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05 March 2019

Ethical Boardroom: Capital allocation – a governance perspective

ICGN´s Policy Director George Dallas writes that capital allocation is a fundamental corporate governance consideration, directly relevant to a company’s long-term success and the interests of company shareholders and stakeholders.

Yet, in some ways, capital allocation flies below the radar as a governance issue and topic for investor engagement. While corporate governance codes address a wide range of issues, such as board structure, risk management, audit quality and remuneration, capital allocation itself is often not explicitly addressed in codes of governance best practice. However, it does warrant focus as one of the key outputs of the governance process affecting investors providing risk capital – both debt and equity.

Capital allocation is where corporate governance and corporate finance come together. For investors, a company’s capital allocation links closely with questions of company purpose, strategy, business model, risk appetite and public disclosures – and, ultimately, to a company’s ability to generate sustainable returns. Most basically, from a balance sheet perspective, it reflects how a company chooses to finance itself, particularly with regard to the balance of equity, debt and other forms of capital funding. From an earnings or cash flow perspective, a key capital allocation question is the division of the ‘spoils’ between dividends to shareholders, share-based incentive awards to company executives and the retention of earnings for capital investment and financial stability.

As a matter of corporate governance, capital allocation is important with regard to achieving the appropriate type and balance of capital funding to allow a company to pursue its mission and strategic objectives, and to provide sufficient returns and protections to providers of risk capital. This is a matter of judgement for executive managers and corporate boards and often capital allocation can involve trade-offs in establishing a sustainable equilibrium between varied interests of shareholders, creditors and other company stakeholders, including employees and customers.

As a corporate governance consideration, investors should be alert to a company’s approach to capital allocation, particularly given the potential for distortions, which can have unfavourable outcomes. In some cases, capital allocation can be overly conservative, particularly relative to shareholder expectations for risk-adjusted returns. In other cases, capital allocation may be overly risky from the perspective of creditors and other long-term stakeholders – and the sustainability of the company itself.

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