Navigating Capital Allocation: Best Practices for Boards

One of a firm’s most crucial responsibilities is capital allocation, a process by which management teams and boards deploy financial resources both internally and externally. Though extremely important, history shows that many companies struggle with carrying out the process correctly.

Take share buybacks, for example, a procedure that’s widely debated. The data show that S&P 1500 companies spent significant capital buying back stock between 2006 and 2008, only to pull back on buying between 2009 and 2011 when their valuations and share prices were much more attractive. The timing was terrible.

The same trend occurs with capital deployed toward mergers and acquisitions (M&A). Companies generally buy high and deploy a disproportionate amount of M&A capital late in the business cycle when valuations and fundamentals are often at their zenith. Companies also tend to increase capital spending in the middle or later parts of other economic expansions—right before demand for their goods declines.

However, the fact that the average company deploys capital suboptimally does not predestine every firm to do so. Not only is it possible to beat the odds, but it is also becoming an imperative. With structurally slower economic growth across most of the developed world, there is more excess capital that needs to be redeployed each year. The returns on this excess capital are becoming a larger driver of long-term shareholder returns, as well as an increasingly important source of sustainable, competitive advantage for firms that deploy capital well.

As a result, it is imperative for boards to create sustainable, comprehensive processes around capital allocation to maximize long-term shareholder value while also benefitting all stakeholders.

I’ve been analyzing companies’ capital allocation decisions and strategies for more than 23 years, first as an analyst, then a portfolio manager, and now a chief investment officer and head of investment strategy. I’ve come to learn that there are several key actions boards must embrace to build strong, repeatable processes around capital allocation. Below are three of the most important.

Compare Returns of All Alternatives When Deploying Capital

Every capital deployment decision should be subject to a comprehensive analysis of the expected cash-on-cash returns over the intermediate term, followed by a comparison to the returns from alternative forms of capital deployment.

In addition, it is essential to consider how the decision will impact the firm’s return on invested capital, free cash flow per share growth rate, cyclicality, and organic growth rate relative to all the various alternatives, including taking no action. Some of the best capital allocation decisions are those to say, “No.”

Monitor the Returns from Capital Deployment

The importance of monitoring returns on capital deployment goes much deeper than simply holding management accountable. It is an opportunity to learn from success and failure.

As part of their normal capital allocation review, boards should ask the following questions:

What are the characteristics of prior capital deployments that delivered strong, mediocre, and poor returns?Which capital deployments generated returns that surpassed our original projections? Which capital deployments generated returns that came in below our original projections? Why?What can we do better and how are we going to do it?

A board that is willing to examine past decisions critically and learn from them is far more likely to improve over time and avoid repeating mistakes.

Never Deploy Capital from a Position of Weakness

A firm should not alter its capital allocation framework, objectives, or return threshold because of changes in the core, underlying business. The firm should not undertake acquisitions, repurchase shares, or approve a large capital spending program to cover up a potential earnings-per-share miss or top-line air pocket. Letting returns become subservient to some broader strategic objective and deploying capital from a position of weakness are likely to destroy shareholder value. Historical evidence also suggests that this defensive capital allocation strategy not only tends to harm long-term shareholders, but frequently fails to achieve the strategic objective underlying the poor capital allocation decision.

For more best practices around capital allocation and to learn from companies who have it figured out, see David R. Giroux’s Capital Allocation, to be published in December.

David R. Giroux is a portfolio manager in the US Equity Division at T. Rowe Price. He manages the US capital appreciation strategy, including the capital appreciation fund. He also is head of investment strategy and chief investment officer for equity and multi‑asset. He is a vice president of T. Rowe Price Group.

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Directors Challenged to Respond to New DOJ Corporate Fraud Initiative

The US Department of Justice’s (DOJ’s) new policy on corporate fraud enforcement and individual accountability is a significant development around risk, and corporate directors should be aware.

As Deputy Attorney General Lisa O. Monaco announced on October 28, the new policy represents a return to the stricter enforcement posture of the administration of Barack H. Obama. In that regard, the policy has implications for board oversight of the corporate legal function and will likely affect how boards evaluate risk and oversee the effectiveness of compliance and ethics programs.

According to Monaco, this shift in enforcement policies reflects the confluence of three developments: the increasing national security dimension associated with corporate crime, the dramatically increased role that data analytics is playing in corporate criminal investigations, and criminals’ interaction with emerging companies in the technology and financial sectors in a way that exploits the investing public. The DOJ’s overarching goal is to “protect jobs, guard savings, and maintain our collective faith in the economic engine that fuels this country,” Monaco said.

The leading theme of the new policy is its unambiguous prioritization of individual accountability in corporate criminal matters. This translates, in part, to a reminder for federal prosecutors to concentrate on individual accountability—at every level of the corporate hierarchy—from the beginning of a criminal investigation.

To this end, the DOJ is restoring prior guidance that premises the receipt of cooperation credit on a company providing the government with all non-privileged information about all individuals involved (not simply those “substantially involved”) in alleged misconduct, regardless of their position, status, or seniority. This disclosure expectation may create significant tension between governance and management during internal reviews, risk evaluations, and investigations.

Reflecting its commitment, the DOJ is providing “surge resources” to its prosecutors, including by embedding a squad of Federal Bureau of Investigation agents in the department’s Criminal Fraud Section and by establishing a Corporate Crime Advisory Group. The DOJ is also urging prosecutors not to be deterred by the fear of losing cases but instead to “be bold” in holding individuals accountable for corporate crime.

The new DOJ policy also includes a series of initiatives related to companies’ prior misconduct and how that may affect DOJ decisions concerning the appropriate corporate resolution. The DOJ’s underlying message is that enforcement at any level should be a matter of concern because the new guidance says that essentially all former enforcement actions are relevant.

In addition, the policy makes clear that the DOJ will consider imposing corporate monitors in the resolution of any corporate criminal investigation when it is appropriate to do so in the interests of continuing compliance.

There is little doubt that the new DOJ policy represents a marked change from the approach of the previous administration. Reorienting strategy, risk evaluation, and executive sensitivity may be challenging and require particular emphasis on tone at the top from the board. The increased risk of enforcement is not just management’s problem.

Thus, it will be important for boards to direct management to reinvigorate its compliance and related protocols, ensuring that they are adequate to respond to this new enforcement environment. Boards should also encourage management to support corporate citizenship efforts, prioritize remediation, and promote cultural change even when seemingly inconsequential (i.e., low-dollar-value) penalties are imposed on the company by a governmental entity. For as Monaco noted, the new policy “is a start—and not the end” of the DOJ’s focus on corporate crime.

Managers and employees may be cynical about the extreme shifts in enforcement policy that seem to arise with each change in administration. It’s the “I’ve seen this movie before” attitude that can disincentivize management or employee buy-in. The board should anticipate such cynicism and move vigorously to ensure that the organization’s culture remains committed to ethical conduct and to legal compliance. That may not be an easy task.

Michael W. Peregrine is a partner at McDermott Will & Emery.

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COP26 Intensifies Boards’ Role in ESG Oversight (The Fundamental Shift in Finance Is Here.)

The United Nations’ annual conference on climate change, which took place in Glasgow and is commonly referred to as COP26, concluded Saturday. The two-week conference produced many historic moments, such as the United States committing to a net-zero economy by 2050 and phasing out federal financing of fossil fuel projects abroad by the end of 2023.

In addition, the Glasgow Financial Alliance for Net Zero was created, comprising 450 financial institutions representing more than $130 trillion in assets. A new global environmental, social, and governance (ESG) framework was also announced—the International Sustainability Standards Board—that aims to provide investors with consistent, comparable reporting of ESG data across countries.

Notably, the event culminated in 200 countries signing the Glasgow Climate Pact. This new agreement includes key elements around phasing down the use of fossil fuels, phasing out some fossil fuel subsidies, increasing climate financing for developing nations, establishing a carbon offset market framework, and requesting all parties come to COP27 next year with updated plans on how they will reduce greenhouse gas emissions by 2030.

Many expect the trend of private ordering that we’ve seen across 2021, with multiple stakeholders pushing for verification that companies are considering climate risks, to continue—increasing the expectations on and of directors. Below are key takeaways and considerations for boards:

1. Understand the energy transition’s financial impact on the business. A key focus of COP26 was the transition away from fossil fuels and toward a net-zero economy, one in which the emissions created are equal to those removed. It is imperative that directors understand how this transition, however fast or slow, will impact business operations and that they ensure this new expectation is reflected in corporate strategy.

Key questions for directors to consider:

How will the transition away from fossil fuels impact our business operations? Do we need to accelerate the retirement of high-carbon assets? How will that affect our balance sheet over time?What is the company’s decarbonization strategy? Are we ready to set our own (realistic) net-zero target?How will the energy transition impact our cost of capital?

2. Know that oversight of climate-related risks is becoming mandatory. While investors have focused on the board’s understanding and oversight of climate-related risks in certain industries, all directors should be prepared for an increased focus on climate competency. Investors are specifically looking for disclosure aligned with the Task Force on Climate-related Financial Disclosures recommendations. Insight into how directors are considering the energy transition’s impact on the business is critical—a lack of disclosure may have implications for director elections, as seen during the 2021 proxy season.

Key questions for directors to consider:

How is the board overseeing climate-related risks? Are climate risks actively integrated into the company’s enterprise risk management process, or are they presented in a silo?How often is management reporting on climate-related risks to the overall business? How are they determining which of those risks are material?What are the company’s top climate risks, and how are we prepared to mitigate those risks?

3. Prepare for increased regulation to meet the US reduction goals. The United States set a target of reducing its net greenhouse gas emissions by at least 50 percent below 2005 levels by 2030. To meet this target, the largest emitters in the United States—corporations—will need to reduce their emissions. Directors need to ensure their management teams have a realistic and achievable decarbonization plan that can be discussed with both shareholders and regulators, such as the US Securities and Exchange Commission (SEC). 

Key questions for directors to consider:

What is the implication of a carbon tax for the company’s operations?How exposed is the company to a more activist regulatory and legal environment?Has the company scrutinized whether management’s decarbonization pledges and targets are feasible?Does the company have an effective internal process to comply with mandatory climate risk disclosures, which the SEC is likely to require over the next 12 to 18 months?

4. Ensure audit committees play a more active role in ESG reporting. The rising likelihood of SEC regulation around climate-risk disclosure, combined with investors’ expectations around disclosing information on climate-related risks, requires companies to ensure the data integrity of their ESG disclosures. As companies ramp up their reporting and reduction commitments, the board—and in particular, the audit committee—has a critical role in ensuring data integrity and rigorous internal controls around ESG data.

Key questions for directors to consider:

How was the data in our ESG report audited and verified?Does the company have the same internal control procedures for ESG metrics and reporting as it does for financial data?

5. Don’t forget the opportunities. While risks abound from the transition to a net-zero economy, directors can encourage management to see the forest for the trees—the energy transition offers ample business opportunities and new revenue streams. Directors should encourage their management teams to explore new revenue-generating opportunities in addition to identifying relevant risks. Companies can differentiate themselves by driving positive socioeconomic outcomes for the business that benefit all stakeholders.

Key questions for directors to consider:

Where can the business reduce costs or create new cost-saving initiatives because of the climate transition?How will this impact our customers and their expectations? Are there opportunities to create new products or services to help clients meet their own commitments? How is management considering ESG opportunities when performing due diligence for mergers and acquisitions?

The outcomes of COP26 will accelerate action by both governments and private markets. There is an increased priority placed on mitigating climate-related risks and integrating climate-related concerns into core board oversight and company strategy. While many of the considerations discussed above are longer term, in the short term, directors should expect a more intense 2022 proxy season, with a heavy emphasis on climate risks and how the company will help achieve the lofty goals set at COP26.

While acting Comptroller of the Currency Michael J. Hsu’s recent comments on climate centered around bank boards, his words ring true for all directors: “Questions that directors ask senior managers can shift [bank] priorities, reveal hidden strengths, expose fatal weaknesses, and spur needed changes.”

Limor Bernstock is senior director of governance and sustainability and Leah Rozin is director, head of governance and sustainability research at Rivel.

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How Transparent Is Your Audit Committee? Three Reasons to Increase Disclosures

Since the Sarbanes-Oxley Act passed in 2002, audit quality in the United States has never been stronger. Thousands of high-quality audits are performed each year, promoting investor confidence in public company financial reporting.

Sarbanes-Oxley requires that public companies’ independent audit committees hire, compensate, and oversee the external auditor’s work. This ensures the external auditor remains independent of the company management that the auditor interacts with day to day throughout the audit process.

The Center for Audit Quality, in partnership with Audit Analytics, measures how public companies’ audit committees approach communicating about their external auditor oversight activities. We’ve published our findings annually since 2014 in the Audit Committee Transparency Barometer.

While our 2021 findings continue to demonstrate a positive, long-term trend of increased voluntary audit committee disclosures, opportunities remain for public companies to increase their transparency around audit committee activities. But why do these disclosures matter?

1. Disclosures are positively correlated with audit quality.

A 2021 study found that disclosure around the audit partner selection process is positively associated with audit quality. Specifically, the study found the following:

Increased audit committee involvement resulted in the selection of rigorous audit partners.Audit committees that disclosed their involvement tended to be more engaged in the selection process.

Accurate, transparent, and reliable financial statements are the backbone of our capital market. It is incredibly important to choose the right audit partner to lead and manage the audit. Increasing disclosures around the audit committee’s involvement in the audit partner selection process can contribute to high-quality audits.  

2. Investors are increasingly using disclosures to make investment decisions.

Investors depend on the information they receive from public company management to make investment decisions. One area that investors are increasingly interested in is cybersecurity—and for good reason. According to PwC’s 2020 Global Economic Crime and Fraud Survey, cybercrime made up 34 percent of all fraud events, outpacing accounting and financial statement frauds, asset misappropriation, and tax fraud.

Even before the pandemic, public companies were increasing—and disclosing—their use of cybersecurity technologies. Our report found that the most dramatic voluntary audit committee disclosure increase continues to relate to responsibility for cyber-risk oversight, growing from 11 percent to 46 percent of S&P 500 companies disclosing this between 2016 and 2021.

This is a positive step toward increasing investor trust. Public companies and their audit committees should consider what other information outside of financial statements are of high interest to investors, such as environmental, social, and governance issues.  

3. Transparency can dispel criticism.

From time to time, critics argue that audit committees don’t exercise enough oversight and that they are ceremonial in nature. Disclosures are a powerful tool for audit committees to increase transparency on the many important activities they perform on behalf of investors.

While public companies have made great strides in increasing their disclosures, there are opportunities for improvement, including as they relate to the following:

Fee negotiation. This does not mean simply stating the audit committee’s responsibility to compensate the external auditor but also providing insight into how fees were negotiated. Were they negotiated with audit quality in mind?Explanation for changes in audit fees. Specific reasons for changes in the fees paid to the external auditor can increase transparency and help stakeholders understand the correlation between fees and efficiency and quality.Significant areas addressed. What areas did the audit committee focus on and spend time addressing? The answer to this can demonstrate the seriousness with which audit committees take their oversight role and gatekeeper function.

To learn more, read the full 2021 barometer report. The report includes data on disclosures for the full S&P 1500 and provides examples of effective disclosure from companies such as MetLife, Darden Restaurants, and KeyCorp. 

Julie Bell Lindsay is the CEO of the Center for Audit Quality, a position she has held since May 2019. 

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Adam Grant Introduces Summit Audience to Scientific Thinking, the HiPPO Effect, and More

Adam Grant does not want directors to misunderstand what he’s suggesting. He is not encouraging leaders of America’s corporations to don a white lab coat and lean over a microscope, play-acting as a scientist. And he certainly is not suggesting that they take steps to actually kill—as in literally demolish—their own companies.

What Grant—organizational psychologist, bestselling author, and top-rated Wharton professor—did want his audience of directors to take away from his kick-off presentation at NACD Summit 2021 is this: it’s time to rethink and unlearn much of what leaders assume to be true. He wanted directors to adopt a scientist’s thinking patterns, relentlessly update forecasts, and run more experiments. And, yes, that includes contemplating on a regular, organized basis what it would take to kill their companies during what Grant dubs “pre-mortems.”

A high-energy tee-up to five days of discussion about the future of the boardroom, Grant’s October 4 session invited directors to take tangible actions to transform their businesses and provided three provocative steps to upend their fundamental business assumptions.

1. Think Like a Scientist

Grant wanted business leaders to not only create a supportive learning environment at their organizations. He also wanted them to schedule time to unlearn and rethink. “Don’t let ideas become your identity,” he implored at the virtual event.

At one Italian start-up, Grant told the audience, leaders were assigned to two groups: a control group and a “scientific thinking group” trained to view each product launch as an experiment, a chance to test their hypotheses. The scientific thinking group brought in 40 times the revenue of the control group. Their willingness to pivot made all the difference.

Too often, leaders embody the role of preacher, prosecutor, politician, or even cult leader, said the Wharton professor. He’s observed that people typically don’t want to be wrong and will die on the hill trying to be right. He urged leaders to liberate themselves from that trap. Adopting a scientist’s methodology, Grant said, “Look for reasons you might be wrong as [much as] reasons why you must be right.”

In the boardroom, Grant invited directors to use this method when considering CEO candidates amid board member disagreement. At the board table and in the C-Suite, leaders must commit to challenging each other, to asking a colleague certain of their opinion, “What evidence would make you change your mind?” Rather than continuing to see arguments as a chance to win, Grant implored, we should view them as a chance to learn. Approach disagreements as dances, not as battles.

To Grant, companies such as Blockbuster, Borders, and BlackBerry lost their hold on the market not because their leaders weren’t great thinkers, but because they weren’t quick enough to think again, to question the assumptions that served them in the past.

2. Update Your Forecasts

The difference between success and failure in any given decision, action, or plan? Frequently, Grant said, it’s the number of possible futures considered. If there are more than two, the likelihood of a win skyrockets. The key to victory is not intelligence or even grit. It’s how many forecasts are sketched out and how often they are updated.

And speed does count. When companies make a forecast and reapproach it with the scientist’s mindset, seeking where they may be wrong, they multiply their chances of landing a better, more accurate plan—one that can foresee black swans and mind the information they’ve not paid sufficient attention to. Grant suggested leaders rethink the forecasts the same day they formulate them.

Don’t have time to try this full tilt? Each additional forecast beyond the initial one or two increases the chances of accuracy exponentially, according to Grant’s findings.

3. Create Psychological Safety

Everyone has heard it said, “Don’t come to me with a problem unless you bring a solution.”

What does that create? A culture in which people are afraid to point out a problem unless they’ve figured out what can be done to fix it, Grant insisted. The result: a leadership team that never hears about what’s going wrong.

Once again, Grant invited the audience to upend their basic assumptions and replace the perennial “suggestion box” with a “problem box” to which people can submit observed trouble spots. Rather than solely having a reporting mechanism for technology bugs, add ones for “culture bugs” and “management bugs.” Grant emphasized that for meaningful success, “We need to hear unpleasant truths instead of comforting lies.” Psychological safety creates an environment inclusive of diversity of thought. It provides a fertile ground for folks to think again.

On a similar note, Grant discourages brainstorming en masse and on the spot, as it demands people voice fantastic contributions at the drop of a hat. Instead, he encouraged “brainwriting”: give people the challenge in advance, and have them come to the meeting with ideas, ready to discuss and debate. Encourage employees to put these ideas in the chat box during the first few minutes of a virtual meeting, and it’ll work wonders, he said. Above all, Grant wants people to work hard to defeat the “HiPPO” effect, in which the group reflexively bows to the “highest-paid person’s opinion.”

The target audience for Grant’s advice stretches from operational management teams to the boardroom. A brainstorming exercise he encourages boards to engage in is “kill the company,” created and propagated by founder and CEO of FutureThink Lisa Bodell. In this exercise, directors have a go at dreaming up ways in which the organization might be put out of business. Why have only post-mortems, he wondered, when we can convene pre-mortems?

Turns out that if leaders make it a habit to reimagine and rethink, are willing to update forecasts relentlessly, and create processes for really listening to their people, new levels of success are within reach every day.

Susan Paley is vice president of the NACD chapter network, executive sponsor of NACD Board Search, a former television script writer and producer, and certified as a leadership coach.

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