By Neal Kissel and John Reynolds

  

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.

This article describes how some companies have achieved exceptional value growth 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.

Growth AND profitability
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 superior shareholder returns require superior profitability¹ in the short term and superior growth² 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.

Strategy, capital management and value
In our experience, top performers manage their capital within an integrated strategic and economic framework, and make allocations according to clear standards and rules.

Figure 1¹ shows the linkages that must be managed if capital allocation is to support strategy and value growth. Linkage 1 is achieved by a value-based 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. The key point is that they must work well together within a system that makes clear distinctions between the three stages of capital management.

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 "ringfences" resources for certain projects to deliver on the broad choices. Executives in top-performing companies use this stage to ensure "lost opportunity" arguments do not compromise the standards for evaluating more than a single option.

Sanctioning is concerned with particular projects that are consistent with agreed strategies. These projects can then draw down the provisioned or ringfenced 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 BU leader in charge of delivering an agreed 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% of the capital being invested – the incremental "annual" investment. Exemplars 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, in our experience, only 10% of new strategies and 60% 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% of all their invested capital.