Capital allocation is one of a CEO's most potent tools to translate strategy into action.
Effective capital allocation has never been more critical in the current business landscape, where most companies navigate digital and sustainability transformations (and the substantial investments behind them).
Despite this criticality, a recent BCG analysis of over 10,000 listed firms has revealed a surprising trend: capital spending (as % of revenues) has decreased by 10% in recent years. While this decrease reflects widespread hesitancy to invest, it's not surprising – given the heightened uncertainty, macroeconomic volatility, and rising interest rates in recent years.
However, this hesitancy to invest comes with a price: slower growth, lower return, and lower valuation.
A 10-year longitudinal data shows us that strategic capital allocation is a linchpin for success: High-performing companies invest roughly 50% more in capital expenditure (capex) than their counterparts, resulting in significantly higher returns on assets (85 percentage point difference) and increased sales growth (78 percentage point difference).
Therefore, it is essential for CEOs to master strategic capital allocation.
In essence, they need to focus on three core disciplines, each with its set of best practices:
Discipline 1: Strategy-driven Capital Allocation
Capital allocation that is driven by the strategy is the cornerstone of effective resource allocation. It involves three best practices:
1.1. Capture also the Strategic Value, Not just the Financial Value
Companies that excel in capital allocation take a holistic approach, investing in businesses that provide both strategic and financial value.
The financial values are typical: 1) High growth; 2) High return.
The strategic values are less common: 1) Strengthen the company's spear of competitive advantage; 2) Supported by strong market trends; 3) Areas of future growth.
This approach helps avoid common pitfalls, such as the maturing-business trap (mature BU gets a lot of capex) and the egalitarian trap (every BU gets a proportional share of capex).
Success cases of this best practice include IBM's shift from hardware to cloud-based services, and Tata Consultancy Services' divestment from call center operations, exemplifying businesses strategically reallocating resources for future growth.
1.2. Allocate Capital Based on the BU's Role in the Portfolio
Companies that excel in capital allocation make sure that their capital allocation follows the logic of their overall business portfolio. This way, the allocated resources will follow the strategic potential of each business.
For example, a client of mine had 5 BUs, each with different roles in the portfolio. To free up money for investments in the growth segments, the capital allocation rules for each business are different:
Formalwear (Declining Business) => No capex, unless legally mandatory.
Casualwear (Mature Harvesting Business) => Maintenance capex only.
Sportswear (Mature Growing Business) => Capex up to 1x OCF.
Accessories (Growing but Risky Business) => Capex up to 2x OCF.
Shoes & Handbags (Fast Growing Business) => Capex up to 3x OCF.
1.3. Review the Overall Balance of the Investment Portfolio
Companies that excel in capital allocation make sure that their capital allocation is balanced. For example, the balance between:
Low risk, low return vs. High return, high risk
Small vs. Big bets
Short-term vs. Long-term
Standard vs. Market Changing
Discipline 2: Capital Allocation Based on True & Thorough Understanding
Investment project selection is a financial exercise, but outperformers go beyond the basics. Here are the best practices:
2.1. Choose Projects Based on True Business Understanding, Not Simplistic Indicators
Companies that excel in capital allocation don't rely on simplistic indicators such as Payback Period and IRR. For instance, Payback Period systematically favours small, short-term projects at the expense of larger breakthrough projects that tend to have longer-term and uncertain payoffs.
While Internal Rate of Return (IRR) is a commonly used metric, its effectiveness is constrained by the quality of assumptions. To enhance this, businesses should require detailed business cases for major investment projects, explicitly outlining critical assumptions and facilitating sensitivity and scenario analyses.
For example, a European food company evaluates projects based on comprehensive profiles (such as strategic profile, financial profile, risk profile, and resource profile), ensuring no implicit assumptions and a robust decision-making process.
Furthermore, companies that excel in capital allocation apply different sets of criteria for different investment types. For example, a confectionery company uses the following approach:
Short-term projects (e.g., efficiency improvement, new equipments, line upgrades) are evaluated based on their financial impact only.
Medium-term projects (e.g., capacity extensions, new plants) are evaluated based on market assumptions (consumer trends, competitor capacity, commodity trends) and their financial impact.
Long-term projects (e.g., digital technology, new food ingredients, hi-tech R&D) are evaluated based on their strategic attractiveness and the resulting options. Financial impacts are not considered.
Such a differentiated approach ensures the company chooses the best projects within each investment type without sacrificing any category.
2.3. Choose Projects Based on a Thorough Understanding of Risks
Understanding and mitigating risks is crucial in project selection.
Too often, companies are overfocused on quantifying some risks (e.g., scenario probability, Monte Carlo simulation, decision tree), instead of uncovering the hidden risks (more important).
Techniques such as pre-mortem analysis and discovery-driven planning can help uncover hidden risks, ensuring a thorough risk assessment before committing funds. Imagining the planned investment has failed terribly and asking why it went wrong would quickly shift focus from its great potential to its hidden risks.
Capital should only be committed when all the relevant risks are fully understood.
Discipline 3: Systematic Performance Management of Capital Allocation
Systematic performance management is critical for selecting, supporting, and tracking major capex projects. It involves these essential best practices:
3.1.Ensure a Systematic Process during Project Selection
Essentially, successful capital allocation is about making the right judgment. And our judgment is prone to cognitive biases.
This is why companies that excel in capital allocation seek to minimise cognitive biases in decision-making.
To counter cognitive biases, they introduce a systematic project selection process. For example, establishing a central investment committee, bundling project investment decisions, and fostering a culture of constructive disagreement are effective counters.
3.2. Ensure a Systematic Accountability during Project Implementation
Companies that excel in capital allocation make sure the teams are accountable for the project's success from the very beginning (and even after they have moved on via long-term incentives).
They link personal targets and incentives to the success of major investment projects. In other words, the project's success needs to be tied to the individual bonus or promotion. Furthermore, external factors are not accepted as excuses for failure.
This ensures that decision-makers and implementation teams are accountable for the long-term success of initiatives, reducing the risk of moral hazard.
3.3. Ensure a Systematic Review along Project Implementation
Learning and adaptation are key components of successful capital allocation. This is why Companies that excel in capital allocation institute feedback loops to capture learning and ensure adaptation.
Regularly reviewing both current projects and past decisions (including the ones not taken) via a systematic review process ensures continuous improvement.
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By following these best practices, CEOs can make wise choices with their capital and bring paramount success to their companies.