Levels of Capital Allocation

The term “capital allocation” has many different meanings — Each level of allocator has its own decision-makers and risks — Confusing the levels undermines effective decision-making.

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LEVELS OF CAPITAL ALLOCATION

Few phrases appear more often in investment writing than “capital allocation,” and few are used with less precision. The same two words describe a plant manager approving a new machine, a chief executive pursuing an acquisition, a portfolio manager buying a stock, and a pension fund creating a model portfolio. These are not variations on a single skill but distinct disciplines, practiced by different people and governed by different definitions of risk.

We find it useful to think of capital allocation as a ladder. At the bottom sit the countless operating decisions made inside a business every day. At the top sit the asset allocators who spread capital across the globe.

As we climb, both the decision-maker and the analysis change. Knowing where a decision sits on that ladder is the first step toward excellent capital allocation.

Inside the Business

Capital Expenditures

In 2024, S&P 500 businesses spent roughly $1 trillion on capital expenditures. No executive team could approve those decisions one by one. Instead, the deployment of a trillion dollars in capital is the sum of many smaller choices made by employees.

Risk at this level is largely execution. Employees purchasing and operating the equipment are generally specialists, and projects are small compared with the scale of the business.

Notably, there is little “valuation” work and typically no financing choice involved in these decisions. The price of equipment is largely set, outside of some potential negotiation with the supplier, and internal cash flow usually covers the bill. This simplifies the decision-making: given the fixed price and the absence of a financing decision, the choice is binary—will the return on the spend hit our hurdle rate, yes or no?

M&A

In 2024, U.S. businesses spent over $1.7 trillion on M&A, decisions made by senior management and boards.¹ The risk associated with these decisions is far greater than typical capital expenditures.

M&A involves not only execution risk but also more complex valuation issues. In theory, sophisticated management teams know how to allocate capital. Unfortunately, studies spanning thousands of transactions find that most acquisitions fail to create value for the acquirer, with failure rates estimated at 70% to 90%.²

Valuation is a far trickier topic than most are willing to admit, making this level of capital allocation more difficult than it first appears.

Buying Back Shares

The third decision inside the business is the return of capital. In 2024, S&P 500 companies repurchased over $900 billion of their own shares and paid over $600 billion in dividends.³ Paying a dividend passes the capital allocation decision up the ladder; we’ll focus on management’s buyback choices.

This capital allocation decision requires comparing the returns on buybacks with all other potential uses of capital, not only today but into the future and at varying prices. This makes the decision more complex than capital expenditures, where the price or return is generally stable, or M&A, where opportunities typically present themselves at a single point in time.

Buybacks have proven to be particularly challenging as studies consistently show businesses buy back shares in good times, at high prices, and sell shares in bad times, at low prices. Failing to appreciate the opportunity for future buybacks drives much of this poor decision-making.

Where Market Risk Enters

The next rung leaves the business entirely. Active investors allocate capital across public companies in search of the best returns for the risk they take. This is the level most people picture when they hear "capital allocation," and it is the first rung where the concept of a risk-adjusted return becomes coherent.

When risk is defined as the volatility of a market price, calculating a risk-adjusted return requires a liquid market in which that price is continuously set. A plant manager weighing a new machine has no such market and no such number.

It is not enough for active investors to generate strong returns; these returns are continually evaluated against the volatility of share prices, a measure of risk we believe is ill-defined. This concept of risk is completely foreign to any decision-maker at a lower level on the capital allocation ladder.

The Top of the Ladder

At the summit sits asset allocation, and here the discipline changes once more. Asset allocators, whether an individual saver or a sovereign wealth fund, choose among cash, bonds, credit, public and private equity, and other investment options.

At this level, diversification is the closest thing finance offers to a free lunch, reducing risk without a matching sacrifice in expected return. Unfortunately, this free lunch does not extend down the ladder. An employee choosing equipment for a single project cannot diversify across machines, companies diversifying into unrelated businesses tend to destroy value, and even active investors face a limit, as maximum diversification simply reproduces the index.

Making decisions at this level requires completely different training and a different evaluation of risk from that required at lower levels of the ladder.

Knowing Your Rung

Capital allocation is not a single competence but a family of related disciplines stacked one atop another. The process and tools for making responsible decisions change at each level, as does the evaluation of risk.

In this context, identifying the “highest and best use of capital” is a far more challenging task than it appears at first glance.

Notes:

1. US M&A Deals | 2. M&A Failure Rate | 3. S&P 500 Buybacks