational expenditures. Capital is critical to running a business—from its day-to-day operations (working capital) to long-term financing of its future growth (debt or equity capital).

The capital management life cycle in an organization typically consists of three phases: (1) capital generation, (2) capital deployment, and (3) capital distribution. Capital deployment, the second phase of the capital management process, is the principal focus of this paper. Organizations often establish a corporate transformation office or project management office to drive strategic and tactical initiatives. They commit valuable resources and human capital to ascertain whether these initiatives are being executed on time, under budget, and whether the execution adheres to the contemplated quality standards.

While these are pertinent metrics to track in the pursuit of prudent capital deployment, an equally important question that often goes unanswered is whether these strategic and tactical initiatives realize the benefits envisioned and become accretive to the organization’s bottom line.

This paper aims to share a strategic perspective on capital allocation and how leveraging this capability, in collaboration with the corporate transformation office or project management office and corporate finance, portfolio managers can successfully steer organizations in pursuing value creation and maximizing shareholder value.    

Forecasting vs. Realization Dilemma

“Forecasts create the mirage that the future is knowable." 
— Peter Bernstein, financial historian

While forecasting is a combination of art and science, requiring a forward-looking assessment of what the world would look like and how the new strategic and tactical initiatives would thrive in the new world, realization is mostly science, based on the pragmatic and usually backward-looking assessment of what was accomplished in support of the said initiatives.

As an illustration, let’s assume it’s January 2018, and the portfolio manager is tasked with the development of a 5-year forecast regarding the viability of a financial services product transformation that would allow the business to penetrate a new market segment and gain market share. The transformation fits with the overall growth mandate that the leadership has established, and the executive steering committee wants to better understand the return on investment associated with the transformation.

Developing such a forecast requires establishing a growth rate over a 5-year period, specifically between 2018 and 2022. The portfolio manager wants to be conservative with growth estimates and establishes a 3% to 5% long-term GDP growth as a proxy for growth rate.

It’s June 2020. The world is amid a pandemic. The executive steering committee asks the portfolio manager to revise the forward-looking growth forecast. The portfolio manager knows that the year-to-date economic growth experienced a double-digit decline (U.S. Bureau of Economic Analysis, n.d.) . The portfolio manager concludes that a 3% to 5% growth, baked into the analysis in January 2018, would be too sanguine—and ultimately, unrealistic.

Consequently, the portfolio manager revises the growth rate assumption downward to 1%. It’s June 2021. While conducting the year-over-year assessment, the portfolio manager concludes that the actual growth rate turned out to be in the high single-digits (U.S. Bureau of Economic Analysis, n.d.) because the pandemic bolstered the growth across financial services.

This is a classic dichotomy between forecast, a forward-looking assessment, and realization—a backward-looking assessment. It would be unrealistic to expect that the forecast and the realization would consistently render the same outcome. However, capital allocation practices can help mature this process so that organizations are more prepared for navigating the unknowns.

Capital Management
Capital generally describes anything that grants value or benefits a business. Capital is often associated with cash deployed for investment or growth purposes (new initiatives and projects, etc.) as well as operational expenditures. Capital is critical to running a business—from its day-to-day operations (working capital) to long-term financing of its future growth (debt or equity capital). The capital management life cycle in an organization typically consists of three phases: (1) capital generation, (2) capital deployment, and (3) capital distribution.

Capital generation stems from business operations as well as debt and equity markets. Capital deployment is about establishing opportunities for capital investments and operational expenses and managing them prudently. Capital distribution usually takes the form of dividends and share buybacks. Capital deployment, the second phase of the capital management process, is the principal focus of this paper.

Capital deployment is a critical aspect of capital management because it allows portfolio managers and executive leadership to ascertain: (a) whether projects are delivering the qualitative and quantitative benefits that management had contemplated to receive post-implementation and (b) whether capital is being deployed toward the highest and the best use. While answering these two questions seems straightforward, organizations typically tend to fall into cognitive traps such as:

• Establishing evaluation criteria that are either too narrowly focused on specific quantitative metrics, such as return on investment (ROI) and net present value (NPV), or too loosely focused on qualitative metrics;
• Anchoring future capital allocations to projects using a trend line based on historical allocations; and
• Making project owners only accountable for time, cost, scope, and quality of the project execution and less accountable for realizing post-implementation benefits.

Unfortunately, these challenges have less to do with organizational inadequacies and more with the humanistic nature (or biases) of the capital management process because priorities across the enterprise are rarely 100% aligned. As an illustration, let’s assume you ask the office of chief operations for their ideas on leveraging technology. More than likely, you will receive guidance on how to leverage technology to improve operational efficiency and minimize cost. In the capital management process, this is considered a bottom-line-driven strategy.

Similarly, let’s assume you ask your office of chief marketing for their ideas on leveraging technology. More than likely, you will receive guidance on how to leverage technology to improve channel marketing and drive customer acquisition. In the capital management process, this is considered a top-line-driven strategy.

This is a classic dichotomy between a bottom-line-driven strategy, which has less regard for top-line growth, and a top-line-driven strategy, which prioritizes top-line growth over the cost of achieving the said growth. The express goal of capital deployment is to drive value creation, which collectively encapsulates top-line and bottom-line growth.

Capital Allocation Framework
The capital allocation framework has two central themes: (a) capital budgeting and (b) capital allocation. Capital budgeting is about striving to maintain a balanced portfolio. The notion of the balanced portfolio can be measured using two different approaches: (a) investment across strategic and operational activities and (b) investment across organic and inorganic (acquisitive) growth. A key requirement of capital budgeting is to decompose strategic themes of the organization into various portfolios of initiatives supporting the key strategic themes instead of compiling an enumeration of projects across the organization.  

Capital allocation requires defining investment criteria beyond specific profitability metrics such as return on investment (ROI). It requires evaluating opportunities comprehensively based on the thematic elements of the strategic plan and establishing hurdle rates based on the inherent risk in the portfolio. Good practice in establishing evaluation criteria is to go beyond typical financial profitability metrics and incorporate growth and expense metrics such as customer acquisition cost and market penetration rate.

As mentioned earlier, an exercise in capital management suffers from cognitive biases, and the capital allocation framework is no different; therefore, it must be augmented by risk and behavioral frameworks:

• Risk Framework and Considerations:
  • Scenario modeling—Business cases should accompany the base case, management case, and worst case to mitigate hindsight bias.
  • Sensitivity analysis—Key metrics and drivers that are linchpins to the business case should be stress tested.
  • Risk-adjusted hurdle rates—Tangential investments and breakthroughs should be evaluated with different lenses.
• Behavioral Framework and Considerations:
  • Hindsight bias—The perception that past events were more predictable than they were; hindsight bias can discourage organizations from conducting robust scenario modeling, as mentioned previously.
  • Anchoring bias—The practice of making future allocations based on historical allocations.
  • Loss aversion—Excessive focus on the payback period may prioritize tangential investments as opposed to breakthroughs

The Case for Capital Allocation Committee
In addition to establishing the risk and the behavioral framework in support of the capital allocation process, the exercise in capital deployment also requires governance and stewardship, which can be addressed by forming a capital allocation committee. For example, governance over realizing post-implementation benefits and stewardship in driving the highest and the best use of the capital would allow organizations to maximize shareholder return.

The best practice in driving change through the capital allocation committee requires establishing a monthly, quarterly, or semiannual cadence of soliciting internal performance and budget-to-actual reports, conducting analysis of variance between the forecast and the projections, evaluating relevance to the strategic plan, and making revisions to the current state of the capital allocation, as necessary.

Figure 1: Capital Allocation Framework

Conclusion
Capital management is an integral aspect of value creation and maximization of shareholder return. Capital deployment is a critical aspect of the capital management process because it allows portfolio managers and executive leadership to ascertain: (a) whether projects are delivering the qualitative and quantitative benefits that the management had contemplated receiving post-implementation and (b) whether capital is being deployed toward the highest and best use.

Often organizations establish a corporate transformation office or project management office to drive strategic and tactical initiatives. They commit valuable resources and human capital to ascertain whether these initiatives are being executed on time and under budget and whether the execution adheres to the contemplated quality standards.

While these are pertinent metrics to track in the pursuit of prudent capital deployment, an equally important question that often goes unanswered is whether these strategic and tactical initiatives realize the benefits envisioned and whether they are accretive to the organization’s bottom line.

The capital allocation framework has two central themes: (a) capital budgeting and (b) capital allocation. An exercise in capital management suffers from cognitive biases; therefore, it must be augmented by risk and behavioral frameworks. In addition, it also requires governance and stewardship, which can be addressed by forming a capital allocation committee.

Governance over realizing post-implementation benefits and stewardship in driving the capital’s highest and best use would offer a disciplined approach to capital deployment. By building this capability in collaboration with the corporate transformation office or project management office and corporate finance, portfolio managers can successfully drive value creation and maximize shareholder value.

Reference

1. U.S. Bureau of Economic Analysis. (n.d.) https://www.bea.gov/system/files/gdp4q22_3rd-chart-01.png

About the Author
Recipient of the Presidential Award from The White House, Vibhu Sinha is an intrapreneurial and bottom-line driven, senior management professional, published author, and public speaker with experience in leadership roles across banking and capital markets. He has advised institutional clients on corporate finance and strategic planning, idea generation and pitching, investor relations, ESG, and corporate development, including mergers and acquisitions. Vibhu developed his acumen in behavioral science at Harvard University as part of the master's degree program and earned an MBA from UCLA Anderson. He can be reached at [email protected].

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