Capital Gets a Reset

Among a number of capital-raising experiments, some companies are seeking investors for specific projects.
Andrew Schwedel, James Root, and James AllenOctober 2, 2017
Capital Gets a Reset

If you look at corporate spending and investment data today, you might conclude that CFOs are highly skeptical about investing in their businesses. Despite a steady decline in the weighted average cost of capital, which we estimate is now between 5% and 6% for most large companies, the average hurdle rate — that is, the minimum rate of return on a project or investment required by a manager or investor — has remained stuck at around 12.5%.

Capital expenditures and research and development budgets have declined on a relative basis, while share buybacks and dividends have increased. According to Reuters, among the 1,900 companies that repurchased shares between 2010 and 2015, buybacks and dividends amounted to 113% of capital spending, compared with 60% in 2000. Meanwhile, spending on R&D has aver­aged less than 50% of net income, compared with more than 60% in the 1990s.

In reality, many CFOs abhor this dynamic. They, their CEOs, and their board members have voiced increasing dissatisfaction, and many institutional investors such as Vanguard, BlackRock, and Warren Buffett have urged greater long-term focus and reinvestment.

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At the same time, however, activist investors have been successful in applying shorter-term pres­sure to the CEO agenda at publicly traded companies. As a result, some companies have been experimenting with alternative investment models.

For example, pri­vate equity firms, which are not subject to such short-term pressure, have lengthened their investment horizons to create value with their portfolio companies, from an average 4.5 years in 2006 to 6 years in 2016. Blackstone, Carlyle Group and others have recently launched funds with even longer target holding periods. Scale start-ups — the leading engine of job creation — are staying private longer, and in some cases they’re even going straight from venture to private equity ownership to provide liquidity to early investors and employees.

New vehicles are also emerging to connect investors to specific investments within a firm — investments that are suited to investors’ risk profiles and do not involve owning a share of the whole entity.

In health care, Pfizer and other pharmaceutical companies have lined up one-off funding for the development of specific prod­ucts, matching their capital needs with the risk prefer­ences and expertise of individual investors. In 2014, Unilever issued a “green bond,” offering clearly defined criteria on greenhouse gas emis­sions, water use, and waste disposal for the projects funded. Peer-to-peer lending and crowdfunding plat­forms such as Kickstarter and GoFundMe illustrate another aspect of this evolution.

Traditional equity and debt raising will continue to be vital to corporate growth, but capital structures are becoming more flexible. That offers the potential to align investors more closely with a firm’s strategy, time horizons, and specific investment projects. That trend will bring its own set of pressures; the emer­gence of these new vehicles will offer new potential for activists to target specific pieces of firms, which will increase the sophistication required of a company’s investor relations strategy.

Over the next 10 years, it’s likely that the line between public and private ownership will blur. Large public companies will pursue long-term anchor investors and adopt the governance practices of leading private inves­tors, while larger private companies will trade in sec­ondary markets that require enhanced investor protec­tions. The line between debt and equity will also blur, as off-balance-sheet project-based equity becomes a significant funding source.

As more investors look for projects rather than companies, a new ecosys­tem of financial intermediaries will emerge to help them identify and gain access to the best projects. Traditional money managers will increasingly adopt activist investor techniques, both short and long term, in pursuit of better-than-average returns.

A useful way for CFOs and CEOs to take advantage of the capital reset is to ask themselves: What would we do if capital and investor require­ments were not a constraint? Are we able to identify more good ideas than we are willing or able to fund?

If so, it’s worth testing whether this is really an unbreakable constraint. In most cases, we believe, it is not. One no-regret action, then, would be to segment the investor base by degree of alignment with the strategy along two dimensions: time horizon and risk appetite. There’s an abundance of capital out there searching for projects that will create corporate growth, and CFOs now have new avenues to tap it.

James Allen co-leads Bain & Company’s strategy practice, James Root leads the firm’s organization practice for Asia-Pacific, and Andrew Schwedel leads its Macro Trends Group.