Recession Concerns? A Time to Plan

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Russ Warren,
Managing Director

Storm Clouds?

As the U. S. economic expansion approaches a decade in June 2019, the R-word is weighing on the minds of many business owners and CEOs.   Today’s economy has been likened to a close baseball game in the 8th.  Will it go into extra innings?

In the third quarter of 2018, EdgePoint spoke with Alexander Cutler, former Chairman & CEO of Eaton Corporation Plc, who framed the economy like this: “We are in one of the longest economic expansions since World War II, yet overall inflation is benign and we are not seeing protracted labor inflation.  There do not seem to be ‘bubbles’ in real estate or stocks.  Commodity prices are expected to surge, and copper did heat up but has now cooled off.  Mid-cap and large-cap stocks are doing well.  Will it last into 2019; into 2020?  Most concerning to me are trade conflicts.  We have never taken on Canada, Mexico, Europe and China all at the same time.  Other countries have elected uber-nationalistic leaders.  We can’t say where it is going.”

Two surveys – by CNBC and Gallup – were conducted in January and February of 2019.  CNBC found 53% of the 2,200 small-business owners they surveyed across the country expect a recession in the next year.  Gallup found U. S. small-business owners’ optimism, while still strong, has declined from its record high in late 2018 to where it was from Q3 2017 through Q2 2018. 

In my 40-year M&A career, I have experienced a double recession in 1980 and 82 from within a Big 4 accounting firm, then in 1990-91, 2001 and the “Great Recession” of 2008-09 as a business owner and managing director of small firms.  Very different experiences.  In those trials-by-fire and the months leading up to them, I observed that some companies took no proactive measures, while others strengthened their long-term situation or pulled off a successful transaction.  What made the difference?  I would say “awareness and preparation”.

What can owners and managers do to come through a recession with the best outcomes?

Before a Recession is Imminent – A Time to Watch and Plan  

  • Study current data about economic health and trends, and continuously track ‘leading economic indicators’, which foretell changing conditions before they are generally noticeable.  One source is the Conference Board Leading Economic Index: An example (from March 21, 2019) is: https://www.advisorperspectives.com/dshort/updates/2019/03/21/conference-board-leading-economic-index-expanding-in-near-term   Another source of useful data and charts is the Federal Reserve Bank serving your region (which reflects the mix of area businesses).
  • Review your company’s revenue, profit and working capital performance in the last recession and reflect on the effectiveness of actions that were taken and results obtained. (Coulda, woulda, shoulda.)
  • Conduct a financial ‘stress test’, much like banks do, to see how your company might perform with a 10%-20% drop in business or loss of a major customer.
  • To be able to react quickly should the need arise, create a detailed and very specific cost-cutting plan for a revenue drop of 10% (or other decline).  If if requires that employees must be let go, name names in the plan, then lock it in a drawer.

During a Recession – A Time to Mow - or Sow?

  • Execute your plan sooner than later, cutting fat but protecting muscle.   I’ve seen anecdotal evidence that a business with a ready-to-go plan can act smarter and faster, minimizing the negative effects of a recession.
  • Consider offensive/positive moves to improve long-term competitive position if conditions permit.   Good employees become available in hard times to fill a void or upgrade a position.  Customers come ‘up for grabs’ as your competitors struggle.  ‘Gently used equipment’ comes on the market at bargain prices.  And so on.
  • Remember, the Chinese symbol for “crisis” consists of two characters – one means ‘danger’ and the other, ‘opportunity’.

And Now – A Time to Reap?

A special situation, of great interest to our firm, is the owner who plans to transition the business within three to four years but fears a recession will intercede to destroy value or defer the plan.  What to do?

In a previous article, Aligning the Stars for Exit, we discussed aligning the three ‘stars’ or elements that enable a business sale to maximize shareholder value.  They are: owner needs, strategic business needs and the macro environment – the U. S. economy and industry conditions.  All should be considered.

Owners’ needs include controllable events like retirement, estate planning, and pursuit of other interests and non-controllable concerns (e.g. health-related).  Controllable events can be aligned with business needs and the macro environment.  Owners may temper the impact of non-controllable events by planning techniques such as a leveraged refinancing to take chips off the table while continuing the journey. 

Business needs reflect the unique competitive and marketplace requisites of the business to thrive in its environment – achieving profitability, consistent performance and growth.  Perhaps a financial investor/partner is needed to best ride out the “crisis”.

Because owner needs and business needs are on-going, middle market mergers and acquisitions occur during all phases of the business cycle, unlike large transactions driven by stock prices of large public companies, which dry up in a downturn.  However, there are costs to selling during a downturn and for several years thereafter.

We are today seeing buyers ask how a business did during the last recession (ten years ago).  The response and its supporting data affects the price and terms they offer.

Price is determined as a Multiple of EBITDA.  In a seller’s market like we enjoy currently, multiples have risen by 1.5 to 2 (or more) turns from recession levels.  EBITDA usually drops with reduced revenue, so in a recession, price takes a double hit.  If many buyers decide to wait out a downturn (they may also need to fix the businesses they already own), the seller’s price advantage disappears.   It becomes a buyers’ market.  Today’s transactions tend to be cash heavy.  To obtain a full price in a downturn, expect cash to be less, and the rest to be earnable in a contingent payout – IF pre-agreed profitability is achieved, which can be a steep hill to climb.

Timing becomes increasingly important if you believe a recession will negatively affect your business.  Many people don’t understand that an effective full sale process (in contrast to negotiating with one or two buyers already at the table) will take at least five or six months from the time an investment bank is engaged and may take nine months (or longer if there are due diligence problems, for example).

What should you do if you think a recession is one to two years away and your intent is to transition the business within three to four years? 

Consider moving up your timetable or decide to hold for another four to five years, the time it typically takes to regain a company’s valuation in a seller’s market.  The most frequent costly mistake I’ve seen owners make is waiting too long.  From experience, when a seller’s market like we are enjoying deteriorates, it happens quickly.  If I were a typical middle market seller, I would rather be “in market” (having buyers called on my behalf) in the first half of 2019 than in 2020.  My crystal ball does not have 2020 vision.

 

© Copyrighted by EdgePoint. Russ Warren can be reached at 216-342-5859 or on the web at www.edgepoint.com.

 

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