Panic, Sell, Re- Evaluate, or Ignore?
Middle Market Approach to Business Cycle Evolution and Monetization
Overview – The overall business cycle for most sectors appears to be moving into a down phase where revenue growth, cost management, liquidity and risk management will all be challenged. This will reduce the number of near-term exits, reduce valuations on those that do monetize and challenge the business model and even the existence of many more middle market companies. This article explores what is happening and why and presents potential high gain business strategies to overcome this challenge.
What’s Driving this Negative Momentum?
Persistent inflation is eroding the spending power and wallet of both businesses and consumers in the U.S. and globally. The Feds and now ECB’s commitment to raising interest rates to reduce demand and therefore inflation while necessary has historically inflicted short-term pain on the economy as it initiates a cycle of lower revenues, cost containment actions (including layoffs) and lower leverage and liquidity as the cost of capital escalates.
Interest rate increases have already dramatically increased the cost of capital albeit from a relatively cheap level through Q3 of 2021. The trajectory of interest rate increases is likely to accelerate further. Core U.S. inflation without the volatile energy and food components is 6.5% and May inflation peaked at 8.6% a 40-year high. The Federal Reserve is in a dicey situation where they must raise short term rates to combat inflation and yet going too far will invert the yield curve which nearly always telegraphs that a true recession in imminent.
Valuations are coming down due to the above but also, I believe a natural transitory cycle out of the 10 years plus bull market before we move into a new bull period.
Why is this Happening and the expected Duration?
Recently, Elon Musk the CEO of Tesla and Jamie Dimon CEO of JP Morgan Chase issued strong warnings about the U.S. economy moving into a challenging period. These are two of the most successful business executives in the world so I would suggest paying heed to their warning. Tesla is already walking the talk and initiating staff cutbacks.
- Federal Reserve Commitment to higher short-term rates to reduce inflation and drain the economy of excess liquidity. As the old saying goes, never ignore (or fight) the Fed. This process has just begun with plans for increased feds funds thru 2023.
- Fed – Quantitative Tightening – the substantial liquidation of the Fed’s $9 Trillion Securities portfolio by not reinvesting maturities will increase the cost of capital throughout much of the yield curve. At the $90 Billion per month level anticipated that will represent that much more competition for all seeking capital in the financial markets driving supply up and prices down while rates escalate. It would also require the better part of 8 years to run its full course although the Fed may adjust the dials to avoid a full economic crisis.
- Increased Energy Costs – Driven by a variety of geopolitical factors including the war and energy policy are forecast currently in the $150 to $200 per barrel range. Increased demand for energy as the world’s economies emerge from COVID in tandem with reduced supply is a toxic combination.
- Pandemic – Impact on supply chains is obviously still an acute concern as domestic and international disruptions are commonplace. The pervasive nature of this factor coupled with its stubborn persistence suggests it is not an easy short-term fix.
- Recession Yes or No? – Prognostications are all over the board as to probability and depth. A well-respected study estimates only a 19% chance of a recession, others say it will happen but be mild. At the other extreme on June 7, 2022, the World Bank warned high risk of a return to a stagflation environment, or a mix of high inflation coupled with sluggish growth and a protracted period to pull out of such a cycle. The truth is no one can predict what comes next but American businesses need to now be prepared for any scenario that evolves.
- Duration – Hard to gauge but unlikely that this is not draconian nor a snap back V shaped recovery. The above factors driving the above recessionary forces suggest 9 to 18 months to move on to a more favorable business cycle. True Stagflation – more like 36 months.
Responsive Middle Market Business Strategies.
There are several ways to approach this, but I will do so based on the universal applicability of your exit horizon timing.
A. Macro Factors Applicable to All – Here are some pervasive factors applicable to all business strategies. It is crucial now to perform an objective and holistic analysis of your entire business encapsulating both:
- Comprehensive Analysis of the current Market, Money, Management, Business Model and Company Momentum. As the market is evolving and may change further under different scenarios so must you.
- Maintains Value Creation Focus – looking at your current state, competitive assessment, and future state plan. Time to update your value creation blueprint and identify accelerators and new agility elements that will be crucial in uncertain times. As an illustration, Newport has a very robust Value Acceleration Program you can analyze.
B. Revenue Growth – While always important, revenue growth is no longer King unless it is accompanied by an improved profitability profile. The message here is that Revenue CAGR, ARR, etc. are still key performance indicators but profitability is more important if a recessionary environment materializes. You also need to assess the probability of revenue contraction for your business as demand decreases.
C. Profitability – Product margins, gross profit, EBITDA, and Net Income now move forward center stage. You must make the appropriate adjustments to maximize near and intermediate term results.
D. Cash Flow – Net Cash Flow from operations and overall Funds flows move up the mission critical hierarchy. Organic funding of Opex and Capex is highly desirable.
E. Leverage – Leverage moves down the hierarchy, overly leveraged businesses run the risk in this environment of being among the dearly departed or at a minimum taking a large valuation haircut for balance sheet risk. You should be proactive in any debt/capital refinancing required in the next year.
We must exit in the next 3 to 12 months.
Several businesses fit this profile be it being in a more resilient sector, stakeholder fatigue, inadequate capital, or ability to execute to the next level and other factors. The following is important to focus on now:
- Due Diligence Proof the Business – Take an honest, objective assessment preferably thru an independent party of what the buyers’ primary issues are likely to be. Solve them before initiating a sale of the company.
- Profitability Enhancement (see above) – In this case to demonstrate staying power and real alternatives to being held hostage to an unfavorable enterprise valuation.
- Marketing the Company – More important than ever to get professional help from an Investment Banker and other professionals to nail the sales process and make the appropriate adjustments to maximize results. Unless you happen to be fortunate enough to live in a sector with strong fundamentals and acute asset scarcity you can count on the sales process to be 2x to 5x harder this year going forward with the distinct possibility no attractive offers emerge.
- Fallback Plan – If it just isn’t in the cards to exit have an alternative plan.
Planned Exit in 12 to 36 Months
Items 1. and 2. above are applicable to you also.
- Perform an Intense Cash Flow and Cost Takeout Improvement exercise. – liquidity will determine those who live to fight another day.
- Explicitly define the criteria and triggers to initiate each phase of the plan.
- Available Cash – Minimum of 6 months for steady state operations. I personally prefer 12 as having been in this situation myself, 6 months goes by very quickly.
- Zero Based budgeting – All expenses should be challenged. Anything remotely questionable is out. Conserve Capital now.
- Capital Plan & Budget – Refocus and concentrate efforts on projects with a high probability of success and financial return. This is not a time to bet on speculative “vapor” projects.
- Product Pricing – If you have some leverage, apply it now with reasonable price increases to enhance product margins.
- Capital Structure – Focus now on plans to refinance or pay off debt maturities. Consider accelerating this process as the cost of capital is highly likely to increase along with tougher loan approval requirements over the next year.
- Competitive Positioning – some may be in the desirable position of having competition with challenged staying power. Look for opportunities for cheap tack on acquisitions or just market share grabs.
Exit Beyond 36 Months
Steady as she goes but monitor trends in valuations in your sector keenly. Just because the next cycle is likely to be more favorable doesn’t guarantee that your sector will move in tandem.
Implement a softer version of the 12-to-36-month plan above to create some capital for uncertainty. You have a long runway to build the business and need to remain forward thinking but also assure you have the capital to get there. On any interim financings you need to be cognizant of potential down rounds for Equity and high-cost debt.
Unfortunately, some businesses will be forced to sell at a deep discount to avert bankruptcy or involuntary liquidation. Both financial and strategic acquirers will low ball these valuations where blood is in the water.
It is imperative that you hire a professional to minimize the discount on your business versus fair economic value. Moving to a 10% discount from 50% will make a huge difference on cap table payouts.
Cyclicality is normal. We have been here before with many different banners, be they “Stagflation (late 70’s), 1986 stock market crash, 2000 Internet Bubble Pop, 2008 Financial Crisis, and even the initial shock of the Pandemic (Q1, 2020). Each time our overall economy and business environment emerged stronger. I have no doubt that will occur again.
Down cycles or recessionary shocks tend to play out the expression “whatever doesn’t kill you makes you stronger”. Survival now is paramount to success and when skillfully executed can evolve fully into Thrive mode. The sun will come out again, prepare now to be ready when it does.