Strengthen the core and seize opportunities to drive growth
There’s a broad consensus that the U.S. is facing a market correction, although there’s less consensus about its depth and duration. A combination of drivers such as high employment, high inflation, rising interest rates, pandemic aftershocks and the war in Ukraine may determine its unique character, creating a potentially unprecedented scenario.
Grant Thornton LLP recently brought together operating partners from private equity (PE) firms to discuss the best ways to create value in such dynamic times. Scott McGurl, Grant Thornton’s National Managing Principal of Strategy Services, prefaced the discussion by outlining three unproductive responses to recession, each of which is embodied in distinct personas:
- Slashers: Aggressive cost cutters who — by slashing growth drivers such as research and development, talent acquisition and retention, and marketing — open the door to competitors willing to take measured risks.
- Hedgers: Conservatives who look outside the core business to place multiple bets, in the hope of diversifying. While they can always get lucky, they overlook the extent to which diversification creates new risks. In this scenario, there’s far more haystack than needle.
- Ostriches: Executives with their head in the sand who put far too much faith in whatever tailwinds they are riding and their conviction that most recessions are short-lived (They are, but that’s not the proper response). Even when they identify opportunities, they often find they’ve moved too late.
Instead of adopting these common but ineffective traits, McGurl recommended that leaders use a mix of defensive moves to strengthen the core business and proactive moves to seize the distinctive opportunities that corrections present.
“You’re punished for getting it wrong in a recession,” McGurl said.
There are clear winners and losers and winning is not simply emerging from a recession — it’s emerging positioned for future success. For example, by contracting in advance with suppliers for business-critical assets, you can position your company to extend its advantage well into the future.
The PE operating partners discussed how this approach played out in six important areas: financial fundamentals, organizational fundamentals, talent (mentoring and recruiting), valuation, and sector characteristics.
- Financial fundamentals: This means looking hard at interest rates, cash flow and liquidity. If you’re considering outsourcing, the value of the dollar must be compared with local rates of inflation as well as the tax and regulatory environment. For example, foreign research and development credits are about to expire, pending congressional action.
- Organizational fundamentals: Participants noted that the kind of bloat that may be tolerated during good times needs to be addressed as recessionary times approach. Nearly free capital excuses a lot of questionable decisions. One participant noted that the larger economic environment gives even well-run companies a reason to look at unnecessary costs, inefficient processes, suboptimal pricing strategies, underperforming lines of business and overlapping roles. McGurl noted that the war on talent has led to rampant wage inflation and excessive retention bonuses, which are now facing retraction through changing market dynamics.
- Mentoring: Challenging times require skills that may not be developed during good times. The attendees found it important that portfolio company officers with limited experience leading through a recession understand what more challenging times require: an ability to respond to interest rate hikes and drops in demand, to proactively manage cash flow and currency strategies, and to root out inefficiencies while seizing strategic opportunities. The panelists noted this was often more a matter of conversations than coaching. One noted, “If it sounds like the C-suite officers are not understanding what needs to be done, then we consider more of a forcing function.”
- Recruitment: The operating partners were also more likely to become involved in hiring decisions by providing screening services, engaging recruitment firms or confirming choices. Both operating partners and the deal team commonly participate in this process. They are always looking for strong CFO candidates, but they can be difficult to find given how industry- and region-specific the position can be.
- Valuation: One of the areas of greatest uncertainty is valuation. While there is an expectation that private and public company valuations will come closer to parity over the coming quarters, one attendee shared, CFOs cannot expect 20x EBITDA anymore — it is unclear when valuations will stabilize, how much they will change, or what effect this will have on activity. The participants unanimously noted an observed decrease in deal velocity and a greater emphasis on integration and focus on core business fundamentals. It’s especially important for CFOs to articulate and support the assumptions behind their proposed valuations.
- Sector characteristics: A recession is macroeconomic. But its effects will vary depending on the particular character of an industry. For example, operating partners with both technology and healthcare holdings anticipated taking significantly different approaches to each. The technology industry has been highly dependent on inexpensive capital and will have to make significant adjustments as interest rates rise. Healthcare, on the other hand, enjoys relative immunity from most downturns but this should not be overestimated.
Seizing the opportunities
One thread was woven through the discussion of each individual topic. Recessionary times are filled with opportunities, if you know where to look and if you’re prepared to seize them.
For example, the possibility of postponed payouts may make desirable CFO candidates more willing to consider leaving their positions for the right offers. Similarly, indiscriminate cutbacks and retrenchments by competitors can create opportunities for exerting greater influence on supply chains and seizing market share. Adam Bowen, Managing Director, Strategy and Transactions for Grant Thornton, recounted examples of “decisive actions taken by clients to steal market share by reallocating budget to sales and marketing efforts,” even “taking advantage of currency tailwinds to capture growth opportunities in the EU.”
This may also be a time to deepen customer relationships, reset sales incentives, realize digital efficiencies and even pursue carefully considered M&A opportunities. Less dramatically, companies that have overextended themselves and are strapped for financing may be open to minority investments on favorable terms.
While recessions often prompt simple cutbacks, succeeding in such times requires a combination of retrenchment and initiative. And that requires a combination of precision, discipline, experience and creativity. Properly approached, dynamic times can yield lasting rewards.
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