The CEO as an Investor: The Capital Allocation Officer
The CEO as an Investor: A Framework for the Capital Allocation Officer
José Antonio Marco Izquierdo Partner with Magnum Industrial Partners. Director of Iberwind
Orliman. Former McKinsey senior consultant. Spain.
A CEO may have never tackled a capital allocation job in previous jobs, while now, on his top position, he is responsible for the capital deployment of 50% of the firm market cap over a 3 to 5 year period. Quoting Warren Buffet, CEOs' experiences usually come from the industry and not from capital allocation. Furthermore, boards focus more on loyalty and prudence than on value creation, the laser-focus of private equities and value investors. The Capital Allocation Officer role has also had limited coverage in media and corporations. CEOs need to recognize that proper capital allocation is a strong value driver and that need to be involved in such process regardless of their preferences and knowledge, and even learn from or hire excellent capital allocators. CEOs need to design an investorbased capital allocation framework that guides their decisions and facilitates board's long term value creation.
Capital Allocation Officer; CEO; Return on Capital Employed; Investor; Framework
Un consejero delegado puede no haberse aproximado a
la función de asignación de capital en sus posiciones
previas, mientras que ahora, en la posición de máxima
responsabilidad de la compañía, es el agente decisor de
invertir, en general, el 50 % del valor de los fondos
propios de la compañía que dirige en un período de tres
a cinco años. Citando a Warren Buffet, las experiencias
de los consejeros delegados vienen generalmente de la
industria y no de funciones relacionadas con la
asignación de capital. Adicionalmente, los consejos de
administración se enfocan más en su deber de lealtad y
prudencia que en su función de creación de valor, el
principal foco de inversores de capital privado y value. El
rol de “director de asignación de capital” ha tenido una
cobertura limitada en las corporaciones y en los medios
de comunicación. Los consejeros delegados necesitan
comprender que una asignación de capital óptima es
una gran palanca de creación de valor y que, por tanto,
es prioritaria su involucración en dicho proceso de
asignación de capital, independientemente de sus
preferencias o conocimiento previo, e incluso deben
aprender o reclutar a profesionales de la asignación de
capital. Los consejeros delegados necesitan diseñar un
modelo de asignación de capital desde una perspectiva
inversora, asegurando que sirve de guía para la toma de
decisiones de inversión, así como fomentar la creación
de valor desde el consejo de administración.
Director de asignación de capital, consejero delegado,
retorno de capital empleado, inversor, framework.
T heads of many companies are not skilled in capital allocation, and that it is not
he legendary investor Warren Buffet said more than 25 years ago (Buffet, 1987) “that
surprising because most bosses rise to the top because they have excelled in an area
such as marketing, production, engineering, administration or, sometimes, institutional
politics”. Buffet followed by saying that those few CEOs that recognize their lack of capital
allocation skills try to compensate by seeking advice accentuate the capital-allocation problem;
that implies that the decision and analysis on capital allocation should mostly remain within
the shareholder and CEO, ultimately being the Capital Allocation Officer.
It is notable that the “Capital Allocation Officer” search in Amazon only provides 24 references
(none with such title), while the “Chief Financial Officer” search provides 25.359 references,
especially when more than 50 years ago Nobel Prizes Modigliani and Miller established the
return on firm investments as one of the five components that drive the valuation of the firm,
being probably the best proxy for value creation (Miller & Modigliani, 1961). In hindsight, the
sustainable success achieved by value investors supports the theoretical fundamentals even
more. The implication of such value driver that Modigliani and Miller established in 1961 can be
put in practical terms for top management and boards: a company deploys capital equal to half
or more of its market capitalization over a three-to-five-year period and, as Warren Buffet says,
the capital allocation skill of top management is usually limited.
This capital allocation skill is even more relevant in a low-growth world, where such growth lever
is difficult to apply, and hence the Return on Invested Capital (ROIC) appears to be the
prominent driver for value creation. For example, a ROIC increase of 1% for a firm with a Cost
Source: Author’s model1.
1 Cost of capital (WACC): 8%; Terminal growth rate: 5%.
Value created by 1% higher ROIC
Value created by 1% higher growth
of Capital (CoC) of 8% and ROIC of 8% would increase the Firm Value in 19%, while an
additional 1% in growth would generate no value. Once, ROIC is above the CoC, even small
growth is highly valuable: for example, an additional 1% growth rate in a firm with a ROIC of
10% (maintaining the same 8% CoC) would increase the Firm Value by 21% vs. a 12% increase
in value by a 1% higher ROIC, implying that once a company has a positive value spread
(ROIC-WACC), a 1% growth increase is more valuable than a 1% ROIC increase (figure 1).
Over the last 17 years I have been working first as a consultant on corporate finance and
strategy and the last 10 years as a private equity investor, and I have been intrigued by what
Warren Buffet stated more than 25 years ago and its implications: Why are so few CEOs
skilled at capital allocation?, does this statement still hold now?, what comprehensive
approach to capital allocation that investors apply could be used in the corporate world?, which
mindset, tools and processes should CEOs use to think as investor allocating capital? and,
ultimately, how boards should evaluate CEOs on capital allocation? The first section analyzes
CEOs’ skills on capital allocation using their previous experiences as a proxy. The second
section develops a comprehensive capital allocation framework from an investor point of view.
The third section applies such framework analyzing from a value point of view the different
capital allocation alternatives. Finally, the fourth section sets a capital allocation scorecard to
facilitate both CEOs and Boards to think as investors and comply with one of the key fiduciary
duties of both roles.
1. Why are so few CEOs skilled at capital allocation?
In his 2011 letter, Warren Buffet stated the first law of capital allocation by saying that “what
is smart at one price is dumb at another” (Buffet, 2011); how many CEOs have been trained
on valuation on the broader sense (strategy at industry and company level and corporate
finance) to determine the price and value of investments? The empirical evidence of
analyzing the former experiences of current CEOs across developed markets provides that
such experience on capital allocation is limited, as Warren Buffet stated more than 25 years
ago. That is, 50% of the CEOs of the companies in the DJIA Index have previous experience
in corporate finance or strategy, either within their industry or company (33%), or as an
advisors (just a few as an investors). That same figure decreases to 32% for those CEOs
running the companies of the EuroStoxx 50 and to 30% for those CEOs that were included in
the HBR Best Performing Ranking (Ignatius, 2014). However, there is a higher percentage of
those CEOs with previous direct corporate finance and strategy experience, as an advisor or
investor, in the HBR Best Performing Ranking (70%) than in the DJIA (40%) or EuroStoxx
50 Index (56%) (figure 2).
Michael Jensen, a Harvard Business School professor, established in a seminal paper in 1986
(Jensen, 1986) that poor capital allocation was also due to an incentive problem of
management and that debt helped to reduce the so-called agency costs. That is, poor capital
allocation at corporations is due to both, lack of skill, as stated by Warren Buffet (Buffet, 1987)
and lack of will as stated by Professor Jensen (Jensen, 1986). In fact, the task of capital
allocation within the CEO role has not been given enough importance; as an example, less
than 5 out of 100 CEOs of the HBR best-performing ranking mention “return on capital” on
their official biography, and in particular none of CEOs whose companies are in the DJIA or
EuroStoxx 50 mention it.
Smart private equity investors and active value investors know that they cannot replace a CEO
for the management of current business operations, but they also know that they are better at
allocating the excess cash generated from operations or from external fund providers. That is
Percentage of CEOs with previous experience in corporate finance or strategy
(either within the industry or company or as advisors or investors)
HBR Best Performing Ranking
Europe (EuroStoxx 50)
Percentage of CEOs with previous experience in corporate finance or strategy for the
company they serve as CEO
HBR Best Performing Ranking
Europe (EuroStoxx 50)
Source: Author’s analysis.
probably the main reason why top quartile private equity firms and value investor firms
outperform public equity markets returns. These investors focus not only on their fiduciary
duty of loyalty and prudence but also on long-term value creation, a not so usual focus for
management and boards of public corporations. In fact, a McKinsey study (Bhagat, Hirt &
Kehoe, 2013) reveals that only 16% of board members understand how their firms created
value, and almost no CEO of companies in the DJIA or EuroStoxx 50 has a background in
private equity or value investment. Furthermore, the lack of concentrated ownership that
happens in private equity or tight family-owned companies means that corporate boards have
less incentives to be more knowledgeable and aligned on value creation. Management and
boards should devote skill and will to get smart on capital allocation as it generates long-term
value: a McKinsey Research (Hall, Lovallo & Musters, 2012) shows over a 20-year period that
those companies that shifted more than 56% of their capital across business units –the
aggressive allocators– delivered 30% higher return to shareholders than those that allocated
roughly the same amount of capital than the previous year. With such evidence, why is almost
non-existent the transfer of capital allocation skills from the value investor and private equity
industry to the corporate world? Those value creation opportunities that exist in these large
corporations are difficult to be captured by the current status-quo and that is one of the
reasons for the existence of the activist and value investment industry. For instance, the
“constructive” activism asset class is emerging as one of the most attractive ones (Cyriac &
Thomsen, 2014); over the last 10 years this class has increased its assets under management
from $50bn to $100bn, with 40 activist campaigns for companies above $1.8bn in 2004 and
48 campaigns for companies above $9.9bn in 2013.
2. An investor-based capital allocation framework
In private equity, and value-based asset management in general, a capital allocation framework
is built to provide clear answers around two questions (figure 3):
1. how attractive are current investments?, that is, do current investments generate a return
over their cost of capital, equity and debt?; this questions focuses around the so-called
2. how attractive are potential new investments?, that is, are potential new investments
expected to generate a return over their cost of capital?; this question focuses around the
so-called “Growth Assets”, always with risk-adjusted returns and cost of capital.
The first question is mostly related to the management abilities of the CEO and his team, but
the second question, where to put capital to work, is more related to an investor-based
understanding of the capital alternatives and their opportunity cost of capital. Briefly, (i) the
uses of capital can be to invest in the business (capital expenditures, working capital or
How to think about capital allocation alternatives
How to integrate a risk and portfolio view
Sources of capital
Operational cash flow
Mergers & acquisitions
Return to fund providers
• Are current and new investments earning
its cost of capital?
• How sustainable is the ROIC of current
and new investments?
• Which are the drivers of such ROIC
sustainability? (barriers to entry,
• Which is the ROIC spread of current and
• Which is the stress-test and ROIC
• Which is the impact of current or new
investments in the ROIC and ROIC spread
of other businesses?
• What is the absolute value creation of
current and new investments? How does
such value creation compare to other
investment opportunities in the broader
sense (e.g. return to funder providers
included –see left hand side of the graph)?
mergers and acquisitions) or return of such capital to fund providers (either shareholders, as
cash dividends or share buybacks, or debt providers) and (ii) the sources of capital can be
generated from the business, either operational cash flow or asset disposals, or from fund
providers, debt or equity.
The excellent capital allocators do not analyze each source and use in isolation but holistically,
comparing cost of capital of each source alternative with the return of capital of each use
alternative, always risk-adjusted, and considering the synergies derived from the portfolio
effect in risk and returns (Thorndike, 2012). It is clear that that task is very different than that
of managing the day-to-day of a business.
The role of the Capital Allocation Officer is to ensure that new capital is deployed in such a
way that the firm value spread (return on capital – cost of capital) is increasingly above the
long-term cost of capital of the firm (figure 4). Industry rivalry makes the firm ROIC to
converge towards the firm long-term cost of capital after a certain period of competitive
advantage, and it is the Return on Incremental Invested Capital (ROICC) deployed the one
that needs to be substantially above the firm long-term cost of capital, so that the target firm
ROIC increases. Both returns and costs are expectations, and therefore have a probability
distribution, that is why it is important that, the threshold ROICC considers a buffer for cases
of lower operating profits or additional capital for the same profits (the so-called “downside
risk capital”), and that management considers the long-term cost of capital vs. the so-called
“new-normal” lower long-term cost of capital.
Return and cost of capital
Role of the Capital Allocation Officer
Competitive Advantage Period
“One of the Pack” Period
Return on Incremental
Invested Capital (ROICC)
Firm ROIC (current assets)
Long-term cost of capital
cost of capital
3. The capital allocation framework in practice
A $500 million revenue firm with a 25% margin, that depreciates its fixed assets in 20 years,
that grows its profit at 5%, with an invested capital of $1.100m ($1.000m in fixed assets,
$100m in working capital that remains constant at 20% of its revenues), and a cost of capital
of 8%, has a firm value of $1.137,5m and 8% ROIC (figure 5). It is clear that the CEO needs to
manage current operations but also needs to decide how to allocate the excess cash that the
business generates from its operations (or from the funds generated from divestures, or raised
from external providers) to invest it into (1) current business operations, (2) business growth
or distribute it (3) to shareholders.
P&L and Cash Flow
Depreciation @ 5% fixed assets
Free Cash Flow from Operations
Increase in working capital @20%
of sales and growing at 5%
Capex @ 5% of fixed assets
Firm Value: EBIAT t+1 (1-g/r)/
WACC-G of which the growth rate
of EBIAT (g) is 5%, the ROIC of new
investments ® is 8% and the cost
of capital (WACC) is 8%
Invested Capital and ROIC
Figure 6 shows the value impact of the different capital allocation alternatives in firm value:
• To current business operations: an allocation to business operations with a 20% negative
deviation versus the base case in capex during 5 years would destroy 8% of firm value. The
amount of capex invested over this 5 years would have been a significant 26% of the firm
value, decreasing firm ROIC to 7.6%.
• To business growth:
– Organic growth: were 50% of the free cash flow invested organically over 5 years at a minus
5% ROIC, 7% of firm value would have been destroyed, having invested 18% of the firm value.
– Growth through mergers and acquisitions. A target company with a size of 20% of the
buyer’s EBITDA acquired at a 30% premium versus buyer’s fundamental value and a 6%
post-acquisition ROIC would destroy 9% of firm value, having invested 26% of the firm
• To shareholders: were free cash flow not distributed to equity holders over 5 years and
remain “invested” in the firm at 0%, that amount would represent 36% of firm value and
would imply a value destruction of 8% of firm value.
Capital Allocation – Current Business Operations
Capital Allocation – Business Growth
Capital Allocation – To Shareholders
Dividends (or buybacks at
20% over 5 years
20% increase in working
capital as a % of revenues
50% of FCF invested over 5
years at a –5% ROIC
FCF not distributed as
dividends over 5 years and
invest at a 0% ROIC
It is not very difficult to think of corporations that (i) retain cash at the firm and that is not
invested over long-periods of time, that (ii) invest in capital expenditures with cost overruns
(e.g. UMTS licences in the telecom industry), that (iii) decide to grow in products or
geographies that generate a risk-adjusted ROIC below firm CoE and that (iv) ultimately
overpay in acquisitions whose synergies do not materialize to sustain firm ROIC above firm
CoE. That cumulative set of capital allocation decision-making errors may add to material
value destruction (35% of firm value in 5 years as per figure 6).
4. The CEO and board thinking as an investor
A recent study by Graham, Harvey and Puri (2014) from Duke University analyzes among
1.000 CEOs and CFOs around the world the degree to which executives delegate financial
decisions and the circumstances that drive variation in the delegation. Such delegation varies
across corporate policies and the personal characteristics of the CEO. They found that CEOs
delegate more, the more informational input need from inside the firm. The research shows
that more delegation happens in capital allocation and investment vs. capital structure and
A CEO and board assessment on capital allocation
1. Historical track-record on capital allocation
b. Investments back to
c. Alignment to build
value per share
The Firm has earned its cost of
capital on the incremental invested
capital of capex, M&A and working
The Firm has returned cash to its
shareholders (either dividends or
selective share repurchases) and
debt providers when new investment
opportunities do not allow to
recover their cost of capital with a
margin of safety included.
Capital is allocated based on the
economic value of each investment,
adjusting for risk and portfolio
synergy value. Long-term value per
share is explicitly discussed.
CEO drives the capital allocation
process across the Firm,
understanding the alternatives in
Board is provided with a capital
allocation dossier for each major
investment opportunity and is an
annual monographic topic (including
the “post-mortem” discussion on
failed investments). Zero-based
capital allocation is performed.
Senior management is compensated
by long-term value creation per
share vs. a peer benchmark. BU
management is compensated by
ROIC and profitable growth.
CEO and Board understand ROIC and
ROIIC drivers and sustainability of
returns is explicitly discussed.
basecase ROIC, incorporating “downside
and stress capital” scenarios. ROIC
“through-the-cycle” is compared to
the long-term cost of capital (unless
for financially constrained firms).
2. Management and governance of the capital allocation process
3. Current performance on ROIC and capital allocation
Firms generates a ROIIC well above its Firm ROIC is below the risk-adjusted
risk-adjusted long-term cost of long-term cost of capital but ROICC
capital (+5%) and Firm ROIC is at least is well above (2%).
2% above its long-term cost of capital.
It is difficult to conclude that the
Firm has invested with returns above
its cost of capital. Firm does not
discuss its long-term value creation
approach or investment failures.
The Firm consistently returns a
predetermined capital amount to its
The Firm has destroyed value in
most of its investments over the
past 5 years.
The Firm capital back to
claimholders is not linked to its
Capital is allocated based on its Capital is allocated based on history
economic value with no discussion of and on the reference company
the differences in risk or synergy ROIC. Limited information is
contribution. provided to the board.
CEO is the ultimate decision maker
but delegates the task in a senior
management member. CEO only gets
involved analytically on M&A
Firm thinks on capital allocation on
an incremental basis, considering the
previous year capital allocation as
the starting point for the next year.
Compensation is not only linked to
long-term value creation per share,
ROIC and profitable growth, but also
to size and market index, with
weights are not clearly discussed.
Quantitative analysis across
scenarios is run without senior
A senior management member is
responsible for the capital
allocation, whose analysis are
mostly delegated to each business
Capital allocation is considered
within the inertia of the annual
Compensation is linked to size or a
general market or industry index.
ROIIC and Firm ROIC is well below
(2% at least) the risk-adjusted
longterm cost of capital.
Capital allocation is driven by the
returns generated on excess cash
payout, with M&A being the least delegated corporate decision as CEOs think they have a
great informational advantage. Also, and not surprisingly, CEOs delegate capital allocation
when they are overloaded, distracted by recent acquisitions and are less knowledgeable.
Furthermore, and a material difference versus private equity investors, capital is allocated
based on “gut feel” and personal reputation, with corporate politics and corporate socialism
affecting capital allocation in European and Asian firms. It is clear that there are firm value
creation opportunities for those CEOs that increasingly think as an investor.
To ensure that CEOs, and boards, think as investors it is useful to test current capital
allocation versus a capital allocation scorecard covering three capital allocation performance
vectors (figure 7):
• Historical track-record on capital allocation to monitor the degree of value creation on
capital invested (current business, growth and M&A) and capital return to fund holders
(equity and debt) and the criteria used for such allocation.
• Management and governance of the capital allocation process, that is, who gets involved
and decides, the type of capital allocation framework used, and the alignment of the
decision maker towards value creation on such allocation process.
• Current performance on ROIC and capital allocation, that is, whether the firm currently
creates value, both at firm level and on its incremental investments. It is also needed a
granular understanding of both the ROIC and ROICC drivers and a risk view on capital
allocation, considering risk adjusted returns through-the-cycle and long-term cost of capital.
Since 1999 and until 2009, S&P 500 corporations spent more than $3.9 trillion on capital
expenditures and were either the acquirer and/or the target in $13.6 trillion of M&A deals. Bottom
quartile companies realized an average ROIC of 6.7% over such decade, while top quartile
companies made an average ROIC of 16.7%. With over 50% of the firm market cap deployed over
a 3 to 5 year period, capital allocation decisions have a large and long-term impact on the value of
corporations and of the country, and society in general. However, top management focus (less
than 5 out of 100 CEOs of the HBR Best Performing Ranking mention “return on capital” on
their official biography) and skill is somewhat limited, at least, if compared with value investors.
A capital allocation framework used by value investors is discussed to help CEOs and Boards
to establish a systematic structure of analyzing and deciding on firm capital allocation. The
role of the Return on Incremental Invested Capital (ROICC) is covered to understand the
ROIC sustainability at firm level. A structured method to capital allocation will not be enough
if it is not complemented by an investor-based capital allocation mindset from top
management and capital allocation oversight by the board of directors. A capital allocation
scorecard ensures that such capital allocation culture is embedded within the organization and
controlled by the board.
«The CEO as an Investor: A Framework for The Capital Allocation Officer». © Ediciones Deusto.
Referencia n.º 4034.
Bhagat , C. , Hirt , M. , & Kehoe , C. ( 2013 ). Tapping the strategic potential of boards . McKinsey Quarterly , February.
Buffet , W. ( 1987 ). Berkshire Hathaway Inc. Annual Letter.
Buffet , W. ( 2011 ). Berkshire Hathaway Inc. Annual Letter.
Cyriac , J. , & Thomsen , J. ( 2014 ). The activist and you: Managing activist investors . McKinsey Alumni Knowledge Video Webcast.
Graham , J. , Harvey , C. , & Puri , M. ( 2014 ). Capital allocation and delegation of decision-making authority within firms . Journal of Financial Economics , 115 ( 3 ), 449 - 470 . http://dx.doi.org/10.1016/j.jfineco. 2014 .10.011 Hall , S. , Lovallo , D. , & Musters , R. ( 2012 ). How to put your money where your strategy is . McKinsey Quarterly , March.
Ignatius , A. ( 2014 ). The best performing CEOs in the world . Harvard Business Review , October .
Jensen , M. ( 1986 ). Agency Costs of Free Cash Flow , Corporate Finance , and Takeovers . The American Economic Review, 76 ( 2 ).
Miller , M. , & Modigliani , F. ( 1961 ). Dividend Policy, Growth, and the Valuation of Shares . The Journal of Business , 34 ( 4 ), October, 411 - 433 . http://dx.doi.org/10.1086/294442
Thorndike , W. ( 2012 ). The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success . HBS Press.