Why Businesses Need to Pursue More Risk, Not Less
At many of the world’s big companies growth has been at best stagnant across the past few years. Total combined EBITDA (earnings before interest expenses, tax, depreciation, and amortization) was almost the same in 2015 as it was in 2010 (see chart 1).
The best way for these firms to reignite growth is to invest in new markets, products, and services. And not just conservative, “experimental” investments either: the few companies that have achieved revenue growth across business cycles, while also improving earnings, consistently allocate capital toward bigger, riskier growth bets.
But the problem is that most senior management teams are moving away from bigger, riskier growth investments and toward exactly the wrong kind of incremental, lower-risk bets. And, although it may not be apparent to many, these companies’ finance teams are a big part of the problem (see this post for more).
Most CFO responses to this risk aversion are insufficient. Nearly every finance team has started or bolstered a program, initiative, or incentive that aims to provoke business managers to become more innovative and risk seeking. Examples include creating a dedicated fund for “transformational” growth investments, setting specific targets for innovation, and highlighting where business managers need to take more risk.
But in a multitude of cases, finance teams work hard to prop up these kinds of “growth ladders” to no effect. For example, one CFO in CEB’s networks of finance professionals told us about a competition for business leaders to access funding earmarked by Finance at the start of each year for “big, innovative projects.” The theory was that dedicating the money and creating competition would identify some of the biggest growth ideas within the company. The reality was quite different. The CFO bemoaned the fact that “the business has been so heads down and operationally focused. Very few people ended up proposing projects, and we had to push earmarked funds through operations instead.”
Chart 1: Combined Fortune 1000 and S&P Euro 350 total EBITDA Indexed to 2010 earnings (millions USD); n=1139 (Fortune 1000 and S&P Euro 350 companies complete financial data from 2010 to 2015) Source: Compustat; CEB analysis
Ladders and Anchors
In some cases these growth ladders do provide some benefit but just not enough; on the whole, growth ladders are insufficient in encouraging business leaders to make the bigger bets they should be taking.
The evil twin of the growth ladder is a phenomenon the “growth anchor.” A growth anchor is the unintended effect of a process or policy that causes business managers to redirect resources and attention away from large expansion projects. Companies with a low prevalence of these anchors dedicate considerably more funding to transformational growth projects, according to CEB analysis (see chart 2).
Growth anchors manifest in many forms, including practices that cause unnecessary bureaucracy, such as lengthy debates about appropriate investment hurdle rates and whether or not projects meet them. One CFO of a Fortune 100 company told us, “Nothing gets done here without Finance on board, and that’s a bad thing.”
They also include the side effects of policies that cause short-term thinking, such as business operating reviews that focus on budget and forecast variances. Other culprits dissuade leaders from proposing riskier projects because they make it dangerous to fail. Still more rob businesses of the capacity to make bigger bets.
Whenever you spot a growth anchor it can almost always be traced back to a corporate governance function, and Finance often bears the brunt of the blame.
Chart 2: The impact of ladders and anchors on company growth focus Level of agreement with CEB Growth Focus Scale; n=73 companies Source: CEB analysis
Note: CEB determines the growth focus of a company through a survey deployed to its leadership. The survey looks at questions such as the extent to which C-suite, business, and finance leaders are willing to take on risks for long-term growth, even if that could decrease current-year profits. CEB asked these questions on a 7-point scale. An average company’s leaders score 4.8 on the scales. Companies that score a 6 or higher on the scales dedicate 1.4 times more funding to bigger, riskier growth projects.
Time to Weigh Anchor
Unfortunately, since the 2008 financial recession, companies have become more anchored. While growth anchors have always existed at companies, their prevalence has increased in line with the growing influence of governance functions like Finance.
In an environment where sales are falling and companies need to contain expenses and navigate a multitude of risks – financial or otherwise – putting processes and policies in place is the natural response. Complex spending authorities, rigorous budgeting practices, and an overall intense focus on operations are just some of the things that governance functions implement (and then never remove) — all with the potential to anchor businesses in risk aversion and incremental investing.
How to Spark Growth
What’s most interesting about the best performing firms of the past 20 years, and their ability to consistently fund big, risky growth bets, is that their management teams are experts at growth anchor removal. Whether it’s addressing finance bureaucracy, short-term incentives, a “dangerous-to-fail” culture, or capacity constraints, these companies constantly product innovative ideas to “unanchor” their businesses.
For example, the management at one firm noticed that internal politics was at the heart of too many investment funding decisions, leading to a failure to put dollars behind true growth opportunities.
Ultimately, the CFO did something drastic. Finance eliminated the use of hurdle rates in receiving and evaluating investment proposals. As the CFO put it, “Once you set a hurdle rate, everyone’s projects magically meet that hurdle rate, and then what gets funded ends up coming down to politics.” Instead, the company now uses a more competitive system where the best projects are funded and published for business leaders to see.
A senior manager at another firm noticed that their company would either shut down growth projects too quickly or attempt to make them succeed at any cost. Senior management was making it dangerous for project sponsors to fail.
To solve this, the finance team instituted a “premortem” for all major growth projects, in which senior leaders and the project sponsor agree on predefined exit triggers for the project across its different stages. An example of an exit trigger would be “more than 50% variance between customer price expectations and company target selling cost.” If this happens, the project sponsor is expected to kill the project and, crucially, is then rewarded for arriving at the right market lessons and resulting action.
These are just two of a vast array of growth anchor removal tactics. Growth anchors pop up everywhere, even at the best companies from time to time. If management teams want to see more risk taking in their company’s growth investment portfolio in 2016 and 2017, removing growth anchors is the most expedient and promising way.