The Capital Allocation Committee

CEOs are better leaders than capital allocators — A dedicated committee can address this problem — The right structure makes discipline the default.

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THE CAPITAL ALLOCATION COMMITTEE

After years climbing the corporate ladder, what CEO doesn’t want the ability to make splashy M&A deals, repurchase shares at any price to support his or her option value, and approve every request for capex as opposed to earning a reputation as a curmudgeon?

For many CEOs, allocating capital is more fun and less work than leading and inspiring in the field.

The Challenge

Capital allocation is inherently situational. The role of capital allocator differs for every business. Most companies offer a capital allocation strategy, but this strategy is typically a list of every available capital allocation tool.

M&A has repeatedly proven dilutive to shareholders, yet empire-building CEOs ignore this truth. Share buybacks are typically done at the worst time, resulting in a lack of capital in downturns when buybacks would be accretive. Dividends have been de-prioritized despite accounting for approximately 31% of the S&P 500’s return since 1926.¹ 

Public market investors recognize the difficulty of capital allocation and willingly pay a premium for businesses where capital allocation is simple. The market rewards companies that grow organically and use excess capital to fund this growth. Similarly, dividend aristocrats earn premiums for their consistent, simple strategy of returning cash to shareholders.

Ultimately, capital allocation can be easy, but only with the discipline to avoid squandering other people’s money. This discipline is often lacking.

Our Plea: The Capital Allocation Committee

Separating capital allocation decisions from the CEO’s day-to-day responsibilities is a best practice, as evidenced by Berkshire Hathaway’s success. In the absence of a Buffett-level capital allocator, companies should establish a dedicated Capital Allocation Committee.

A small group (CEO, CFO, Chairman, etc.) should serve as the decision-makers. Valuation and due diligence should be handled by a dedicated support team.

This structure enables the team to produce standardized, unbiased valuations to inform M&A and buyback decisions. In the absence of these opportunities hitting high hurdle rates, the committee can simply decide between paying dividends or holding cash.

This committee should meet only as needed and meetings should be short. Strict hurdle rates, unbiased models, and a simple decision framework minimize discussion.

The Functional Operations

A conservatively constructed valuation model should be used for share buybacks. The committee should meet when share prices experience drastic declines, and approve sporadic, highly accretive repurchases.

For M&A, an independently built valuation model can be compared against internal investment opportunities, absolute hurdle rates, and buyback accretion.

This valuation decision should stand apart from the strategic nature of the deal—when an acquisition is deemed “strategically necessary” it is likely because the valuation does not make sense.

Finally, a strict leverage threshold should be set in stone. Imperiling a business’s long-term future for short-term M&A or buybacks is never the right move.  

A Nuisance Committee

This committee should be deliberately inconvenient. Meetings should frustrate participants and be less enjoyable than day-to-day operational roles.

High hurdle rates should deter weak M&A proposals and allow the team to quickly triage deal flow. Superfluous capital expenditure requests will be eliminated as managers learn they won’t be approved. No discussion about buybacks will be necessary as decisions will be guided by a conservative model.

With this dynamic, few committee meetings will need to be called. Like Warren Buffett sitting on his hands in Omaha, this committee should strive for similar lethargy. Only through restraint is capital available at the infrequent but most opportune times.

The Disciplined Approach

Nothing said above is exciting. There is no glamor in sitting on one’s hands or playing the “abominable no-man.” The rewards of this approach are not immediately visible, particularly compared to the headache of implementing and executing this approach.

This explains why so many businesses continue to mismanage capital, destroy value, and disappoint shareholders.

¹ S&P Global