Human capital and value creation: theater or reality? by Korn Ferry

Human capital and value creation: theater or reality? by Yannick Binvel, Didier Vuchot, Gérard Cléry-Melin, and Dominique Finelli

December 2010 Human resources decisions have not yet risen to the board level in France, even as CEOs and CHROs acknowledge HR’s vital role in value creation. As HR leaders make the case for more strategic consideration of human capital, they should focus on what concerns boards, including performance targets, succession planning, compensation, and creating growth.

In today’s circumstances—particularly in France— human resources have been seen as tool to reduce operational costs, but not as a strategic method of deploying capital. This is why the Paris office of Korn/Ferry International teamed up with IFA to perform two surveys and organize a conference on the human capital and value creation to further this debate. We owe the concept of “human capital” to the work of two economists, Gary Becker and Theodore Schultz, Nobel Prize winners in the 1960s. In corporate world, human capital can be explained as the sum of the knowhow and skills of each employee, multiplied by the organizational value a company can bring to bear (working conditions, management systems, job satisfaction, etc.). Hence human capital should be at the core of business leaders’ concerns; in the words of Henri Lachmann, president of Schneider Electric, “We are all human resources directors.” But this is not the case. Decision-making on human resources has yet to rise to the highest levels, at meetings of the board of directors. A survey of company directors in the SBF 120 index, conducted by IFA and Korn/Ferry in June 2010, found that only 6 percent of respondents had dealt with HR issues at the strategic committee level of the board. Does that mean that the ongoing debate about the value creation and human capital is nothing more than theater? That it is nothing but a show around insubstantial issues?

No, at least not judging by the findings of a second survey from Korn/Ferry on the same issue—the respondents this time being the chief executive officers (CEOs) and chief human resources officers (CHROs) of companies in the SFB 120 index. The survey highlighted that for 63 percent of the respondents, good “social” performance (meaning, broadly, sound, professional relationships in the workplace) is necessary for good economic performance. By contrast, only 15 percent of the respondents said that good economic performance was a condition for good social performance. So where do we stand? How important is management of human capital to value creation in business? Are Nicolas Mottis and Maurice Thévenet, both professors at ESSEC Business School, ending the debate by saying (as they do) in a book soon to be published, that research doesn’t show a conclusive link between good HR practices and business performance? Reviewing the survey results and the content of a debate Korn/Ferry and IFA hosted September 21, 2010, we found participants agreed upon three broad tenets: 1. Human capital management is critical to corporate performance and value creation. 2. There is still a substantial gap between discourse and reality regarding human capital management. 3. There is an urgent need for strategic thinking that reconciles the social and economic aspects of business. We shall now develop these three points.

Social and economic issues, hand in hand To cope with the 2008 financial crisis, many companies restructured to contain the damage to profitability, and how to manage human capital was the focus of much discussion. But the discussion was not just how many jobs to shed, but also how to retain talent—and thus maintain the potential for growth when economic recovery was restored. Jean Pierre Clamadieu, CEO of Rhodia, says he found it difficult not to think about staffing as part of the whole business. “Human assets are essential and only with greatest difficulty can be excised from our thinking about the assets of the company more generally,” he says. Indeed, human capital is the primary component of a corporation’s “intangible assets.” In an interview on this topic in 2007, Alain Chamak (then a

KPMG partner) said that “Ernst & Young analyzed 98 listed European companies. They showed that intangible assets accounted for an average of 60 percent of total enterprise value (in a range of between 10 and 90 percent, according to company and activity sector).” He then added, “Furthermore we know that, again on average, 50 percent of intangible assets are constituted by human capital in the widest sense of the word. This is equivalent to saying that human capital, in its widest sense, accounts for an average 30 percent of the market capitalization of a company.” Directors understand that. Among to the IFA survey respondents, 95 percent said that human capital is a matter worthy of consideration by the board of directors. This conviction is shared by those in charge of operations, the CEOs. In the Korn/Ferry survey, 86 percent of responding CEOs opined that the human resources division contributes to corporate strategy specifically because it brought in a human capital component. Clamadieu called that finding a warning “to the 14 percent of CEOs and HR directors who currently declare that they are not defining any HR strategy.” It is also clear that, some believe that human resources should remain within their historic bounds, as simply the administrative managers of staff. But HR has become increasingly professional, and is now beginning to carry more weight in the spheres of competitiveness and value creation. This is the conviction of Dave Ulrich, professor at the University of Michigan’s Stephen M. Ross School of Business, who proposed in his 1996 book Human Resources Champions (published by Harvard Business school press), a redefinition of the HR function along four main lines:

1. Supporting strategic implementation 2. Ensuring the promotion of change by acting on culture and on procedures 3. Promoting employee motivation 4. Optimizing the management of administrative tasks

This redefinition has positioned human resources as a core function of executive responsibility in most firms.

HR as a corporate executive responsibility As the Korn/Ferry survey demonstrates, the HR division is an organ of corporate general management. In 86 percent of cases, HR directors are themselves members of the executive committee, and in 90 percent of the cases, they report directly to CEO or chairman. Does this mean that HR has ascended to the appropriate level? Or is that reporting structure simply the best way senior management have found to

make the necessary financial and commercial adjustments in the company, when faced with increasingly aggressive competition? According to Henri Lachman, the fact that HR is raised to the highest level of responsibility within senior management, does not absolve the CEO from the need to be fully involved. According to Lachman, “the true HR director in any company should be the president, and people management is the responsibility not of one but of all managers.” However, it would appear (and the recent financial crisis has borne this out) that market instability makes adjustments to the organization and the people within it increasingly necessary. Thus, the HR function, and its prime representative, the CHRO, are seen as “critically important business partners,” as Jean Charles Pauze, CEO of the Rexel group, puts it. The HR director provides the expertise to implement needed changes with all necessary urgency. It is easy to see how the HR director might move center-stage in a recession. But that is not fully the role that CHROs desire. Those convened at the HR Congress in 2009, for instance, raised vital questions. Could they strike a new balance between human capital and financial capital? They referred to HR as “locked into its legal and social expertise,” and worried it had lost “the battle for meaningfulness.” They clearly felt the gap between discourse and reality.

Lip service to the role of the CHRO Nearly all would agree that human assets are an engine driving value creation. Globalization, market deregulation, adoption of information technologies—all these are human processes generating new knowledge and obtaining economic results. They are also a source of potentially new challenges, which must be analyzed and anticipated. Failure to do so will have very serious consequences on value creation. Interestingly, in 2005 the Organisation for Economic Co-operation and Development (OECD) analyzed investments by central governments in the “harder” products/tools versus investing in the people and knowledge. It found that investment in knowledge is now growing at the same pace as investment in the “harder” elements. The study found that “hard” and “soft” investments made an identical contribution to labor productivity. (That raises an interesting question: What do the markets reward when they greet the announcement of massive job losses by a rise in stock price? Is this recognition of management’s nimbleness in reacting to events? Or is

it a reward for the sacrifice of a part of the intellectual heritage and of the labor force on the altar of short-term speculation? ) Still, the time available to discuss the investments in human capital is limited. Rhodia’s Clamadieu says that “in the last nine annual meetings of the board, each lasting three hours, 50 percent of the time was dedicated to explaining the group’s business lines.” This is doubtless the reason why there are no systematic reviews of HR strategies, either in strategic committee meetings, or meetings of the full board. According to the IFA survey, only 6 percent of directors dealt with such issues in the strategic committee, and only 29 percent in the nomination committee—and even than in somewhat haphazard manner. Combining financial and extra-financial indicators is a complicated business when making management decisions. Jean Christophe Deslarzes, the CHRO of Carrefour, believes that in the field of human capital, not everything can be measured in hard cash terms—but that doesn’t mean they aren’t valuable. High-quality teamwork is, after all, the royal road to improved performance. We previously noted that CHROs generally report to the chief operations officer or president. But more than half the time, HR nominations do not require approval by the board’s nominations committee. This shows why they find it difficult to position themselves within the corporate governance system. This was echoed at the September 21, 2010 conference, where it was pointed out that HR is the executive function with the least representation on boards. Some CEOs do, of course, involve their CHRO in board meetings by allowing them to speak on subjects in their field. But bear in mind that, for only a third of board members responding, did HR topics even arise annually. Also telling: 72 percent of HR directors surveyed said they had no benchmarks on which to base their own assessments. It is largely up to CHROs to improve how HR activities are measured as a contributor to enterprise value, as a recent Hewitt Barometer reports asserted. Still, what can be measured when the yardstick is so variable? It is difficult to speak to the board if one has nothing to report to them. Sure, everyone agrees that good human capital management converts weaknesses and underused resources into strengths. And yet rates of return on such human capital investments (and the cost of human capital is, on average, equivalent to one third of a company’s revenues) are not precisely measured? Executives proclaim that “teams are a major strategic asset,” but does that belief translate into resources to manage human capital as effectively as the issues demand?

What the board wants French business law requires that the board of directors be kept informed on “matters pertaining to the environment and staffing,” as part of its oversight of issues about non-financial performance. So clearly, the subject of human capital is not, in principle, beyond the scope of the board. So what should the board know? Proposals put forward at the September 21 conference included: 1. Forward-looking plans for management of employment and skills 2. Analysis of the impact of human assets on strategic projects 3. Mapping of human risks in the analysis of company risks 4. Performance targets relating to talent issues to include in calculating variable compensation for senior executives Additionally, the IFA and Korn Ferry surveys suggest four areas where CEOs, CHROs and board directors should confer: 1. Recruitment of key talent and talent management 2. Succession planning 3. Compensation policy 4. Creating growth by improving the interrelationship of social and economic dimensions of the company Having an employee representative on the board was also identified as a positive step. Such a person can draw the attention of directors to human capital aspects of issues. Schneider Electric’s Lachmann even believes in setting up a human resources committee reporting to the board, as happens on many Anglo-Saxon boards, where it is called the nomination, compensation, or development committee.

Considerations for CHROs As Jean Paul Betbèze, chief economist at the Crédit Agricole, said in an interview in 2007, when you’re working with “intangible assets” like human capital, being average is not good enough. “Human Resources management means working with anticipation, ceaselessly innovating,” he said. “The management needs to deviate from, not achieve the standard. It needs to work on the promise of the future, keep on the move. When managing intangible capital, one of the dimensions is how to provide cover for future outcomes, act as a safety net, like an insurance policy. But the

other dimension is the need to innovate. The ability to manage both dimensions at once is what makes the difference over the longer term.” Let us keep this dual goal in mind, and first consider the future-outcomes “insurance policy” side of things. If HR is to have credibility, it will stem from measuring relevant indicators, so that the CHRO can address the board on the human aspect of increasingly sophisticated issues. As the 2004 book Play Your Strengths recommends, why not use tried and trusted indicators: individuals, work processes, management structure, information and sharing knowledge, decision making, and systems of compensation. Each can be enriched and interpreted to organize an HR strategy that will give companies the assurances they need. What about the trail-blazing, innovative side of HR? The board is always particularly interested in questions of optimizing performance. Research has shown in the last few years that 75 percent of people performance depends on the attitudes. Good leadership is key. “Management is about being exemplary,” Henri Lachmann says, “or put another way, a fish rots from the head down.” Research shows that 95 percent of high-potential executives demonstrate high performance in their current position; but only 45 percent of high performers have high potential to move to the highest levels of management. If a company’s whole management line were assessed to create a complete succession plan, then it would be possible to identify the importance of skills and performance levels. Then the company could increase its professionalism and engage in meaningful discussions about development and the value of human capital. Indeed, human capital would come into alignment with corporate strategy. Boards also desire forward-looking annual targets, and HR should strive to create them, rather than reviewing the past. This way, HR can address the challenges facing the company—without losing sight of Jean Pierre Clamadieu’s observation that operational cycles are shorter than HR cycles. Finally, there is a need to provide incentives and leadership. As Henri Lachmann says, it is the responsibility of the chairman of the board to put human capital on the agenda. But as Jean Christophe Deslarzes adds, it is the responsibility of the CHRO to give those matters a sense of urgency.

Conclusion Human resources management creates value and lies at the heart of a company’s competitiveness. There is no doubt that the HR function has a fine future ahead, all the more guaranteed if it responds to the evolving needs of companies. Jean Charles Pauze, chairman of the board of the Rexel Group, says CHROs too will need to grow into a larger, more strategic role. In his view, the CHRO is a “managing director” with functional responsibility, not one who is necessarily a human resources expert. According to Jean Christophe Deslarzes, who was managing director of a $14 billion business, CHROs must have the legitimacy to raise human capital concerns at the highest levels of corporate decision-making. That is not unreasonable. Many CEOs expect their CHROs to engage with them on creation and deployment of corporate strategy. But that will require general experience within the company, not just HR specialization. The development of such responsibilities for HR echoes the changing role of the board, which is increasingly viewing its mission as to orient enterprise strategy across all these dimensions. This means anticipating the risks that arise during periods of transition, transformation, or development. People are at the heart of all such processes, and CHROs have a fundamental role to play.

Yannick Binvel is a Senior Client Partner in Korn/Ferry Whitehead Mann’s Paris office and a leading member of the Firm’s Global Industrial Market.

Didiert Vuchot is Chairman of Korn/Ferry Whitehead Mann in Europe and Chairman, European Board Services.

Gérard Cléry-Melin is the Office Managing Director of Korn/Ferry Whitehead Mann’s Paris office.

Dominique Finelli is a Senior Client Partner in Korn/Ferry Whitehead Mann’s Paris office, focusing on the consumer goods, hospitality, retail, media and sports sectors.

About Korn/Ferry Whitehead Mann Korn/Ferry Whitehead Mann, with a presence throughout the Americas, Asia Paciﬁc, Europe, the Middle East and Africa, is a premier global provider of talent management solutions. Based in Los Angeles, the ﬁrm delivers an array of solutions that help clients to attract, develop, retain and sustain their talent.

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