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Capital management key to linking strategy and value growth.

Profitable growth is the key to unlocking long-term value creation, and no management process exerts more influence on the profitability of growth than capital management. However, the key role played by capital management in value growth is seldom reflected in the attention paid to it. At most companies, capital is allocated during the annual budgeting process, and focuses on requests to fund projects rather than strategies. The result can be an investment strategy that is not connected to business strategy and that will not deliver superior performance.

Yet, some management teams have achieved exceptional growth in the value of their companies by replacing this traditional "taxi-rank" approach to capital management with a more critical, better-informed and more flexible capital management process that links strategy more closely to long-term value creation.

A recent study by Marakon Associates of about 800 leading corporations in North America, Europe and Asia confirmed what senior executives of the world's top-performing companies already knew: that exceptional value growth requires superior profitability in the short term and superior growth in the long term. Both are necessary, but neither is sufficient, and the evidence suggests that the often conflicting requirements of growth and profitability can only be reconciled when capital management decisions take into account the cash flow potential of all strategic alternatives.

Based on experience, top performers--those that sustain top-quartile total shareholder returns (TSRs) over time relative to industry peers--manage their capital within an integrated strategic and economic framework, and make allocations according to clear standards and decision rules.

Figure 1 shows the linkages that must be managed if capital allocation is to support strategy and value growth. Linkage 1 is achieved by a value-focused strategy development process. Linkage 2 ensures good capital is not thrown after bad, and Linkage 3 makes sure good strategy is delivered. How the linkages are managed in practice will vary from company to company, but the important point is to develop a system that allows these linkages to be managed together. Making clear the distinction between three stages of capital management--allocation, sanctioning and monitoring--can help.


Three Stages of Good Capital Management

Every capital management process involves allocation decisions, sanctioning decisions and monitoring (which may or may not lead to reallocation decisions). But in the traditional capital management process, the CEO reviews a queue of new project investment requests on a first-come, first-served basis. The distinctions between the stages are then blurred because allocation is presumed to guarantee sanction, and strategic decisions tend to be set in stone.

In good capital management, allocation commits resources to broad strategic choices: what markets to grow in, what mix of funding to use and whether to grow organically or by acquisition. It is a provisional assignment of capital and only implies subsequent sanctioning insofar as it designates resources for certain projects to deliver on the broad choices. Executives in top-performing companies use this stage to ensure "lost opportunity" arguments and do not compromise the standards for evaluating more than a single option.

Sanctioning is concerned with particular projects that are consistent with agreed-upon strategies. These projects can then draw down the provisioned or "ring-fenced" capital. Sanctioning ensures that only projects supported by the required financial and strategic information are approved.

The difference between allocating and sanctioning is reflected in the forums used, the people involved, the information referred to and the nature of the debates. The chief executive is almost always involved in the allocation process, but he or she often delegates sanctioning of capital to the CFO and business head in charge of delivering a strategy.

Monitoring tracks the performance of strategies and projects, and compares them with expectations at the allocation and sanctioning stages to identify under-performers. Project-driven capital management processes only look at about 10 percent of the capital being invested--the incremental "annual" investment. Top performers monitor the performance of all investments supporting a strategy, and stand ready to reallocate capital if a strategy seems to be failing.

A readiness to reallocate capital is vital, because experience shows that only 10 percent of new strategies and 60 percent of expansion strategies achieve their initial growth and profitability targets. Some top performers enforce reallocation by setting minimum annual "capital recycle" targets of 10-15 percent of all their invested capital. One of the world's best-performing oil and gas companies called this process "bottom slicing," and used it effectively not only to improve overall returns but also to "raise" internal capital to hind higher-value projects.

Acquiring capital from internal sources requires that executives determine the opportunity cost of capital invested to back businesses and strategies. When capital is constrained, this can be the cheapest source of funding. For example, a large international financial services institution determined that disposing of an economically profitable business was beneficial to shareholders because the opportunity cost of maintaining the investment relative to other value-creating opportunities was too high.

In other words, the value of the foregone opportunity was higher than management's view of the business currently in the portfolio. This approach brings a discipline to portfolio strategy (if capital is constrained) by ensuring that no business is sold without a clear view of where the capital will be put to work and at what return level the new opportunity will need to deliver to make the disposal value-creating.

Good Capital Management In Practice

It is one thing to acknowledge the importance of distinguishing between the three stages of capital management; it is quite another to make good decisions at each stage. Our experience with top performers suggests that the quality of capital management decisions can be enhanced by strict adherence to three principles: always consider the alternatives; establish and abide by clear decision rules; and create conditions for open debate on where and how capital is invested.

Good capital management identifies, analyzes and compares all opportunities open to a company at the allocation and sanctioning stages in a constant search for better strategies. At an industry-leading United Kingdom bank, for example, all business units are asked to submit at least three strategic alternatives--one that maximizes long-term value, one that maximizes short-term cash flow and one that minimizes costs. By evaluating alternatives, the CEO and CFO know exactly which opportunities they for-go when committing resources to a particular strategy or project. This knowledge ultimately leads to higher value-creating strategies.

The need to keep many well-articulated alternatives open creates demand for information tailored to the needs of capital management. The best capital managers are not content with the information existing systems already provide. They build their own information, step by step, from the bottom up, by clearly outlining the strategic, customer, financial and operational information they need to make good decisions.

Exploring and debating alternatives has helped a top-performing FTSE 100 company strike the right balance between growing long-term value and delivering near-term economic profit. The executive committee systematically reviews alternative strategies from the business units, requiring consistent information so it can see which strategies will, when combined, increase the odds of delivering both near-term profit growth and longer-term value growth.

As one chief executive said, "I have 48 quarters left in this job, and each one is equally important." Making this work requires an organizational ability to develop alternatives and build the right information base. Figure 2 is a simplified illustration of how the use of alternatives in capital management can improve portfolio management and identify different strategy choices.

Applying Standards And Decision Rules

Capital management standards set expectations for how and why decisions will get made. More often than not, top performers have made these standards explicit as a mechanism for providing guidance to managers, in advance of capital decision debates. One standard--zero-based capital allocation--ensures that all capital (not just incremental) is considered available to fund profitable growth.

Making this standard real has the benefit of focusing management time on its track record of performance, as well as on the accuracy of its forecasts for additional capital investments. Standards provide guidance to managers and are important scene-setters for the changes that a new capital management process will put in place.

Decision rules are criteria that guide the evaluation of strategy alternatives and help determine which alternative is best to fund. They go beyond the singularity of value (as the primary criterion) to include additional "tests" designed to build confidence that any given alternative can be delivered.

For example, a sector-leading global insurance company regularly tests to make sure that alternatives are aligned with overall corporate strategy, in order to discriminate against undesirable diversification. In one instance, the executive committee decided to pass on a value-creating opportunity to invest in a profitable emerging market because the opportunity did not align with corporate strategy. The company also tests whether an alternative supports goals for profitability, cost and capital productivity to discriminate against endless "J-curve" strategies that erode performance before improving it.

Decision rules improve the quality of requests for funding and help explain why some are approved and others are rejected. They set the standard for deciding, prioritizing and shaping competing demands for capital and, as a result, help create the conditions for an open debate on capital management decisions.

The power of alternatives and decision rules to influence behavior depends on the extent to which they are openly accepted and debated. Good capital managers know that decisions taken in open debate are more likely to stick than those taken behind closed doors because they raise the stakes for accountability and self-discipline. True dialogue (as opposed to a series of monologues) is the essence of open debate.

Several years ago, the management team at one of the world's best-performing energy companies was able to work together more effectively by moving the debate from the "smoke-filled room" to a series of open dialogues. Today, a well-defined process (including advance preparation) enables its CEO to establish ground rules and contribute ideas without coming across as prescriptive or dictatorial.

The Payoff of Better Capital Management

Introducing new processes and agreeing on new standards for capital management are not easy, and maintaining them over time is even more difficult. But the payoffs, in the form of faster, higher-quality decisions leading to superior performance, are considerable.

Better capital management leads to better strategies. A wider range of "real" strategy choices and clearer standards for decision-making are two key benefits. In addition, performance management information and systems improve as both income and capital are managed at lower levels in the organization.

Advantaged capital management is the most influential lever that senior managers have to impact business strategy and financial performance. Unlike any other management process, it instills the discipline and accountability necessary to improve returns and accelerate profitable growth over time. Ultimately, it helps companies deliver on expectations for the future--and with that comes greater demand from investors and easier access to capital.

Standards for Capital Management

* Fund strategies, not projects--Make capital allocation and capital release decisions that support business unit strategies, not individual projects with no clear linkage to executing strategies. Individual projects have interdependencies that may reinforce or counteract each other. Strategies provide a roadmap to ensure program interdependencies are reinforcing.

* Tolerate no unprofitable growth--Demand clear line of sight into where and how strategies will deliver profitable growth, and have the discipline to keep good money out of bad strategies. Investing in value-destroying strategies "crowds out" resources that can be put to better use.

* "Zero base" capital allocation discussions--Review all capital invested, including annually reinvested capital, when deciding which strategies to fund. This will subject ongoing investment to more scrutiny about where and why it is being invested. It will also help identify opportunities to redeploy capital to more effective uses.

Neal Kissel ( is a Partner and John Reynolds ( is a Senior Manager, both in the London office of management consulting firm Marakon Associates (
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Author:Reynolds, John
Publication:Financial Executive
Geographic Code:1USA
Date:Sep 1, 2003
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