Business conditions are constantly changing, yet most organizations’ capital allocation is suspiciously similar from year to year. Incremental improvements to the investment prioritization process aren’t enough, the authors argue. What leaders need to do is adopt the behaviors of successful activist investors and private equity firms, and apply them to the internal management of funding and resources. This means following three strategies: 1) Maintaining a relentless focus on the differentiators that drive long-term value creation; 2) Creating more nimble investment allocation practices; and 3) Forcing trade-offs in operating resources.
For most organizations, funding levels across business lines and initiatives don’t meaningfully change from year to year. Business conditions, however, are constantly changing. Companies today face an impending earnings recession, disruptive competitors, and fundamental shifts in customer and consumer behavior.
To stay competitive, companies need to adopt “capital responsiveness” — the ability, in the face of changing business conditions, to:
- Quickly shift capital to new high-value uses
- Quickly shift capital away from new low-value uses
- Make significant, rather than incremental, changes to where capital is allocated
In other words, it is not enough just to meaningfully fund current investments. Senior executives must don the mantle of activist investors to make sure capital flows to its highest-value uses across the enterprise.
Only 38% of companies consistently achieve any one of the above components of capital responsiveness, and only 17% consistently achieve all three, according to a Gartner analysis of capital allocation practices across 100 companies. The most responsive companies realize, on average, 2.5 percentage points more in economic value added (return on invested capital minus weighted average cost of capital) than their less-responsive peers.
More Than Process Improvements
Too often, companies try to address the responsiveness problem through improvements to the investment prioritization process, such as:
- Standardizing investment evaluation metrics across the enterprise
- Streamlining investment decision rights by reducing excessive layers of spending approval
- Simplifying investment business cases
According to our research, roughly 80% of companies who reduce drags in investment prioritization still didn’t achieve capital responsiveness. This is because reducing process friction alone doesn’t meaningfully change the destinations to which capital flows.
When companies reduce process friction and introduce a new set of guiding imperatives that we call “capital activism,” however, the results look very different: 71% achieve a high degree of capital responsiveness.
What Is Capital Activism?
Capital activism takes behaviors embraced by the most productive activist investors and private equity firms and applies them to the internal management of funding and resources. It requires functional and business leaders to actively direct capital flows by:
- Looking at the enterprise investment portfolio as a set of trade-offs and synergies.
- Applying a “nothing is sacred but the strategy” mindset to the company’s investment options. (Assuming the current strategy is correct.)
Capital activism improves capital responsiveness because it actively challenges attachments to legacy investments and new opportunities that reinforce siloed — rather than enterprise-wide — priorities.
Capital activist leaders follow three strategies:
1. They maintain a relentless focus on differentiators.
Capital activism creates responsiveness, in part, because it maintains focus on the narrow set of differentiators that drive long-term enterprise value creation. This reduces the likelihood that competing priorities from different business units will anchor spending in siloed, existing uses.
For example, Moneris, a large financial technology company, developed a simple project intake form for proposed new investments that both streamlines the investment prioritization process and ensures differentiators are emphasized. The form is underpinned by a scoring model that generates a single score for each project, based on mission-weighted evaluation dimensions. An independent control group validates form responses to ensure fairness and objectivity, and approved project scores are meaningfully force-ranked. Executives review this forced rank during monthly project update meetings as a shared evidence base for prioritizing new projects for funding. This approach ensures the most strategically aligned, highest-value-add projects are consistently prioritized for investment.
2. They create more nimble investment allocation practices.
Capital responsiveness is more than just the ability to execute a one-time reset of funding flows. It implies changes to investment allocation practices that allow the organization to pivot at any time (and as many times as needed).
Leaders at one multinational software company realized their annual funding process and resource allocations quickly became misaligned to strategy as the business context evolved and new opportunities emerged. In response, the company’s digital enterprise services group reorganized its resources and funding around internal “product lines” aligned to core business objectives.
However, once funding and resources were assigned to product lines, reallocating them was disruptive to product workflows and led to “orphaned” or underfunded product lines that couldn’t support products’ core capabilities. Product line funding with two distinct categories of funds and resources helped minimize the disruption to workflows:
- Fixed funds and resources are dedicated to each product line to ensure stability and support the core capabilities.
- Flexible funds and resources are allocated based on a product line’s contribution to strategic priorities and can be reallocated as priorities change.
The company funds its product lines through both IT and business or corporate investment budgets, with a significant portion of the IT budget allocated as fixed funds to support core capabilities for each product line.
3. They force trade-offs in operating resources.
Even when executives succeed at driving enterprise-level capital shifts, their organizations still struggle to realize returns because operational resources — people, technology, and other capabilities — don’t flow to support execution.
This happens because business and functional leaders often have a high degree of autonomy when allocating operational resources. Budget owners are generally biased toward supporting existing, siloed uses of resources for a variety of entirely rational reasons, including their compensation incentives, to focus on a particular business unit or function and a desire to see their in-flight projects succeed.
To ensure operational resources are responsive to investment reprioritization, capital activist leaders:
- Track resource utilization by services and skills rather than budget categories
- Classify operational expenses into strategic categories to analyze resource use against strategic objectives
- Use metrics cascades (i.e., the drivers of shareholder value) to put resource trade-offs into enterprise perspective
One large medical-device company drives capital activist thinking in the business by having finance leaders coach operations leaders and their teams on the enterprise’s financial and business models, including strategic time frames and key business drivers. To show the causal chain between operations and financial performance, it connects types of operational decisions to shareholder value-map elements.
In two-hour trainings, finance leaders break down the ultimate goal of shareholder value through various levels of financial and operational metrics to show how individual initiatives impact cash flow. Analyzing an individual decision or initiative (e.g., adding a new feature to an existing product) through the lens of not just additional expected revenue but also non-obvious costs such as design cost, manufacturing line changes, and additional warranty costs is key for driving investment and resourcing decisions that are in the best interest of the enterprise. It also helps make the operational-financial link personal for business teams. Such an exercise allows business leaders to see how shifting (or not shifting) operational resources to align to new strategic investment priorities affects enterprise performance.
Capital responsiveness is essential to staying competitive in a disruption-filled world. To achieve it, leaders need to adopt the behaviors of successful activist investors and apply them across all investment prioritization activities by driving relentless focus on differentiating bets, creating optionality in funding flows, and forcing operating resource trade-offs that will drive enterprise value.