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First Capital, Then Strategy

The turbulence of financial markets is reversing the sequence of an optimal planning process.

(originally published by Booz & Company)

Illustration by Lars Leetaru

Sometime during the last 25 years, the best-run companies settled into a routine for capital planning. Every year, the top executives would get together to discuss their strategy for generating growth. The discussion would typically start with the identification of market niches that were underserved and undersupplied. It would then move on to an assessment of internal needs and of whether the staff’s talent and re­sources were sufficient to seize the opportunity. If they weren’t, an ac­quisition or partnership might be proposed. Finally, those present would talk about funding and set priorities.

Different companies handled this planning in different ways. Some treated it as a two-year planning cycle, others as a five-year; some limited the meeting to top executives, others invited hundreds of managers; some held the meeting in the Caribbean, others at the local Hyatt. But for all, the idea was the same and the sequence identical: Strategy discussion first, capital availability discussion second.

That sequence, it turns out, has become passé. It is a form of corporate planning that is as outdated as the notion that AT&T is a stock for widows and orphans or that a board appointment can be a sinecure. Successful companies, now and in the future, will discuss their sources of funding first, and only turn to strategy afterward. To be sure, there were companies in the past that started their corporate planning sessions by talking about capital availability, but those companies typically were either startups or already facing financial ruin. What’s new is the impatience felt by the C-level executives of many established and fundamentally sound companies during the strategy part of the discussion. They have a sense that the discussion is starting in the wrong place. They should trust this instinct. Ideas are no longer the scarce resource at most companies, the factor on which everything depends. Capital is.

The Impatient Herd
The underlying cause is, of course, related to the crisis that struck capital markets in early 2008. But the fundamental cause isn’t a scar­city of capital. In fact, there is a tremendous amount of capital in the world. That’s clear to anyone who has followed the rise of such sovereign wealth funds as the Abu Dhabi Investment Authority (now a big investor in Citigroup Inc.) or the China Investment Corporation (now a big investor in Morgan Stanley and the Blackstone Group). What’s different these days is the be­havior of capital: None of it is patient. Today, capital has a short-term nature that borders on the ruthless.

Short-term thinking about financial assets has been a prevalent factor in corporate strategy since at least the 1980s; former U.S. Treasury Department official Michael T. Jacobs lamented the trend in his 1992 book, Short-Term America: The Causes and Cures of Our Business Myopia. But in the last few years, the short-term emphasis for investors has penetrated more deeply and become far more widespread. The globalization of financial markets and the emergence of counterparties everywhere have turned short-term thinking into an American export, as common in Singapore and Kuwait as it is in New York. The US$7.5 billion that Abu Dhabi’s sovereign fund invested in Citigroup in 2007 could be just as quickly withdrawn if Abu Dhabi doesn’t like where Citigroup is heading.

One result of this global impatience is that old mechanisms of allocating capital have lost their primacy. The clearest casualty has been fundamental research. Investors no longer believe that good research can help them beat the market; in fact, in many cases, they have given up trying to beat the market in the first place. Instead, their goal is to be the neither first to embrace a new investment thesis nor the last to abandon it. We’d wager that as much as 90 percent of the world’s capital moves in a herd, waiting for an investment to gain momentum and then joining in.

Along with the removal of international barriers, this herd mentality explains why market bubbles are happening more frequently, are of greater intensity, and are bursting (when they inevitably do burst) more dramatically. The dot-com implosion at the beginning of this decade shouldn’t have been a surprise — that’s what happens when investors stop thinking critically and clamber into the latest hot stock group or asset class, pushing it to levels that defy reason. A similar implosion is taking place now, of course, with subprime mortgages. Next up could be the bursting of a bubble in commercial real estate, which has doubled in price in the last seven years. Or maybe the bubble will be in commodities, if justifiable bullishness, brought about by emerging-country demand for raw materials, attracts copycat speculators. No one knows for certain where the bubbles will form or when they will burst. We only know that, with the herd mentality currently in place, more speculative bubbles are coming.

For executives trying to figure out how they’re going to kick off their company’s five-year strategy session, the changed investor environment poses a dilemma. On the one hand, long-term investments cannot be abandoned. Many companies tried such a strategy during the 1980s and ’90s, focusing only on short-term returns, and in most cases those companies have been acquired. In a global market where customers can quickly discard old brands for new ones, innovation and investment in new technology may be more important than ever. And those who live by expediency die by expediency.

On the other hand, few shareholders are going to hitch their fortunes to a management team that says, “Look, we’ve got a five-year journey ahead of us; stay with us.” That appeal might have resonated in an earlier era, but it doesn’t work with the hedge funds, private equity funds, and sovereign funds that increasingly constitute a company’s most vocal shareholders. Whatever else those shareholders may be, they are not a CEO’s friends. Their willingness to fund a company’s capital agenda cannot be assumed. It must be stress-tested.

The Fickle Capital Quotient
Increasingly, an effective capital-procurement strategy — whether based on debt, equity, or a com­bination of the two — will require the same kind of market segmentation of the capital base that many companies already conduct for their customer base. The questions that executives must answer include: Who is providing our capital and over what duration? Under what terms and conditions are they providing this funding? What are they expecting in return for their investment? And what actions will they take if we don’t meet their expectations?

As part of the same analysis, executives should ask themselves some broader what-if questions that could also affect their access to capital. What if interest rates spike? What if the short-term debt markets choke us off? What if our sector falls from favor? What if an influential shareholder group such as CalPERS suddenly rejects us for its own reasons, such as perceiving us as not being green enough?

Executives whose companies have been the target of activist shareholders have already gone through this self-assessment process; they’ve had to. But getting a read on capital sources should be a priority for every executive today, whether a hedge fund is knocking at the door or not.

In many cases, the only way to appease one’s capital base and maintain access to capital is to generate short-term returns in a way that reinforces long-term prospects. This can be done operationally, by picking projects whose near-term success is virtually certain — for instance, outsourcing a function to generate immediate savings or revenue instead of undertaking the long-term investment that would be required to build the capability internally. An example of a real-world missed opportunity: In 2007, Yahoo was reported to be considering a partnership with Google to boost its search results. Had Yahoo consummated such a partnership, it would have been assured of higher near-term revenue and profit — a circumstance that might have helped the company avoid Microsoft’s unwanted 2008 acquisition bid.

Alternatively, the short-term payback can be generated finan­cially — by increasing the dividend or initiating a stock buyback. In 2006, media giant Time Warner fended off a boardroom coup by financier Carl Icahn by acceding to his request for an accelerated stock buyback program. Icahn ultimately went away, taking his larger threats with him.

Whatever executives do to generate short-term returns, they will gain traction to the extent that they are doing what the hedge funds, sovereign funds, and private equity firms would have them do anyway. There is no shame in such a stra­t­egy; it’s part of surviving.

As executives’ priorities shift this way, they are left with the question of what constitutes a sufficient level of short-term payback — and how they can ensure it. Two steps are required to figure this out.

The first is pinpointing the half-life of investor demand for a given industry — how many years, on average, shareholders tend to stick around. Investor fashions change, so this number is not fixed. Still, there is often a positive correlation between investor tenure and the predictability of an industry’s profits. Industries that produce more predictable profits can, in general, be more open about taking on additional risk.

The second step involved in figuring out how much overt risk to take on is understanding the discount rate investors use to evaluate the payoffs from long-term projects. Lower rates, of course, imply more-certain cash flows. If you were Nokia at the beginning of the cell-phone boom in 1998, with your business taking off in every corner of the globe, you could be pretty sure that most of your investment in new mobile devices and in R&D would increase your profit. That’s a long-term undertaking with a low discount rate. Conversely, if you are a biotech company in 2008 working only on a cure for pancreatic cancer, you have no idea whether your compound will work or get government approval. It’s a Hail Mary: high discount rate.

Though the calculations aren’t simple, these parameters allow for at least some comparisons between industries. For instance, you would expect media companies, which rise and fall based on individual “hit” products (a movie sequel here, a prime-time television show there), to look for ventures that produce more stable short-term returns. And you would expect beverage companies, most of which generate plenty of cash, to have the license to do more things that represent overtly long-term payoffs. Thus, an in­creased dividend would probably go farther to mollify investors at Walt Disney Company than it would at Pepsico Inc. Similarly, an e-commerce company that ends a costly promotional initiative — and increases its near-term profit margin — would gain more with investors than a household products com­pany that did the same.

Other factors also enter the equation. One is the size of the long-term investment. For instance, although a regional electric utility company such as Duke Energy (based in Charlotte, N.C.) could theoretically take advantage of its predictable returns to build a new nuclear plant, its investors might not support Duke if it decided to build five plants — an undertaking that would require a capital outlay equal to the company’s entire market value.

Thus, to their industry-related calculation, or what might be called the “fickle capital” quotient, executives must add factors specific to their company. This requires, to begin with, unflinching answers to the questions we posed earlier: How much capital can the company attract, at what cost, and how much patience can be expected of stockholders and bondholders? That’s the fact-finding part of the mission. The trick lies in deliberately allocating the capital between a mix of short- and long-term projects. If you have to sell one of the “cash cows” in your domestic portfolio at a pre-peak price to fund a 10-year foray into China, then that’s what you do. In other words, if you can’t trust investors, with their increasingly impatient mind-set, to allocate the capital you need for long-term investment, you’re going to have to raise the money yourself and move it around.

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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