Successful companies rely on a strategic approach to allocate capital and continuously transform and innovate their business. Thereby, these firms frequently rely on acquisitions to invest in transformative, technology-oriented business models as a mean to spark further business transformation. Interestingly, the relative importance of such deals has increased significantly over the last years, even during the Covid-19 crisis: despite scarce capital and decreasing overall investment activities, low-tech firms have shown an increasing appetite for transformative deals (Figure 1).
Porsche Consulting and the Management Accounting Research Group at Philipps-Universität Marburg headed by Professor Marc Steffen Rapp conducted a large-scale empirical analysis on capital allocation patterns and business transformation. The joint study examined more than 600,000 ventures and M&A deals announced by non-high-tech companies over the last 25 years1.
The study shows that investment by low-tech industry firms in transformative business—i.e., acquisitions with a focus on new technologies and digital-, software-, or platform-based business—has steadily increased over the last 15 years. While in 2005 one out of 20 deals was of transformative nature, in 2020 this increased to one of every five deals.
“Firms willing to transform their business often engage in transformative deals and use the target firm as a focal point for disruptive transformation,” notes Professor Rapp. Thereby, it is critical that capital allocation supports the firm’s strategic path and allocates sufficient capital to the newly acquired firm, he adds. Sufficient capital will allow the new business to grow—most likely, much faster than the existing core business—and ensure that it ultimately becomes a pivotal part of the firm’s overall development.
A pattern that Porsche Consulting observes in the day-to-day work of their consultants:
“Together with our clients, we have long worked on shaping their strategic transformation journey. The mechanics of systematic capital allocation have thereby become more and more important,” outlines Pschemyslaw Pustelniak, Partner and global Finance Practice lead of Porsche Consulting.
Selecting the right investment opportunities and tailoring the investment portfolio to fit the corporate strategy – that is one main ingredient for driving strategic transformation and unlocking the value behind it.
Capital markets reward such a systematic capital allocation to transformative business, according to the study. A sectoral deep dive into the automotive industry reveals that a capital allocation focus on transformative business translates to three times higher valuation multiples, compared to companies with a traditional allocation focus.
“We see an impressive outperformance of companies that systematically allocate a crucial part of their available capital into transformative businesses,” states Pustelniak. “Applying—and constantly repeating—the right deployment mechanisms then accelerates the transformation and creates sustainable growth and value.”
Figure 2: Company valuation (market-to-book ratio of equity) of companies with low deal activity in transformative business (“Traditional allocators”—black), compared to companies with high transformative business deal activity (“Transformative allocators”—red).
Successful implementation of transformative capital allocation requires a fundamental change in business planning. Porsche Consulting distilled six key design choices from its client projects to guide companies on their transformation journey:
- Embedded capital allocation within strategic planning
- Clear guidelines for the target business portfolio
- Reflection of portfolio decisions in budgets
- Systematic prioritization of investment opportunities
- Governance mechanisms to ensure investment success
- Distinctive steering model to support future business models
It is now up to strategically thinking CFOs to live up to their responsibility of unlocking value. Shifting the focus of capital allocation towards future growth is key—true to the creed of “putting your money where your vision is.” Find out more about the application of the capital allocation approach—especially during times of crisis—in our strategy paper capital allocation.
1 About the study:
Porsche Consulting and a team of researchers supervised by Professor Marc Steffen Rapp from Philipps-Universität Marburg analyzed all deals (M&A, ventures, and other partnerships) announced between 1995 and 2020 by listed firms headquartered in Europe, the USA, and Japan. The categorization as a “transformative” deal is based on textual analysis of deal descriptions using natural language processing and qualitative assessment by industry and technology experts. Market-to-book multiples are defined as the ratio of respective year-end market capitalization over book value of total shareholder´s equity. A technical summary of the study is found here: t1p.de/MARG-RIB-01-2021.