After a decade of relative macroeconomic stability, the global economy has entered a period of significant uncertainty driven by political, economic and social volatility. The warning signs of an economic slowdown are clear. Sustained inflation is forcing central banks to take drastic monetary policy action. Soaring energy prices are crippling entire industries in Europe. Credit markets are tightening in many countries. The Chinese economy is slowing as a result of its “zero-COVID” policy. Global supply chains have become highly unpredictable, if not unreliable. Labour markets are extremely tight in many of the largest economies. Short-term FX volatility is creating new uncertainties with a significant impact on various parts of businesses, from asset valuation to margin management. And the list goes on. In short, the global economy has recently entered into a period of significant, if not unprecedented, uncertainty.
The accumulation of significant risks suggests global economies are facing their highest level of turbulence since the GFC. While the impact felt will be wide-ranging across geographies, industries, and companies, the most ominous challenge will be navigating what we don’t know: the extreme uncertainty around the depth, breadth, and length of the turbulence. For leaders of PE-backed companies, now is the time to act. They must build the resilience required for their organizations to survive, or better yet thrive in, a wide range of future potential economic scenarios.
Here are five steps leaders can take to weather the impending storm.
1. Perform a recession readiness assessment.
Senior executives must have absolute clarity on the potential impact of a deep and potentially prolonged economic downturn. Think of drastic shifts in key macroeconomic factors, such as increasing or sustained inflation, tightening of credit markets, or persistent labour shortages. Regardless of what is to come, the first crucial step is for leaders to understand the implications of a wide range of scenarios on their business’ P&L, balance sheet, and short to mid-term liquidity position.
Once various scenarios are developed and the implications are assessed, executives should devise action plans that can be triggered in response to warning signals, such as macroeconomic indicators or corporate KPIs. These action plans should include specific initiatives with clear accountability and should address both the P&L and capital expenditures. Management should consider all potential levers: capturing incremental revenues, shedding cost and complexity, and increasing its focus on cash generation. Finally, initiatives must be prioritized and sequenced, and trade-offs between short-term performance improvement and the firm’s long-term strategy should be well understood.
2. Stress-test the balance sheet and act to build liquidity.
History has demonstrated that companies that thrive through a recession entered the tumult with a robust balance sheet. These companies proactively took action to strengthen their balance sheets at the first sight of trouble. They didn’t wait until the environment was melting down. In contrast, companies which enter trouble with stretched balance sheets quickly go from stretched to stressed to precarious, and are forced to amend credit agreements and manage liquidity challenges from a position of weakness.
To stress-test the company’s balance sheet, executives should forecast the impact of various business and interest rate increase scenarios, including “WoW” (worst-of-the-worst) scenarios. Negative shocks could include a dramatic deterioration in customer demand, customer and supplier bankruptcies, and financing counterparty defaults. It is important to assess how much flexibility the balance sheet can provide in a stressed scenario, where the credit market might be tight or closed and raising additional capital may be challenging.
If risks are identified, executives should immediately take action to build liquidity and maintain balance sheet flexibility. Building a “cash war chest” to sustain the business through the crisis will not only ensure survival but also create opportunity. Cash reserves can be built up by shedding fixed costs, delaying capital projects, or reducing working capital. Management of long-term assets and liabilities, such as a proactive divestiture, or a credit facility restructuring, will also enable flexibility. A strong balance sheet will enable companies to exploit a downturn for their benefit, rather than be defeated by it.
3. Reset and over-communicate priorities.
A dim economic outlook signals a need to step back, take stock and refocus. Massive shifts in the economic landscape should impact a company’s prioritization framework. For example, projects that drive long-term ROI may suddenly take the backseat to those that generate short-term cash flow. Senior management should zero in on the three to five most pressing “make-it or break-it” actions that will bring the company to its next milestone. Staying focused on “must-haves” (versus “nice-to-haves”) will enable teams to be more productive and impact-driven.
Once priorities have been reset, effective leaders will communicate (and re-communicate) revised priorities to align the organization. Amid rising uncertainty, employees will be overwhelmed and unsure of what is to come. Clear and transparent articulation of new priorities, including the rationale for changes in direction, will provide employees with a sharpened sense of purpose. Finally, senior management must ensure that a disproportionate amount of resources are laser-focused on the company’s new objectives.
4. Watch the competition and be ready to pounce.
In competitive markets, incumbents will take drastic measures in times of stress. Mass layoffs, rapid pricing adjustments, withdrawal from specific market segments, and industry consolidation are all possible. When confronted with volatile environments, continuous tracking and monitoring of competitors are critical. Understanding the landscape will enable executives to take rapid action to mitigate competitive risks and ensure their company is not seeing its market share erode.
Beyond remaining competitive, scanning the competition can identify opportunities. For market leaders with strong fundamentals and robust balance sheets, challenging times create fertile conditions for consolidation or vertical integration. Well-positioned companies should be on the hunt for strategic M&A and talent acquisition opportunities that arise as weaker competitors flounder.
5. Go to battle with the right mindset.
A leadership team which has been successful in periods of economic stability will not be able to keep the same mindset in a period of tumult. The team which succeeds in a period of stress may have to take decisive actions which would be anathema to a management team accustomed to a “normal” operating environment. Significant headcount downsizing, the closure of facilities, the culling of customers, and the cancellation of long-term investments must all be considered. The team might also have to pivot on past decisions: legacy, history, and sunk costs must be ignored. Finally, battle-ready leaders must be comfortable making these high-stakes decisions amid dramatically heightened uncertainty.
Successful leaders must also have the ability to articulate how once unthinkable decisions will enable the business to survive and thrive in the downturn. Rank and file employees will be shocked by some of the decisions taken. Colleagues will be let go, projects will be cancelled, and organizational structures will change. Successful leaders will communicate a consistent and compelling rationale for the actions being taken, helping employees contextualize events. Understanding the “why?” keeps employees committed and engaged.
Finally, it is imperative to not underestimate the emotional impact on the management team and the potential politics which may result from navigating a stressful environment.
Final thoughts
As companies take the 5 steps described above, leaders will quickly realize whether they should be playing “offence” or “defence” over the coming months and potentially years.
Companies facing income statement or balance sheet stresses may find that being defensive is their only chance of survival. These companies should navigate the downturn by refocusing on their core strengths, protecting their revenues and margins and preserving their balance sheet. They may reduce R&D and marketing costs, restructure assets or manage working capital more effectively. A defensive strategy may be perceived as “weaker,” but can be effective at providing the operational realignment needed to prepare for expansion post-downturn.
On the other hand, companies with strong balance sheets and profit margins that can withstand the most challenging economic scenarios should take an offensive approach. Opportunities to capture newly available talent, pursue revenue growth, and consolidate struggling players will arise. These companies can benefit competitively from the same economic disruptions that will imperil their competitors. If they embrace change and are prepared to move quickly, they will emerge stronger than their rivals.
Irrespective of which position companies ultimately find themselves in, vigorously pursuing these five actions will increase companies’ chances of playing offence over time.
