Why Leaders Should Start Acting Like Activist Investors
Trading conditions are constantly changing, but most organizations’ capital allocation is eerily similar from year to year. Incremental improvements to the investment prioritization process are not enough, say the authors. What leaders need to do is adopt the behaviors of successful activist investors and private equity firms, and apply them to internal funding and resource management. This means following three strategies: 1) Maintaining a constant focus on the differentiators that drive long-term value creation; 2) Create more agile investment allocation practices; and 3) Force trade-offs in operating resources.
For most organizations, funding levels for business lines and initiatives do not change significantly from year to year. Trading conditions, however, are constantly changing. Businesses today face a looming earnings recession, disruptive competitors, and fundamental shifts in customer and consumer behavior.
To remain competitive, companies must embrace “capital responsiveness” – the ability, in the face of changing business conditions, to:
- Quickly move capital to new, high-value uses
- Quickly move capital away from new low-value uses
- Make significant, rather than incremental, changes to capital allocation
In other words, it is not enough to significantly finance current investments. Senior executives need to take on the role of activist investors to ensure that capital flows to its most important uses across the business.
According to a Gartner analysis of capital allocation practices at 100 companies, only 38% of companies consistently achieve one of the above components of capital responsiveness, and only 17% consistently achieve all three. The most responsive companies achieve, 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 counterparts.
More than process improvements
Too often, companies try to solve the responsiveness problem by improving the investment prioritization process, such as:
- Standardization of investment valuation metrics across the enterprise
- Streamline investment decision rights by reducing excessive spending approval levels
- Simplify investment business cases
According to our research, approximately 80% of companies that reduce barriers to prioritizing investments have still not achieved capital responsiveness. Indeed, reducing process friction alone does not significantly 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 the behaviors espoused by the most successful activist investors and private equity firms and applies them to the internal management of funding and resources. This requires functional and business leaders to actively direct capital flows by:
- Consider the company’s investment portfolio as a set of trade-offs and synergies.
- Apply a “nothing is sacred but strategy” mindset to the firm’s investment options. (Assuming the current policy is correct.)
Capital activism enhances capital responsiveness because it actively challenges connections to legacy investments and new opportunities that reinforce siled rather than enterprise-wide priorities.
Activist capital leaders follow three strategies:
1. They relentlessly focus on differentiators.
Capital activism creates responsiveness, in part because it maintains focus on the narrow set of differentiators that drive the company’s long-term value creation. This reduces the likelihood of competing priorities from different business units anchoring spending into existing siled uses.
For example, Moneris, a large fintech company, has developed a simple project intake form for proposed new investments that streamlines the investment prioritization process and ensures differentiators are highlighted. The form is underpinned by a scoring model that generates a unique score for each project, based on mission-weighted assessment dimensions. An independent vetting group validates form responses to ensure fairness and objectivity, and approved project scores are ranked meaningfully. Executives review this forced ranking during monthly project update meetings as a shared database to prioritize new projects for funding. This approach ensures that the most strategically aligned and highest value projects are consistently prioritized for investment.
2. They create more agile investment allocation practices.
Capital responsiveness is not limited to the ability to execute a one-time reset of funding flows. This involves changes in investment allocation practices that allow the organization to pivot at any time (and as many times as needed).
Executives at a multinational software company completed their annual fundraising process and resource allocations quickly became misaligned with strategy as the business environment changed and new opportunities emerged. In response, the company’s digital business services group reorganized its resources and funding around internal “product lines” aligned with key business goals.
However, once funding and resources were allocated to product lines, their reallocation disrupted product workflows and resulted in “orphaned” or underfunded product lines that could not support basic product functionality. . Funding the product line with two distinct categories of funds and resources helped to minimize disruption to workflows:
- Fixed funds and resources are dedicated to each product line to provide stability and support 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 IT and business or enterprise capital budgets, with a significant portion of the IT budget allocated as fixed funds to support the core capabilities of each product line.
3. They impose trade-offs on operating resources.
Even when leaders are successful in driving capital transfers at the enterprise level, their organizations still struggle to realize returns because operational resources – people, technology and other capabilities – are not flowing to support execution.
This happens because business and functional leaders often have a high degree of autonomy when allocating operational resources. Budget owners are typically inclined to support existing, siled uses of resources for a variety of entirely rational reasons, including their incentives for compensation, to focus on a particular business unit or function, and a desire to see their projects underway. to succeed.
To ensure that operational resources meet the redefinition of investment priorities, activist capital leaders:
- Track resource usage by departments and skills rather than budget categories
- Classify operational expenses into strategic categories to analyze resource utilization against strategic objectives
- Use metrics cascades (i.e. drivers of shareholder value) to put resource trade-offs into business perspective
A leading medical device company stimulates capital activist thinking in the company by having finance leaders coach operations leaders and their teams on the company’s financial and business models, including strategic timelines and key drivers commercial. To show the causal chain between operations and financial performance, it links the types of operational decisions to the elements of the shareholder value map.
In two-hour trainings, finance leaders break down the ultimate goal of shareholder value across different levels of financial and operational metrics to show how individual initiatives impact cash flow. The analysis of an individual decision or initiative (for example, adding a new feature to an existing product) in terms of not only the expected additional revenue, but also non-obvious costs such as design costs, manufacturing line changes and additional warranty costs is critical to driving investment and resourcing decisions that are in the best interest of the business. It also makes it possible to personalize the operational-financial link for the business teams. Such an exercise allows business leaders to see how moving (or not) operational resources to align with new strategic investment priorities affects business performance.
The responsiveness of capital is essential to remain competitive in a disrupted world. To achieve this, leaders must embrace the behaviors of successful activist investors and apply them to all investment prioritization activities with a relentless focus on differentiating bets, creating options in funding streams, and forcing trade-offs on operating resources that will generate value for the business.