Capital allocation extends beyond financial factors

The principles driving corporate capital allocation are undergoing a dramatic revolution in SA and worldwide as management teams shift away from using purely financial considerations.

In addition to generating returns for shareholders, which historically informed nearly all capital allocation decisions, companies are placing greater emphasis on achieving a far more balanced range of objectives such as maintaining their social licence to operate and other environmental, social and governance targets.

A social licence to operate is the acceptance of a firm’s business practices by all its stakeholders, including shareholders, employees, consumers and the public.

In a survey conducted by EY, including more than 500 global CFOs, 72% of them admitted that their capital allocation processes needed improvement. Only 40% of them said that their capital allocation approach had enough flexibility to cater for an ever-changing operating and sociopolitical environment.

While capital allocation has long been thought of as the assessment, planning, review and prioritisation of the use of financial resources across an organisation, it has evolved to be much more than that. It is now a far more nuanced set of targets, benefiting a far greater base of stakeholders.

Sasol, for example, recently made it clear that sustainability will be the defining topic until 2050, with greater focus on environmental, social and governance (ESG) goals in capital allocation. It also anticipates viable green technologies becoming more economic in future.

MORE CAUTIOUS

Though it may seem counterintuitive to the traditional approach in which shareholders demand financial returns for the capital that they provide to investee companies, sustainability has become an important requirement to them, too. An investment is only a sound one if it is made in a company that can balance these financial returns with longevity, which requires good governance, social responsiveness and environmental responsibility.

It may well be part of this realisation, that led to SA’s private, nonfinancial corporate now holding more than R1-trillion, according to the Reserve Bank. While some commentators believe that this is driven predominantly by policy and economic uncertainty, EY is of the view that companies are also more cautious in developing and selecting capital applications that enable them to achieve their broader goals. Noble goals are however not enough: a company has to build the capacity to accurately assess whether a specific decision will yield the desired results, as set out in ESG goals. The measurement of these goals is far more challenging than a simple return-on-investment, or return-on-capital calculation. How is social impact best measured? What goes into measuring whether a specific investment promotes a net zero carbon goal?

It is when wrestling with these broader measures for achieving a differentiated set of goals that the information used to assess a specific use of capital also comes into sharper focus. A total 42% of the respondents to the EY survey cited insufficient data as one of the primary barriers to the optimal allocation of capital.

MINING INDUSTRY

SA investors have seen this play out in investments made by companies that did not pan out as expected, and even jeopardised their overall financial stability.

Nowhere is this more evident than in the mining industry, notorious for its capital intensity and the volatility of earnings driven by a combination of exchange rate and commodity price uncertainty.

But a well-timed, and properly considered allocation of capital can have a positive effect.

Sibanye is a good example. It has delivered record results driven by a decision to allocate capital to diversification and expansion, based on detailed assessment of the prospects. This has not only brought the company financial rewards, but also longevity in the form of a stable of new, long-life assets that play into global environmental and emissions targets.

Another challenge is monitoring capital allocation decisions. A robust tracking system can enable project owners time to fix projects and creates a culture that allows the freedom to fail and kill underperforming projects.

Historically, SA investors have often believed that a specific project or transaction cannot be paused, or abandoned, if too much time and money has been spent on it. Over the past few years however, some companies have boldly stepped away from strategies that did not play out as anticipated — expansion into Africa or further afield come to mind.

This resulted in divestiture of assets that did not enable the company to meet its overall strategic objectives. Instead, funds were applied to better aligned capital priorities.

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