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Capital allocation: A governance perspective

Capital allocation is a fundamental corporate governance consideration directly relevant to a company’s long-term success and the interests of company shareholders and stakeholders.

Yet, in some ways, capital allocation flies below the radar as a governance issue and topic for investor engagement. While corporate governance codes address a wide range of issues, such as board structure, risk management, audit quality and remuneration, capital allocation itself is often not explicitly addressed in codes of governance best practice. However, it does warrant focus as one of the key outputs of the governance process affecting investors providing risk capital – both debt and equity.

What is capital allocation?

Capital allocation is where corporate governance and corporate finance come together. For investors, a company’s capital allocation links closely with questions of company purpose, strategy, business model, risk appetite and public disclosures – and, ultimately, to a company’s ability to generate sustainable returns. Most basically, from a balance sheet perspective, it reflects how a company chooses to finance itself, particularly with regard to the balance of equity, debt and other forms of capital funding. From an earnings or cash flow perspective, a key capital allocation question is the division of the ‘spoils’ between dividends to shareholders, share-based incentive awards to company executives and the retention of earnings for capital investment and financial stability.

As a matter of corporate governance, capital allocation is important with regard to achieving the appropriate type and balance of capital funding to allow a company to pursue its mission and strategic objectives, and to provide sufficient returns and protections to providers of risk capital. This is a matter of judgement for executive managers and corporate boards and often capital allocation can involve trade-offs in establishing a sustainable equilibrium between varied interests of shareholders, creditors and other company stakeholders, including employees and customers.

How can capital allocation be problematic?

As a corporate governance consideration, investors should be alert to a company’s approach to capital allocation, particularly given the potential for distortions, which can have unfavourable outcomes. In some cases, capital allocation can be overly conservative, particularly relative to shareholder expectations for risk-adjusted returns. In other cases, capital allocation may be overly risky from the perspective of creditors and other long-term stakeholders – and the sustainability of the company itself.

Japan is a good example of where capital allocation concerns relate to conservative capital structures. Many Japanese companies are known for balance sheets with considerable cash balances, non-strategic corporate cross shareholdings and relatively limited use of debt finance. While this approach may provide a stable financial cushion for the benefit of employees and creditors, it also can be inefficient by generating low returns on capital for equity investors – particularly compared with peers in North American and European markets.

To some extent, this reflects differing business philosophies, time frames and approaches to company purpose. However, the profitability of Japanese companies is a clear concern for overseas equity investors, who represent more than one-third of the Tokyo Stock Exchange market capitalisation. The Japanese Financial Services Authority’s Council of Experts for Japan’s Corporate Governance Code is currently reviewing the Japanese code with regard to addressing investor concerns about Japanese capital allocation practices.

At the other extreme, capital allocation runs the risk of being overaggressive, particularly in Western economies, and can exacerbate financial risks for companies and providers of risk capital. Examples of questionable practice include:

Aggressive use of debt leverage A risky financial strategy is not intrinsically wrong as long as this strategy is clearly communicated to both creditors and shareholders. However, while undercapitalised balance sheets may increase the potential for shareholders to generate high returns on equity, they also enhance financial risk and expose a company to lower credit quality – and, in extremis, to insolvency

Inappropriate dividend policy While investors generally like dividends, they need to appreciate when payments of dividends may be inappropriate in the long-term interests of the company, given poor financial performance or a more urgent need for the company to deploy retained earnings for capital investment

Inappropriate share buybacks Buybacks can be a legitimate tool for companies to manage their capital structure. But the scope for manipulation should bring this practice more clearly onto the radar of both long-term shareholders and creditors – both of whose interests can be compromised by buybacks that may be unwise (such as buying back shares at the top of the market) or cynically engineered to game performance targets, such as earnings per share ratios

Starved capital spending For most, if not all, companies, some form of capital spending is an ongoing strategic and operational imperative to remain competitive and positioned for sustainable value creation. However, the level and timing of capital spending is often subject to company discretion, and investors should be alert to companies that may short-change critical research and development or capital spending programmes to accommodate short-term pressures for dividends and earnings growth

Poor executive pay structures The potential for these questionable capital allocation practices can be increased or diminished through remuneration and incentive structures. Investors should be alert to pressures for inappropriate capital allocation decisions in ways that flatter short-term performance metrics, thereby triggering bonuses and other incentive awards

Investor expectations of company boards 

From an investor perspective, the challenge in all markets is to encourage capital allocation practices that establish a sustainable foundation for company value creation while meeting the needs of both debt and equity investors.

A fundamental starting point in this debate should be a company’s ability to achieve a positive return on its risk-adjusted weighted average cost of capital. This requires, in the first instance, the company’s ability to understand and measure its cost of capital, and then to manage the company so that it can adequately generate an ‘economic profit’ – a technical term for meeting its cost of capital. In many ways this is a more meaningful investor expectation than asking companies to generate ‘alpha’, a term of art that means achieving an excess return to the market. Companies have little direct control over their share price or alpha generation – that depends on market forces. But they should have the ability to develop capital structures and corporate strategies in a way to achieve positive economic profits.

“FROM AN INVESTOR PERSPECTIVE THE CHALLENGE IN ALL MARKETS IS TO ENCOURAGE CAPITAL ALLOCATION PRACTICES THAT ESTABLISH A SUSTAINABLE FOUNDATION FOR COMPANY VALUE CREATION WHILE MEETING THE NEEDS OF BOTH DEBT AND EQUITY INVESTORS”

In practical terms, executive management and board directors should review their balance sheets and consider how cash positions, debt and equity can be blended prudently to achieve both acceptable returns for investors, while maintaining a sufficient level of capitalisation and liquidity to provide a cushion against foreseeable systematic and unsystematic risks. This means having an adequate, but not excessive, amount of cash or other liquid assets, as well as an appropriate balance of debt and equity capital to achieve an acceptable equilibrium of financial stability and returns for investors. It also provides a foundation for company capital allocation decisions relating to how company cash flows are allocated between capital spending, dividends, share buybacks, executive remuneration and investments in non-strategic assets that may not be core to the company’s own business or sector.

Disclosure recommendations

Corporate reporting and disclosure are critical for investors to better understand a company’s approach to capital allocation. Companies should be specific in articulating their financial policies and how their capital structures mesh with their strategies, risk appetites and business models. The company and its investors should benefit from the company disclosing its own weighted average cost of capital – which can help to identify situations where inefficiencies might contribute to diluting returns on capital, particularly if the company is not meeting its cost of capital.

From a regulatory perspective, there is scope to consider more detailed disclosure requirements in this area for companies in their annual reports and other disclosures that help investment decision-making. This could include specific disclosures of the company’s calculation of its own cost of debt and equity capital, and how this relates to the company’s long-term value creation, including its use of cash, debt and equity.

Link to investor stewardship

Public disclosure of this nature would be a positive benefit for providers of debt and equity capital and we believe that such disclosures would form a strong foundation for investor engagement with companies. This is where investor stewardship fits in, and it is our hope that more robust disclosures relating to capital allocation can contribute positively to management’s own understanding of its own capital management, as well as enhance investors’ ability to provide constructive inputs to investee companies with regard to their own expectations relating to the company’s financial structure, performance and sustainability.

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Ethical Boardroom is a premier website dedicated to providing the latest news, insights, and analyses on corporate governance, sustainability, and boardroom practices.

ethicalboardroom
Ethical Boardroom is a premier website dedicated to providing the latest news, insights, and analyses on corporate governance, sustainability, and boardroom practices.
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