Resource re‐allocation capabilities in internal capital markets: The value of overcoming inertia

• Author: Alexander L. Brown,David Bardolet,Dan Lovallo,David J. Teece
• Date: 01 August 2020
• DOI: http://doi.org/10.1002/smj.3157
• Published date: 01 August 2020

RESEARCH ARTICLE

Resource re-allocation capabilities in internal

capital markets: The value of overcoming

inertia

Dan Lovallo

1

| Alexander L. Brown

2

| David J. Teece

3

|

David Bardolet

4

1

Rm 4138, H70 - Abercrombie Building, The University of Sydney Business School, The University of Sydney, New

South Wales, Australia

2

232 Liberal Arts Social Sciences Building, Department of Economics, Texas A&M University, 4228 TAMU, College

Station, Texas

3

Director, Tusher Initiative for the Management of Intellectual Capital, Institute for Business InnovationHaas School of

Business #1930, University of California, Berkeley, Berkeley, California

4

SDA Bocconi School of Management, Milan, Italy

Correspondence

Dan Lovallo, Rm 4138, H70 -

Abercrombie Building, The University of

Sydney Business School, The University

of Sydney, NSW 2006 Australia.

Email: dan.lovallo@sydney.edu.au

Funding information

Australian Research Council, Grant/

Award Number: Discovery Grant

(DP160102290)

Abstract

Research summary:We examine the correlations

between financial resource allocation flow between busi-

ness segments and two measures of overall firm financial

performance using a sample of Compustat firms. Our

analysis finds a consistent inverted U-shape (or alterna-

tively, V-shape)relationship between those measuresand

firm profitability. Interestingly, nearly all the data lie on

the upward sloping part of the curve. Taken together,

these results support the notion that flows of financial

capital are most often positively correlated with financial

performance.

Managerial summary:A key question for any organi-

zation is how reallocating capital across business units is

related to overall firm performance. We examinethe cor-

relations of firmprofitability with a measure of change in

year-to-year allocations acrossbusiness units in a data set

of several thousand firms spanning 18 years. Except in

cases of the most extreme reallocations, our measure of

firm reallocation is positively correlated with firm perfor-

mance. Because we cannot prove causality,we cautiously

Received: 27 June 2018 Revised: 13 February 2020 Accepted: 18 February 2020 Published on: 21 April 2020

DOI: 10.1002/smj.3157

Strat Mgmt J. 2020;41:1365–1380. wileyonlinelibrary.com/journal/smj © 2020 John Wiley & Sons, Ltd. 1365

concludethat our findings are consistentwith a story that,

in most cases, firms would benefit from greater internal

reallocation of capital. The managerial question then

becomes “what dynamic capabilities are necessary to

increase the flow ofresources across business segments?”

Policies aimed at increasing allocation flow are likely to

be beneficial.

KEYWORDS

corporate finance, dynamic capabilities, internal capital markets,

inertia, resource allocation

1|INTRODUCTION

A private enterprise economy isbased not only on how markets andprices can reallocate resources,

but also on how strategic managers and business firms can allocate externally sourced and inter-

nally generated capital to new and better opportunities (Nelson, 1981).Understanding capital allo-

cation in a market economyrequires insights from strategic management and economics.Through

the combined studyof markets and managers operatinginside business organizations, meaningful

insights into how the private enterprise system allocates capital can be developed. Like financial

markets, a firm'sinternal capital market must allocate capital to high-yield opportunities/uses and

away from low- or negative-yield activitiesfor the firm to function properly.

Economics has neglected firm-level resource allocation, and the focus of modern finance

has been asset pricing and capital structure. This creates a void in examining internal capital

markets (henceforth, ICMs). Strategic management is well-positioned to fill this void. The stra-

tegic management literature recognizes several paradigms: Porter's (1980) Five Forces and Posi-

tioning (Porter, 1985, 1996), the Resource-Based View (e.g., Amit & Schoemaker, 1993;

Barney, 1991; Wernerfelt, 1984), Added Value (Brandenburger & Stuart, 1996, 2007), Transac-

tion Cost Economics (Williamson, 1975, 1985), and Dynamic Capabilities (Teece, 2007, 2014;

Teece, Pisano, & Shuen, 1997). We find inspiration in investigating resource allocation from the

dynamic capabilities framework due to its focus on shifting assets over time, which is the

essence of resource allocation flow. Specifically, we find the asset orchestration aspect of the

dynamic capabilities framework particularly relevant.

There are two primary areas where asset orchestration competencies may differ between

firms: investment timing and managerial discretion. That is, managers must be both intelligent

enough to identify an area where reallocation would be beneficial and also have the processes

in place to quickly take action to profit from that intelligence. In the past, asset orchestration

capabilities generally have been perceived as revolving around the former competency, the

managerial ability to “make well-timed investments”(Bower, 1970; Bromiley, 1986; Helfat

et al., 2007; Teece, 2009) and to effectively combine and deploy those investments (Helfat

et al., 2007). This view assumes that firms, to different degrees, possess allocation processes that

allow managers to be able to redirect resources to the right place at any point in time, neg-

lecting the latter competency. Our observation is that this is not always the case. We posit that

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