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Published: June 10, 2008


First Capital, Then Strategy

Crafty Capital Creation
Indeed, for some companies, de­ploying capital may mean being a little bit sneaky — in effect, making capital investments in ways that don’t call attention to themselves. For instance, a supplier to the en­ergy industry doesn’t necessarily have to go out and buy a maker of wind turbines, which would be the sort of investment that is imme­diately capitalized and that immediately shows up on a company’s balance sheet. Instead, the CEO can increase payroll, adding more turbine-building engineers to the R&D group, whose activities the company isn’t required to divulge.

Real-world examples abound of this sort of crafty capital creation. For example, banks sometimes lower their target ratios, the percentage of assets they commit to keep on hand as backup capital. The bankers may not necessarily describe this change as a capital-raising maneuver, but the billions that are freed up are every bit as real as the proceeds from issuing a bond.

One way to think of the decision facing corporate executives is to imagine a two-axis chart, with transparency about capital use on one axis and risk concentration on the other. Companies need to figure out where on the two axes they would like to fall.

At one extreme is a small group of entrepreneurial technology-focused companies. They won’t have a choice. Their position at one corner of the chart — with high transparency and high risk — will be obvious, and there will be a limit to how creative they can get with capital raising and deployment. These companies should just tell investors, “You shouldn’t put a penny into us unless you know what you’re doing. We’re betting it all on finding that cure for pancreatic cancer. If we succeed, we’re going to be a moon shot, with a return on equity of 40 percent. But there are no guarantees, and the risk is high.”

For most other companies, which are less concentrated in their risk, it may make more sense, frankly, to be less transparent. These are the companies that have deep and heterogeneous capital bases on the one hand and multiple projects on the other (whether because of the diversity of their business portfolios or because of their access to alliances). Meanwhile, the one place on that chart where it will be untenable to reside is the middle — meaning moderately capital-intensive, with a middling degree of transparency. The current environment favors companies at one extreme or the other.

It seems reasonable to ask how long it will take for the corporate environment to revert to a capital structure that feels more familiar — an environment that will allow businesspeople to first consider strategy as they used to, without the need to continually reassess all their capital sources. In time, some of the factors creating the current global financial instability will probably abate. The U.S. dollar won’t always be as weak as it is now, alternately tempting and scaring non-U.S. investors in particular. And the deep capital surpluses in emerging economies and energy states may shrink as a result of inflation.

But even if the geographic source of the capital shifts, its ruthless quality will remain intact. That is inevitable in a world in which there are so few barriers to moving money among countries, companies, and assets; in which fundamental research has largely disappeared; and in which investor loyalty is a thing of the past. The new environment is probably here to stay. In that sense, every CEO is leading a startup, competing furiously for funding with no stability in sight.

Reprint No. 08202

Author Profiles:

Seamus McMahon is a vice president with Booz & Company based in New York. He specializes in working with commercial banks and brokerage firms. He was previously a banker with HSBC and Toronto Dominion.

Michael McKeon is a senior vice president at Booz & Company based in New York. He specializes in capital markets and wealth management.
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