Journal of Business Strategy

Building firm capability: managerial incentives for top performance

Francesco Castellaneta
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 Building firm capability: managerial
incentives for top performance
Francesco Castellaneta
Francesco Castellaneta is
Assistant Professor at
Downloaded by Universidade Catolica Portuguesa At 06:47 16 September 2016 (PT)
Católica Lisbon School of
Business and Economics,
Catholic University of
Portugal, Lisbon,
Portugal.
DOI 10.1108/JBS-03-2015-0030
Introduction
Improving organizational capabilities for leadership, operations, marketing, customer
service, research and development, production and human resources is a top priority for
most companies. In 2014, a McKinsey survey of executives representing all regions,
industries and company sizes reported that capability building was among their top three
priorities. Yet strangely enough, many firms lack an explicit strategy for building capabilities
or do not know how to build them effectively. For example, only 33 per cent of respondents
to a 2010 McKinsey survey reported having a specific focus on developing their
companies’ critical capabilities. Even where there is a focus on building capabilities, efforts
to shift and improve company practices can be swamped by what the survey called an
“organizational resistance to change”.
Capabilities are important to companies because, like most intangible assets, they tend to
be valuable, rare, hard to imitate and difficult or impossible to substitute (Barney, 1991).
These qualities make capabilities an important source of competitive advantage – but only
a source. In practice, capabilities can only create actual performance, and a competitive
advantage, when executive decisions are consistent with organizational goals – that is,
when there is “interest alignment” between managers and firm goals. To understand just
how important interest alignment is to firm performance, consider this: Even a firm with
superior capabilities can end up with zero performance. Only when managers are given
proper incentives to use organizational capabilities, in pursuit of organizational goals, do
performance, capability development and competitive advantage become possible.
This paper has two complementary goals. First, it makes a case for how creating alignment
between managers and organizational goals can improve firm capabilities, thereby
sustaining or growing a competitive advantage. Second, it documents interest alignment in
action in the private equity industry, where buyout firms use a “carrot and stick” approach
to influence managers’ incentives and, in turn, build capabilities that improve performance.
The lessons learned from private equity firms can be applied to other companies, as well.
Theory and literature
Individual goals and organizational goals do not always lineup (Fama and Jensen, 1983;
Jensen and Meckling, 1979). Without incentive to act in keeping with organizational
goals – that is, without interest alignment – executives might make decisions that do little or
nothing to improve performance or even actively thwart an organization’s efforts to improve.
As the 2010 McKinsey survey noted, a major reason why firms fail in their efforts to build
capabilities and competitive advantage is an “organizational resistance to change”. When
this happens, even firms with superior capabilities can end up with no performance
advantage.
VOL. 37 NO. 4 2016, pp. 41-46, © Emerald Group Publishing Limited, ISSN 0275-6668 JOURNAL OF BUSINESS STRATEGY PAGE 41
 The problem is, while capabilities with the potential to generate value are necessary to
create a competitive advantage, they are not in themselves enough. There must also be a
strong alignment between organizational goals and the interests of individual managers, up
to and including the possibility for top managers keep a portion of any performance gains.
The payoff might come in the form of improved salaries, bonuses, stock options or
participation in lucrative future projects. The goal is a “win-win” – an increase in managerial
effort that improves performance for the firm and its shareholders (Castanias and Helfat,
1991).
An interesting example of successful interest alignment comes from Great Little Box, a
manufacturer of cardboard boxes and packing supplies in British Columbia. The company
grew its manufacturing facilities by 5,000 per cent (from 5,000 square-feet to 250,000
square-feet) between 1982 and 1994, largely by using profit sharing and shared ownership
to motivate its employees (Heymann, 2013). For instance, plant workers earning C$11-12
per hour had the possibility to earn incentive payments of up to C$300 a month.

A new model: interest alignment and capabilities development

The level of interest alignment determines how much of a firm’s potential performance will
be realized (Gottschalg and Zollo, 2007). The assumption is that as executives get more
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incentives to support firm goals – that is, as interest alignment increases – they become
more likely to make decisions that leverage firm capabilities to raise economic
performance. However, this is just one part of the story; interest alignment also impacts the
extent to which an organization will develop new capabilities from sources within the firm
(internally) or from sources outside the firm (externally). Taken together, then, the author
can say that interest alignment influences the use and development of organizational
capabilities in three ways:

1. it influences how much existing capabilities are used;

2. it influences how new capabilities are developed internally; and
3. it influences how new capabilities are sourced externally.
Ultimately, leveraging an organization’s capabilities, and forming new capabilities both
internally and externally, make it more likely that an organization’s competitive advantage
will be sustainable. Figure 1 represents the proposed model, explaining the relationship
between interest alignment, capabilities and competitive advantage.

Leveraging existing capabilities

No matter how many capabilities an organization develops, it will not perform well without
giving managers incentives to use those capabilities. In other words, executives leverage
existing organizational capabilities when their interests are aligned with organizational
goals. The level of interest alignment determines how much of the performance potential of
capabilities will be realized. When there is interest alignment, executives are able to
capture a portion of the value that result from their enhanced motivation, while the
organization can capture the rest. This results in a “win-win game”.

Figure 1 The model proposed

LEVERAGING EXISTING
CAPABILITIES

INTEREST SOURCING CAPABILITIES COMPETITIVE

ALIGNMENT INTERNALLY ADVANTAGE

SOURCING CAPABILITIES
EXTERNALLY

PAGE 42 JOURNAL OF BUSINESS STRATEGY VOL. 37 NO. 4 2016

 In the same way that interest alignment impacts executives’ willingness to leverage existing
capabilities, it also impacts their willingness to develop new capabilities because part of
the economic value that new capabilities create will accrue to the executives themselves.
The author explores the role of interest alignment for two modes of obtaining new
capabilities: internal development and external sourcing (Capron and Mitchell, 2009).

Sourcing capabilities internally

“Internal development refers to creating a new capability within the existing boundaries of
a firm by recombining the firm’s existing capabilities or creating new ones” (Capron and
Mitchell, 2009, p. 6). Examples of internal development include internal training, internal
product development and opening new R&D labs. As interest alignment increases, and
executives get an opportunity to gain from developing new capabilities, they will be more
likely to encourage and support a setting where that development occurs.

Sourcing capabilities externally

External development happens when firms explore and source new capabilities that are
distant from what they already know. Finding external sources for new capabilities helps to
overcome the constraints associated with “single source” internal development. External
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sourcing methods, such as purchase contracts, alliances, acquisitions and partnerships,

create opportunities to obtain distant resources and trigger on path-breaking change.
Managers in a position to gain from their firms’ new capabilities will be more likely to explore
and encourage new and novel sources of knowledge.

Interest alignment and capabilities development in buyouts

Private equity buyouts are an excellent setting for observing how modifying incentives to
increase interest alignment can shape a firm’s stock of capabilities and ultimately its
competitive advantage (Figure 2).
Buyouts improve the alignment of incentives between shareholders and managers with a
“carrot and stick” approach (Jensen, 1986, 1989). Executive are given a positive
incentive – the “carrot” – in the form of financial gains (for example, a bonus). These
incentives align the interests of all parties involved and also reduce agency conflict after the
buyout. In return, managers are encouraged (if not forced) to increase their share of equity
ownership in the company to a significant level – a change that increases the personal
costs of inefficiency and reduces any managerial incentive to shirk (Berg and Gottschalg,
2005). Changing status from manager to co-owner also gives managers incentive to
embrace efficiency gains and seek out new, smarter strategies.
The “stick”, or “pain equity” in a buyout usually comes in the form of a substantial,
undiversifiable equity investment by executives, which can reach 15-20 per cent of firm

Figure 2 Interest alignment and capabilities development in buyouts

VOL. 37 NO. 4 2016 JOURNAL OF BUSINESS STRATEGY PAGE 43

 equity (Heel and Kehoe, 2005). Contrary to equity holdings in traditional firms, the equity
owned by executives in buyouts is illiquid during the investment period, and stock options
can only be exercised when the buyout ends. These arrangements – a form of negative
incentive – create high costs for inefficiencies and force executives to share a buyout’s
long-term financial risk.
Buyout firms also increase the sensitivity of pay-to-performance for a large number of
employees in the company (Jensen, 1986, 1989). Motivational systems get installed and
contracts are changed in a way that motivates employees to achieve key tasks. These
motivational systems include changes in the way employees get evaluated and
compensated. In some cases, buyouts even introduce employee share ownership plans or
other shareholdings schemes.

Leveraging existing capabilities

As markets mature and become increasingly competitive, private equity firms need more
than financial engineering to add value to their portfolio companies. For this reason, private
equity firms pay particular attention to company characteristics when deciding which target
to buy. The ideal candidate is a company with strong, non-cyclical and stable cash flows
and significant, unused borrowing capacity (Talmor and Vasvari, 2011). The firm’s service
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or product is preferably well-established, with minimal requirements for capital

expenditure, research and development or aggressive marketing campaigns. Overall, this
suggests that the ideal candidate for a buyout is a company with strong internal capabilities
and strong incentives to leverage those capabilities.

Sourcing capabilities internally

Private equity firms promote initiatives in their portfolio companies aimed at increasing
operational effectiveness (e.g. cutting costs and improving margins, reducing capital
requirements, replacing inefficient management teams) and at increasing strategic
distinctiveness (e.g. redefining key strategic variables, replacing top management,
refocusing corporate goals) (Wright et al., 2001). Increasing operational effectiveness has
a positive impact on a firm’s balance sheet by, for instance, increasing operating margins
and cash flows. All these initiatives can be achieved only through the internal development
of new capabilities that enhance overall productivity and operational effectiveness. When
incentives are properly aligned, managers in buyout companies can appropriate part of the
value created when that company develops new capabilities internally.

Sourcing capabilities externally

Levers for value generation within the boundaries of the portfolio company are only partially
related to characteristics of the private equity investor. However, there are also levers for
value generation that are driven specifically by investor characteristics, including the
investor’s network, expertise, experience, capability and strategy. These levers act on
interactions between the portfolio company and its equity investors. The author describes
three of them below:

1. Mentoring capabilities: Similar to the effect of being part of a certain corporation for a
specific business unit, private equity firms can have an important impact on the value
their buyouts create. Although buyout firms differ in the degree to which they are
involved in the management of the portfolio company, they can support value creation
in their portfolio companies by restoring an entrepreneurial spirit, advising and
enabling change (Wright et al., 2001).
2. Monitoring and controlling capabilities: Because private equity firms are professional,
active investors that participate in a large number of buyout investments over time, they
are likely to have a comparative advantage over third-party equity investors in
monitoring managers after a buyout. Changing a buyout’s governance structure can
improve monitoring and control of top management, making it possible to reduce

PAGE 44 JOURNAL OF BUSINESS STRATEGY VOL. 37 NO. 4 2016

 agency conflicts. Concentrating equity in the hands of active investors also
encourages closer monitoring and leads to a more active representation in the board
of directors. Board members involved in monitoring have direct access to confidential
company information, making it easier to track ongoing operations and evaluate
longer-term strategies.
3. Financial arbitrage capabilities: These abilities allow firms to generate returns from
differences in the valuation applied to a company between acquisition and divestment,
independent of changes in the underlying financial performance of the business (a
“buy-low, sell-high strategy”). The ability to generate value using financial arbitrage
depends on several factors: access to private information about the portfolio company,
superior market information, superior deal-making capabilities and an optimization of
corporate scope. These skills become particularly important when a buyout engages in
corporate development activities (such as mergers and acquisitions) and when the
buyout is put up for sale (which typically happens five years after it was acquired
initially).

A dynamic perspective: learning to align interests

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The success of an interest-alignment program depends on several aspects of the

organizational context, including employees’ individual preferences, strategic objectives
and cultural norms and values. Over time, organizations can learn how to develop
incentives that facilitate the alignment of decision makers’ personal goals with the strategic
objectives of the organization (Castanias and Helfat, 1991, 2001). The organization
develops the ability to align personal and organizational goals over time (Zollo and Winter,
2002) because it learns both how individual preferences, objectives and cultural norms and
values evolve and how different mechanisms can be used to align incentives more
effectively. For instance, to improve a firm’s reward system and incentive plan, an
organization has to learn the most effective way to structure pay-for-performance
remuneration schemes or equity plans for top management and employees.

Conclusions
Even firms rich in capabilities can underperform – or not perform at all – if their managers
do not have incentive to use those capabilities in pursuit of firm goals. Aligning the interests
of managers and firms influences how existing capabilities are leveraged and how new
Keywords: capabilities are developed (both within the firm and from sources outside of it). In other
Capabilities, words, forming and developing capabilities is a dynamic process – one that can be
Competitive advantage, influenced by a careful alignment of interests. Firms that learn to align managers’ interests
Incentives, with organizational goals can improve the development of capabilities at the firm level.
Private equity, Moreover, by adjusting the levers of interest alignment over time, with a close eye on
Buyouts, changes to internal and external competitive pressures, firms have an opportunity to
Interest alignment transform new capabilities into enduring advantages.

References
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Vol. 17 No. 1, pp. 99-120.

Berg, A. and Gottschalg, O.F. (2005), “Understanding value generation in buyouts”, Journal of
Restructuring Finance, Vol. 2 No. 1, pp. 9-37.

Capron, L. and Mitchell, W. (2009), “Selection capability: how capability gaps and internal social
frictions affect internal and external strategic renewal”, Organization Science, Vol. 20 No. 2,
pp. 294-312.

Castanias, R.P. and Helfat, C.E. (1991), “Managerial resources and rents”, Journal of Management,
Vol. 17 No. 1, pp. 155-171.

Castanias, R.P. and Helfat, C.E. (2001), “The managerial rents model: theory and empirical analysis”,
Journal of Management, Vol. 27 No. 6, pp. 661-678.

VOL. 37 NO. 4 2016 JOURNAL OF BUSINESS STRATEGY PAGE 45

 Fama, E.F. and Jensen, M.C. (1983), “Separation of ownership and control”, Journal of Law and
Economics, Vol. 26 No. 2, pp. 301-325.

Gottschalg, O. and Zollo, M. (2007), “Interest alignment and competitive advantage”, Academy of
Management Review, Vol. 32 No. 2, pp. 418-437.

Heel, J. and Kehoe, C.F. (2005), “Why some private equity firms do better than others”, McKinsey
Quartely, Vol. 1 No. 1, pp. 24-26.

Heymann, J. (2013), Profit at The Bottom of the Ladder: Creating Value by Investing in Your Workforce,
Harvard Business Press, New York, NY.

Jensen, M.C. (1986), “Agency cost of free cash flow, corporate finance, and takeovers”, Corporate
Finance, and Takeovers: American Economic Review, Vol. 76 No. 2.

Jensen, M.C. (1989), “Active investors, LBOs, and the privatization of bankruptcy”, Journal of Applied
Corporate Finance, Vol. 2 No. 1, pp. 35-44.

Jensen, M.C. and Meckling, W.H. (1979), Theory of the Firm: Managerial Behavior, Agency Costs, and
Ownership Structure, Springer, New York, NY.

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Wright, M., Hoskisson, R.E., Busenitz, L.W. and Dial, J. (2001), “Finance and management buyouts:
agency versus entrepreneurship perspectives”, Venture Capital: An International Journal of
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Entrepreneurial Finance, Vol. 3 No. 3, pp. 239-261.

Zollo, M. and Winter, S.G. (2002), “Deliberate learning and the evolution of dynamic capabilities”,
Organization Science, Vol. 13 No. 3, pp. 339-351.

Further reading
Armer, R.B., Otto, S.S. and Webster, G. (2015), Building Capabilities for Performance, McKinsey
Insigths, New York, NY.

Castellaneta, F. and Gottschalg, O. (2014), “Does ownership matter in private equity? The sources of
variance in buyouts’ performance”, Strategic Management Journal, Vol. 1 No. 1.

Gryger, L., Saar, T. and Schaar, P. (2010), Building Organizational Capabilities: McKinsey Global
Survey Results, McKinsey Insights, New York, NY.

About the author

Francesco Castellaneta is Assistant Professor in Strategy and Entrepreneurship at
Catolica-Lisbon and International Faculty Fellow (IFF) at MIT Sloan School of Management.
His main areas of research include the mechanisms through which private equity firms
enhance buyouts’ performance and the role of institutions in the development of the private
equity and venture capital industries. He has published in journals, such as Organization
Science, Strategic Management Journal and Entrepreneurship Research Journal. He also
consults for private equity and venture capital fund investors, including banks, insurance
companies, family trusts and pension funds.

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