The competitive advantages of decentralized structures

by John Wilson, Mawer Investment Management, via The Art of Boring Blog

As long-term investors, our ideal holding period for any company is forever—so we are keen to understand how the companies we own will be able to scale efficiently over time. In other words, how can a business continue to grow while still retaining the internal characteristics that helped contribute to its past success?

Often with growth comes certain challenges, such as managing costs and increasing bureaucracy. Effective managers, therefore, can be important contributors to a company’s continued success as they can create an environment that promotes entrepreneurship, agility, or a cost focus.

We believe one of the ways to accomplish this is by introducing a decentralized operating structure, where more decisions are pushed down to the subsidiary level rather than exclusively being driven by senior management. If structured correctly, decentralized organizations can maintain their agility and operational excellence despite growing in size.

Over the years, our team has observed that decentralized structures work best when the following are in place:

1. Aligned incentives
2. Efficient oversight systems
3. Methods for “aggregating up” knowledge and sharing best practices

Companies that incorporate these into their operations can remain agile, which is a good defense to the negative aspects of change.

Aligned incentives

For larger (or growing) businesses, an effective incentive structure is the means of motivating co-operation and competition within the various components of the organization. Having aligned incentives means that all its players or units ultimately share in the risks and rewards of the business. Being able to accomplish this while still allowing individual management teams a significant degree of freedom around how to achieve their goals can be tricky.

ACOMO, a company that sources, trades, processes, and distributes natural food products has managed to both foster an entrepreneurial spirit and align its subsidiaries with its overall goals.

ACOMO is run in a decentralized manner where each business line has its own CEO. To align its CEOs with the overall strategic aim for the entire organization (achieve a higher return on capital), the parent company charges its subsidiaries for capital. Effectively, if one of the subsidiaries wants to build a new plant, its CEO asks for a loan from the parent company which then charges it interest. This process encourages alignment with the parent organization’s aim of garnering higher returns on capital—if a subsidiary has to pay 10% interest on their loan, their efforts better generate a return greater than that!

But it also allows for the individual CEOs to retain a high level of decision-making authority. Having flexibility on how to achieve company goals is a crucial incentive. If too much is standardized, the entrepreneurship component gets lost, which can result in bureaucratic, slow moving organizations.

I recently attended software provider Constellation Software’s AGM. At a session with TSS—one of their subsidiaries—I learned that after they were acquired in 2013, they saw their margins tripleover the next four years, a staggering amount. The main driver, they said, was the decision to subdivide the company into more granular operating segments and appoint individuals with the autonomy and motivation to act as the leaders of each smaller unit.

We refer to this autonomy as “field marking” or “roles and goals,” on our own global small cap team. We know what our goals are, what we can do, what we need to seek approval for, and where we have room for experimentation. In short, goals are set by our leader, but how we ultimately achieve these goals is up to us as individuals—though always informed by our firm’s values.

Field marking eliminates the inevitable bottlenecking that would happen if every move or decision had to be approved by our leaders. Rather, having clear expectations, a high degree of trust, and creative freedom is more efficient and, I find, highly motivating.

Effective oversight systems

Of course, as a company grows, there needs to be oversight systems in place for an organization to stay aware of and refine any incentive shortfalls, as well as maintain quality standards and firm culture.

As an example, Bravida—a company that installs and maintains electrical, heating and cooling, water, ventilation and security systems—has highly granular accounting systems that can measure profitability at the individual branch level. And though Constellation Software is run in a highly decentralized manner, it has a core, standardized set of 10 values that all subsidiaries must orient their operations around.

Sharing is caring: Aggregating up

A large contributor to the success of an organization is the flow of communication. Two potential disadvantages of a decentralized system are the tendency to not share information and the formation of silos. Sharing best practices keeps staff current and the organization unified—and therefore, competitive.

This post was originally published at Mawer Investment Management