10 minute read 20 Dec 2018
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How to stress test your Capital Agenda

Authors

Jeffrey Greene

EY Corporate Development Leadership Network Leader

Counsels senior executives on the corporate finance implications of strategic and operating decisions. Thought leader on life sciences and the capital agenda — M&A, portfolio management and valuation.

Steve Krouskos

EY Global Vice Chair – Transaction Advisory Services

Driving growth and investment priorities for global EY TAS. University of Florida alumnus. Son, husband and father of four.

Julie Hood

EY Global Deputy Vice Chair – Transaction Advisory Services

Passionate ambassador of an entrepreneurial mind-set in the workplace. Aspiring digital guru. Avid supporter of innovation. Trained architect. Youth mentor. Charity volunteer. Mother.

10 minute read 20 Dec 2018

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A good business strategy won’t work without a robust capital strategy – but how can you tell if yours is fit for purpose?

The new EY book The Stress Test Every Business Needs explores how business leaders can ensure long-term success through maintaining a resilient Capital Agenda.  

Failure to recognize how macroeconomic factors, such as interest rates and regulation, interact with forces like technology disruption and activist shareholders can quickly result in poor strategic decisions and underperformance.

Your Capital Agenda – how your organization manages capital, executes transactions and applies corporate finance tools to strategic and operational decisions – must be flexible enough to withstand such challenges.

The stress that is triggered by poor flexibility and a biased culture can leave companies vulnerable to both unexpected threats and missed opportunities. Instead, a Capital Agenda that builds agility and encourages open-minded debate by implementing the leading practices as EY teams have codified in the Stress Test book should ultimately drive value creation and sustainable competitive advantage.

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Thoroughly stress testing a Capital Agenda strategy involves various processes – but one of the most important is a premortem. This process involves assuming that a business effort has completely failed before it is implemented. This encourages those involved to think of all the possible reasons for the failure, before considering better ways to future-proof the project.

  • In this transformative age, there are a number of reasons as to why any company could end up in a challenging strategic situation. In the case of Allergan – which found itself at the center of a takeover bid – a premortem could have strengthened dialogue with investors to ensure they understood its growth strategy and demonstrated the productivity of its long-term R&D investments. 

  • In 2014, pharma firm Allergan learned of two US Securities and Exchange Commission filings that placed it in the crosshairs of Pershing Square Capital Management LP, an activist shareholder, and Valeant Pharmaceuticals International, Inc., a hostile acquirer.

    The move surprised Allergan – it had increased revenue by 12% and had a 90% shareholder return in 2013. Moreover, its flagship product was growing at double-digit rates, and it had recently divested a struggling business to free up resources.

    However, the company’s allocation of 17% of its total revenue to R&D and 38% to selling, general and administrative expenses were considered high, while its tax rate was 8.5 percentage points higher than the average for similar companies. In addition, it held roughly $1.6 billion in cash on its balance sheet and little debt – meaning it had substantial reserves waiting to be deployed.

  • Valeant’s growth-through-acquisition model made Allergan a particularly attractive opportunity. While Allergan’s performance was strong relative to its peers, its absolute performance created an opening for Valeant’s critique, as some saw a path to even better results.

    With a heavily leveraged balance sheet and a market capitalization almost equivalent to Allergan’s, Valeant needed help from Pershing Square to launch its bid. Pershing Square’s valuation analysis of Allergan’s relatively high tax rate and operating expense levels showed that its likely return was worth the risks of an activist campaign.

    After a seven-month struggle of competing investor presentations, press releases and litigation, Allergan was acquired by Actavis PLC through a white-knight bid of more than US$70 billion. This was roughly twice Allergan’s market capitalization before Valeant weighed in.

  • Although Allergan’s journey proved lucrative for its shareholders, its former CEO and board were left wondering what went wrong.

    While the company’s high SG&A-to-revenue ratio was viewed as a weakness by investors, David Pyott, its former CEO for 16 years, countered that Allergan had “to create not only sales forces, but market competencies.” Nonetheless, looking back on what went wrong, Pyott conceded that Allergan should have looked harder at M&A opportunities – “we should have used the balance sheet more aggressively [instead of] trying to be disciplined,” he said. 

    A thorough premortem of Allergan’s capital strategy may have helped identify some of the underlying issues facing the firm before they became existential. 

Understanding your Capital Agenda with a premortem

The EY Stress Test book provides a sample premortem framework to help work through things that could potentially go wrong with a Capital Agenda to help anticipate and get ahead of possible issues before they happen. Here are some of the questions to consider:

 What went wrong?

 What caused it?

We overpaid for the acquisition.

  • Our CEO fell in love with it.
  • Our due diligence did not properly vet the optimistic projections.

We failed to capture the planned synergies for the acquisition.

  • Integration planning wasn’t considered during due diligence.
  • We didn’t allocate enough resources to the functional work streams.

We waited too long to divest an underperforming business.

  • We thought we could fix it.
  • The group leader was incentivized on revenue and EPS contributions, not on shareholder value.

We had to retreat from an important market.

  • A new competitor from another sector provided our best customers with a dramatically better value proposition.

We had to give the activist shareholder a board seat.

  • We couldn’t refute the activist’s detailed critiques of our business units’ returns on invested capital (ROICs).
  • We couldn’t articulate why our strategy was better for shareholders.

Our stock was downgraded.

  • We have too much cash unnecessarily tied up in working capital.

We lost money on the joint venture.

  • The business unit sponsor rotated into a job in another part of the company.

 

 

There are a number of a guiding principles that can help give direction and aid in prioritization as you try to optimize your organization’s Capital Agenda.

  • Investment decisions – from capital expenditures and acquisitions to dividends and share repurchases – are among the most important functions of your executive team. To ensure they are being made as objectively as possible, evaluate them using criteria that remains consistent across the organization. 

  • Understanding how a company can create strategic and financial value is a fundamental cornerstone of success. One of the best ways to improve the chances of adding value and driving growth is to build organizational agility at a tactical level to enable you to act on unexpected opportunities when they arise.

  • Capital structure and financing choices for individual investments don’t just happen in isolation – they also combine to help shape a company’s overall resilience. To maximize that resilience, dividends and share repurchases should balance shareholder preferences, operating needs and risk – and carefully consider if and when to go public.

  • The capital agenda is what converts a company’s strategy and operating model into shareholder value. With rising uncertainty, ongoing success needs closer collaboration between policymaking and implementation teams across finance, operations and strategy to give greater flexibility and efficiency. 

Capital allocation improvement

72%

of CFOs of large companies admit their capital allocation process should be improved.

Summary

Our new book, The Stress Test Every Business Needs, has a number of suggestions on how to build and maintain a resilient Capital Agenda. As well as recommending a premortem to test how your capital strategy might perform under pressure, it offers key four principles to help prioritize your Capital Agenda decisions.

About this article

Authors

Jeffrey Greene

EY Corporate Development Leadership Network Leader

Counsels senior executives on the corporate finance implications of strategic and operating decisions. Thought leader on life sciences and the capital agenda — M&A, portfolio management and valuation.

Steve Krouskos

EY Global Vice Chair – Transaction Advisory Services

Driving growth and investment priorities for global EY TAS. University of Florida alumnus. Son, husband and father of four.

Julie Hood

EY Global Deputy Vice Chair – Transaction Advisory Services

Passionate ambassador of an entrepreneurial mind-set in the workplace. Aspiring digital guru. Avid supporter of innovation. Trained architect. Youth mentor. Charity volunteer. Mother.