Capital Allocation: How to Emerge From the Pandemic In a Stronger Position

CFOs have to balance unforeseen COVID-driven capital issues with the need for investment that drives long-term value creation.
Vincent RyanOctober 7, 2020

COVID-19 has turned many industries upside down. Suddenly, high-performing companies have become cash-constrained during the pandemic while historically low-growth companies are selling out product and are flush with cash. For CFOs on both sides of this spectrum, making quick and effective capital allocation decisions may be more difficult than anticipated.

Evan Sussholz, Ernst & Young

Cash-constrained companies have likely had to decide how to quickly and effectively re-prioritize current and planned uses of capital. This is so that companies can redeploy cash to continue operations, maintain dividends, or service debt. Many news stories mention companies that are making across-the-board cuts in capex, R&D, or M&A instead of taking a “surgical approach” to cuts in capital spending.

On the other hand, companies facing surges in demand are likely focused on meeting the current demand, trying to understand how long the surge will last, and planning how to invest now to drive future value creation opportunities that can replace COVID-related sales. Despite their short-term differences, both types of companies face the strategic challenge of emerging strongly from the current downturn.

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Beyond the Pandemic

CFOs need to play a leading role in developing a disciplined capital allocation process that drives long-term value creation while also balancing unforeseen COVID-driven capital issues. They should have their finger on the pulse of macro-level factors such as industry-, economic-, and business-level performance to forecast and plan. This may require revamping the forecasting process by incorporating multiple scenarios and using nontraditional data points to increase effectiveness.

At the same time, CFOs should ensure the organization can make micro-level decisions through technology, tools, and formalized, yet agile, decision frameworks that allow for rapid re-prioritization.

For example, EY professionals helped a company in the medical device industry develop a real-time demand-and-supply model that leveraged publicly available COVID case information, regional differences in COVID restrictions (such as social distancing), and multiple scenarios. The model helped management predict changes in demand by product, customer, and region to make daily changes to production schedules.

Struggling With Success

The headlines are filled with companies struggling in this crisis and facing significant liquidity issues, but companies meeting newfound demand for products also have challenging decisions. While it may appear that these companies have had it easy because of their COVID-related success, the ability to capitalize on consumer demand has often required significant investment and agility and has not been without difficulties.

Ben Hoban, Ernst & Young

For example, a specialty retail company pivoted to invest heavily in digital to stay relevant with at-home and curbside pickup consumers. While doing this, it found that its existing capital investment process was less efficient when managing a significant number of digital investment projects. Instead of pulling back, the company took the time to review and update its investment process to incorporate key performance metrics more relevant to software and digital development.

CFOs of companies seeing current demand strength may need to find ways to balance capital demands and effectively deploy capital to drive long-term value creation, lest they find their place on the winners’ podium to be short-lived. For example, funneling significant portions of excess cash to build out additional capacity based on current demand may end up destroying long-term value if sales drop post-COVID and the capacity cannot easily be shifted to other products. This can lead to overcapacity and decreasing asset efficiency. The problem can be compounded if other strategic investment opportunities such as M&A, R&D, and divestitures were passed over to fund the build-out.

Given that capital is typically limited, there are ways that organizations can balance these short- and long-term priorities:

  • Expand smartly by considering joint ventures, alliances, or partnerships; this allows for expansion and strategic investment, but with the sharing of risk and capital requirements.
  • Increase planning process effectiveness by incorporating scenario planning and non-traditional data.
  • Incorporate optionality into the organic investment process by utilizing stage-gate decision frameworks and monitoring investments to ensure that capital can be redeployed or investments can be course-corrected if goals are not being met.
  • Review and optimize the business portfolio and divest non-strategic businesses to free up cash and refocus priorities.
Keep M&A Alive

M&A, an essential aspect of strategic capital allocation and long-term value creation, also cannot be neglected during the pandemic. Acquisitions can be a source of strategic value creation, while divestitures can be a key source of capital. The pandemic offers an opportunity for CFOs to help rebalance or optimize their company’s portfolio and invest through the economic cycle.

While M&A is often the first thing to get shut down during periods of decreased performance or economic uncertainty, EY research shows that companies that made acquisitions or divested businesses during the last global financial crisis saw significantly higher total shareholder returns (approximately 60% vs. 40%) in the years following the crisis (see chart, above).

In times of crisis, CFOs should remind themselves of the following four factors when making capital allocation decisions to create sustainable value:

  • Balance short-term needs with a continued focus on long-term investments
  • Include all sources and uses of capital (e.g., divestments, joint ventures, working capital)
  • Utilize scenarios and new sources of data so that the forecast process is truly informative
  • Employ technology to improve the efficiency and agility of capital decision-making

The views expressed by the authors are not necessarily those of Ernst & Young LLP or other members of the global EY organization.

Evan Sussholz is a partner, strategy and transactions, at Ernst & Young LLP.  Ben Hoban is a senior manager, strategy and transactions, Ernst & Young LLP.