“Understanding intrinsic value is as important for managers as it is for investors. When managers are making capital allocation decisions … it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. ... Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value.” – Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1994.
Berkshire Hathaway Chairman Warren Buffett is widely regarded as one of the most successful investors in history; his management track record is arguably just as singular. A hallmark of Buffett’s management philosophy is his unusual attention to capital allocation. He advocates that capital allocation is equally, if not more, important than operating prowess in driving long-term shareholder value. Studies show that companies that continually evaluate the performance of business units, acquire and divest assets and adjust resource allocations based on relative market opportunities outperform those that do not. The development of a capital allocation framework is a strong catalyst for value creation. While capital allocation is generally perceived to be more relevant for public companies, it is just as important for private companies.
Capital allocation decisions are vital in determining a company’s future and, as such, are among management’s most important responsibilities. Managers have three basic choices for deploying capital:
- Reinvesting in the existing business (underwriting capital expenditures, funding research and development or adding to the sales team)
- Acquiring another company
- Returning cash to claimholders (issuing dividends, redeeming shares and repaying debt)
Choosing between these options requires discipline and careful consideration. An unsound capital investment decision can hinder value creation in a business by depriving more deserving initiatives of scarce resources. Capital allocation’s importance becomes more apparent over a business’s life cycle. In the early stages, decisions about allocating capital are relatively simple – most of the cash flows are poured back into the growing company, and there is typically limited cash to deploy. Eventually, a business matures, meaningful organic growth opportunities tend to diminish, and cash is accumulated. Whether capital is generated through operations or raised through the issuance of debt or equity, the deployment of capital drives the long-term value creation opportunity for the business.
Why Capital Allocation Matters for a Private Company
While capital allocation is a central issue for all firms, it deserves particular attention for private businesses for which capital is scarce and less readily accessible compared with publicly listed companies. Capital allocation decisions are often viewed too simplistically by business owners who frequently take a reactive approach, such as defaulting to decisions made at year-end to reduce taxes. The year-end purchase of a new piece of equipment may reduce near-term taxes, but may also underfund other opportunities to accelerate longer-term growth and larger future distributions to shareholders. Although it is important to operate in a tax-efficient manner, tax planning should inform, not determine, long-term business strategy.
In addition to having limited access to capital, an owner of a private company is also uniquely challenged to balance the needs of the business with personal estate planning, particularly as private company stock often represents the largest asset on his or her personal balance sheet. Unforeseen personal events can present additional demands for capital that affect the business and make the capital allocation calculus more difficult. This can be further complicated particularly in multigenerational businesses with passive shareholders and/or institutional investors that have conflicting holding periods and priorities for liquidity vs. reinvesting in the business. Developing a disciplined approach to decision-making will help owners navigate the capital allocation process and drive long-term value in their business.
A Private Company Approach to Capital Allocation
The manner in which companies allocate capital is remarkably varied. Some companies make capital decisions based on relative size, performance or growth potential of the business units. Others simply apportion the same resources provided in the prior year. Regardless of the approach, capital allocation decisions should be guided by an active and objective approach to identify, analyze, execute and evaluate the firm’s options for managing its capital.
Well-run public companies develop core principles to steer their capital allocation decisions. For instance, General Electric (GE) establishes specific capital allocation goals that encompass growth funding, mergers and acquisitions, dividends and buybacks. GE also tracks various metrics, such as revenue growth, operating profit margins and return on invested capital (ROIC), to assess the success of its capital allocation strategy and inform future decisions. For GE and other leading companies, a clearly defined framework and set of objectives is the roadmap for effective capital management.
For private companies, the principles developed to guide capital allocation decisions should support the business’s needs and strategies and take into consideration shareholder liquidity timeframes and objectives. The ultimate outcome of capital allocation choices is rarely immediate or obvious, thus requiring decision-makers to adopt a long-term view when developing goals and assessing success. In that sense, most private companies are well suited to the capital allocation process given their orientation toward building a sustainable business that can be passed on and harvested across subsequent generations. Similar to the multiyear business planning process, it is important to create a multiyear capital allocation plan that is guided by long-term owner goals and business objectives while also maintaining sufficient flexibility to adjust to changing market conditions and act decisively when opportunities arise. A robust process will enable decision-makers to identify competing capital needs, analyze the various opportunities, execute the strategy and evaluate the effectiveness of the decisions made.
Identify Capital Needs
The first step in the capital allocation process for business owners is to identify the capital demands within the business. Beyond fundamental tax and debt service requirements, the uses of capital are often more situational and dependent on a variety of factors, including risk appetite and business life cycle. Owners with higher risk appetites and a history of successful business integration are likely to be more comfortable accelerating growth through an acquisition strategy. Owners with lower risk tolerances may favor more gradual organic growth strategies while diversifying their holdings through dividend distributions.
After establishing the capital needs to support the business strategy, business owners must consider debt obligations and near- and long-term shareholder liquidity needs. Finally, they should determine whether capital is necessary to achieve certain long-term personal goals or objectives, specifically business succession. For example, the sudden death of an owner can create a major taxable event that puts unnecessary stress on the business’s capital if a thoughtful, tax-efficient estate plan is not established ahead of time. Acquisitions, ownership transfers and stock redemptions are other key capital-intensive events that are best handled within the firm’s long-term capital allocation plan. Balancing these competing demands requires careful consideration and discipline. Equally as important as planning is retaining the flexibility to move business resources to adjust to shifting market conditions and act decisively when opportunities emerge.
Analyze Allocation Options
Business owners should evaluate the alternatives before deciding on how best to allocate capital. Many private companies rely on qualitative approaches such as “gut feel” to make capital allocation choices; however, when contemplating a project (e.g., building a new factory) or business initiative (e.g., growing the sales team), strategic imperatives should be quantitatively assessed using an appropriate technique such as ROIC, internal rate of return or net present value. Smaller firms are more apt to lean on simpler metrics such as payback periods to evaluate projects, as future project cash flows are less predictable and owners are less likely to utilize external sources of capital to fund initiatives. Regardless, these quantitative tools bring discipline to decision-making and can help the business owner make deliberate, well-informed decisions.
Execute the Allocation Plan and Evaluate the Results
Capital allocation decisions should be revisited, reviewed and refined continually as circumstances and opportunities change. Looking back at historical perceptions and actual outcomes is an honest way to weigh the success of prior decision-making. Many companies form internal committees to collaboratively decide on the best uses of capital within the business. Others rely on board members and advisors to debate capital allocation decisions on a formal biannual schedule and link the two areas of competing demands – family and business. It is important to appreciate that the allocation process is evergreen. The process itself is a positive feedback loop, as the lessons learned deploying capital in prior years will inform and improve future decisions.
Capital allocation is a key priority at Brown Brothers Harriman (BBH) and permeates all facets of our business daily. As investors, it goes hand in hand with our value investing philosophy, as we partner with investment managers and management teams who are exceptional stewards of capital. Because of our private partnership structure, BBH Partners are both owners and managers of the firm, giving careful consideration to capital allocation decisions like other private business owners.
Bringing an investor’s mindset to the business of management is as critical as operational excellence. While the details are specific to each company’s unique business strategy, capital structure, financial condition and owner needs, and there is no one-size-fits-all solution, the development of a capital allocation strategy is important for every private company. A well-defined approach to capital allocation will lead to better decisions and drive long-term value creation.
The Corporate Advisory Group (CAG) is dedicated to building and expanding relationships with clients and prospects of Brown Brothers Harriman (BBH) Private Banking through an objective long-term corporate finance dialogue. CAG operates outside of the traditional transaction-focused, success fee-based investment banking model. As a result, CAG is able to approach clients’ unique needs without bias for any particular outcome and provide advice to best help clients achieve their business and personal goals and objectives. For more information on CAG, please contact your BBH relationship manager or Charles Shufeldt, Head of Corporate Advisory, at Charles.Shufeldt@bbh.com.
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