Improving the capital allocation decision-making process
In an increasingly complex business environment, using risk-return techniques to allocate resources across projects or business units can promote more robust decision-making, according to a new Deloitte report.
Current decision-making practice has a number of limitations, including inconsistency in planning assumptions, as well as in the evaluation of constraints and appraisal techniques, according to the report, Enhanced Portfolio Management in Uncertain Times. Focusing solely on investment or business unit return, without taking into account the risks involved, is another common drawback. Case-by-case appraisal, resulting in return-driven capital allocation, can also lead to unexpected portfolio concentrations.
The approach to portfolio management described in the report builds on current processes to incorporate transparency into the assumptions made and seeks to improve the quality and consistency of supporting data. The aim is to provide a quantified view of risk and incorporate it into the decision-making process.
Use of the approach facilitates the comparison of diverse investment opportunities and considers them in the context of the overall portfolio and the business’s risk appetite, the report says. It can also help businesses identify where to prioritise capital spending to deliver maximum return for an acceptable risk and where capital should be allocated within a particular business unit to support the company’s strategic objectives. Further advantages include improved transparency and communication with stakeholders, according to the report.
The approach draws on elements of the best practices witnessed in the financial services sector and adapts them to the corporate environment. In consumer businesses, for example, it can contribute to a deeper understanding of the relative risk and return of strategic investments in emerging markets. It can also provide quantitative insight on reputational and brand-resilience risks. For life sciences firms, it can yield a risk-return profile for each element in the research-and-development pipeline, as well as the portfolio. The approach can also point to more realistic measures of return that recognise the challenges inherent to the sector, such as long lead times and low probability of success.
The steps towards an enhanced approach to corporate portfolio management, according to the report, are:
Step 1: Evaluate the key risks and sources of uncertainty. Move beyond qualitative rankings of impact and likelihood to develop quantitative estimates for investment or business-unit-specific risks, as well as cross-business risks.
Step 2: Identify the risk-return metrics and planning assumptions. Evaluate decision-making criteria and associated metrics. Define common planning assumptions and parameters. And build consistent investment “base cases” for the range of capital allocation options.
Step 3: Develop the universe of capital allocation options. Build the portfolio model to:
- Consolidate the range of capital allocation options.
- Flex the “base cases” using the quantitative risk estimates.
- Run the “universe” of capital allocation options.
Step 4: Analyse outputs and take action. A quantitative risk-return analysis allows decision-makers to:
- Optimise the investment of incremental capital.
- Understand risk and return at the portfolio and business unit level.
- Align capital allocation with company risk appetite – maximising return for a given level of risk.
The authors recommend that organisations adopting the approach start with a pilot project in one area of the business. This creates the ability to make improvements to the process as it is rolled out to other units.
—Samantha White (email@example.com) is a CGMA Magazine senior editor.