For CEOs and CFOs seeking to drive growth, one of the most powerful tools available is a company’s approach to allocate capital across its portfolio of businesses.
Capital allocation at the top value creators is characterized by two distinct practices. First, these companies take a highly differentiated approach to allocating capital among business units in the corporate portfolio. Second, they translate strategy into action by linking strategic priorities to capital allocation, financial plans, and specific growth initiatives, and by actively managing the corporate investment portfolio from the top. This approach consists of four steps:
To determine the roles that different business units can play in the company’s portfolio, it’s important to evaluate each one in terms of three different but complementary perspectives. The first perspective focuses on the dynamics of the market: Is the market, customer segment, or region in which the business unit operates growing? If so, is the business in a position where it can grow?
The second perspective focuses on the financial position of the company’s business. Senior executives need to ask: Is growth in this business likely to create value? Or will it come at the cost of eroding gross margins or of increasing our risk profile and eroding our valuation?
Finally, in establishing a company’s strategic priorities for growth, executives must also assess the prospects of each business unit from an ownership perspective: Are we the best owner to grow this business? How does growth in this business contribute to making the performance of the portfolio as a whole better than the sum of its individual parts?
Many companies use exactly the same KPIs to manage each business unit in the portfolio—usually on the theory that consistency is important or for reasons of “fairness.” But a large mature business that generates a lot of cash but has minimal growth prospects shouldn’t be assessed the same way as a small business that produces far less revenue but has strong growth prospects. In the former business, which provides cash to fund promising growth businesses as one of its primary roles, a KPI such as cash flow margin would make sense. In the latter, however, the rate of revenue growth would be a far more important metric.
Too often, companies evaluate every potential growth initiative in terms of net present value (NPV). But that approach can lead to an overemphasis on clearly defined, incremental short-term investments—at the cost of neglecting more long-term but strategically important investments whose NPV is uncertain or difficult to calculate.
All growth investments are not created equal. Basic research, technology platform investments, product development, and product updates all have different profiles in terms of ability to forecast financials, payback, and risk. Start by defining different areas of growth investments. Given the company’s strategic priorities, how much should be invested in basic research, product development, or product updates?
Once the corporate center sets the global budget for each type of growth bucket, it can prioritize investments within each bucket on the basis of criteria appropriate for that type of investment.
Once capital allocation decisions are made, the corporate center must actively manage the investment portfolio over time to make sure that initiatives stay on track and to maximize flexibility. The best way to do so is by establishing an interdisciplinary investment committee made up of representatives from important constituencies such as strategy, finance, operations, and R&D. The committee’s primary task is to continuously evaluate the overall investment portfolio to ensure a good fit with the company’s strategic growth priorities.
Executives on the committee need to think much like venture capitalists do: invest in the team, not just in the idea or project. Doing this effectively requires a tight link among the committee, operations, and HR.