Accountability Related To Capital Allocation

I asked seven CFOs “Do you conduct a post-mortem of your capital allocation decisions?” Fewer than I had hoped said “yes.”

Here are excerpts from these conversations:

The “disciplined” answer:

“Every three years we reviewed every project that came to the board. We compared what transpired to what we said. Every year we review capital allocation, how much money went through the system, how much went through dividends, how much went through engineering and development, like a big engine program, and all those things producing savings. “

“We follow a red, yellow, green flagging process. There are always some reds, particularly on the M&A side. Just don't get too red. Anytime management would come to us and say, this project needs to be approved right away because time is at the essence, I said, watch out, because the engineering wasn't done, the scope wasn't chosen, and you start doing the engineering while you're building the project, and you're likely in for a big, critical, long run, negative surprise. Never a pleasant surprise when that happens.”

The “kind of-sort of” answer:

“There was a fairly rigorous look at big capex spending. As stuff got to be bigger, there was a fairly robust look at it. You have to empower your management team. Empowerment is a 45-degree line and the Y axis is your level of empowerment and your X axis is your track record of results. The more results you give over time consistently, the higher level of empowerment you get.”

The groupthink problem:

“I have to give a silly, overly simplified answer. At the end of the day, they're accountable by how the company's doing and how the stock is performing. At the end of the day, it gets put into sort of one big grade, and capital allocation is part of what creates that grade.”

“Timing is also an extraordinary important factor. You may have the right thought, but timing may be all wrong in the sense that you just bought it at the wrong time, and you paid the wrong price. That happens all the time.

“Let me explain what happened in an M&A transaction that I thought was an insane deal from the acquirer’s perspective. Decision making is a very funny thing. And in the heat of battle, people don't have the perspective that you can have from getting up on the top floor and looking down or with the passage of time. Boards want to get along. People in a group setting where there's the need to be a cohesive group that has to get along, there is an enormous barrier to independent thinking. I attribute that to group dynamics. There's a whole behavioral psychology thing that goes into play.

In this one terrible deal, I think it was a CEO, who had a vision. He was frustrated with his company, he wanted it to change dramatically. He got enamored of the M&A transaction. He didn't really share much with his management. They did due diligence for three days, that's it, over a weekend. And when it was all presented to a board, he was driving the decision-making and the board wanted to say, “okay, we trust the CEO and respect him. It's what he wants. We'll go ahead.”

So, there's a lot of that I think went into that situation, but I attribute it, to a large extent, to the ill-fated vision of one man. and to the group dynamics and psychology of how boards operate, particularly when they're not given a lot of time, and in an environment where I think independent thinking was perhaps less commonplace.”

Confusing growth for value add:

“We have a number of acquisitions that have shown a lot of EBITDA growth and free cash flow growth, and they still don't earn their cost of capital. There are plenty of old school managers around here who are like, “what are you talking about? Look at all the growth this has driven.” I’d tell them, “4% return on invested capital means we are not earning our cost of capital. These deals are failures.””

Suggested fixes:

“When you run a P&L within this company, there's really not a balance sheet that comes with that. If we lived in a world that was nirvana, everyone would have their own balance sheet and be thinking about their own return on capital.”

“Find a sponsor for your acquisition. If you want to sponsor an acquisition at my company, when the diligence work is done and the diligence binder is prepared, there's a memo called the top memo, and I'm at top memo as the sponsor of that acquisition. You are signing up to two to four KPIs. These KPIs must be objective, measurable, they must exist within our IT systems. A report gets prepared every six months, that report goes to the senior manager of this team, and it is marked as “red, yellow, green.” Based on how you are doing versus your deal model, that is what's in that report. If you have multiple lines in that report that are red, you are going to have a problem the next time you come back knocking on the door for M&A Capital.”

Concluding comments:

You will note that most of the comments refer to acquisitions. For obvious reasons, acquisitions are somewhat easier to think about. I did not come across many CFOs who apply the same disciplined thinking to how ROIC internal capex generated. And this problem becomes worse when we think of investment in intangible capital such as R&D and human capital.

In sum, accountability in capital allocation is somewhat mixed based on my small sample of interviews. Please drop a line to share your experience with this problem.