April 9, 2020
Winston Churchill wisely said, “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”
These are extremely challenging times for all of us on many levels—health, family, community, and business. In many ways, the emotional roller coaster of the past month has been akin to the various stages of grief—denial, anger, bargaining, depression—and hopefully, for most of us, we are now at acceptance.
When we arrive at acceptance, we can start looking forward. With reactionary triage and urgent items you have had to address for your company soon in the rearview, you can now move to thinking about the important strategic initiatives that will drive your business forward in a post-stay-at-home world.
The current economic situation is, in many ways, very different from the Great Recession, but there are also some similarities. This is, first and foremost, a health crisis, so there is a unique sensitivity to the human element, with a secondary focus on the financial impacts.
Americans have rallied together in so many positive ways to address critical needs, including countless companies shifting resources to focus on personal protective equipment sourcing or manufacturing, providing altruistic funding for restaurant and retail employees, and encouraging community support for healthcare and other frontline workers.
The Great Recession had a myopic focus on economic consequences. Today, we are not faced with the severity of systemic issues in the financial world that we experienced in 2008, largely due to the Federal Reserve having codified the playbook and employing it proactively. Banks are in a much stronger position now, due in part to regulatory changes designed to avoid another financial crisis. Further, there is an unprecedented amount of private capital available, with a capital overhang in the U.S. of $860 billion compared to $478 billion in 2008 (Source: Pitchbook). In addition, there is now a tremendous amount of family office capital that is investing directly in companies, versus only through funds, which was not a prevalent source of equity capital back in 2008.
Some aspects are not as positive this time around. For instance, corporate debt is much higher now than in the Great Recession, but it will likely be more manageable for most companies given the low interest rate environment. Additionally, banks are more willing to be flexible and help companies manage through these times, a dynamic not seen in the Great Recession.
Given the health element to this crisis, banks are being more accommodating. In a way, the human side of this crisis is driving financial behavior, as opposed to the other way around.
Against this backdrop, we believe that many company owners will soon be in a position to, and should, shift focus. It will be critical to adjust your field of vision to see the opportunities presented before you in these difficult times, and lead your company to move from defense to offense to capture them.
So, what will those opportunities be? As our title suggests, the opportunities created through this crisis will not likely be the same as those in the past years. Rather, they will change form and present themselves in different ways.
Some opportunities will be organic. With the hyper-speed of change in all aspects of business, we are already seeing massive dislocation within industries. Certain competitors will be financially challenged, and others will not survive. This may afford you the chance to position your business for expansion and take share coming out of this downturn. Additionally, the opportunities will present themselves to hire great people that may not have been available prior to the crisis.
Other opportunities will be acquisition-focused, as many companies will emerge from this period with severe balance sheet issues, unable to sustain themselves as an independent company, especially after this initial grace period when banks will refocus on dealing with portfolios of challenged loans. There will be numerous opportunities for company owners to acquire competitors, and likely at very attractive valuations.
The one common truism is that CEOs need to ensure they take proactive actions now to ready their companies to execute on opportunities when they arise. Having the financial and human capital to seize the moment will be critical factors in determining competitive advantages and success going forward.
As we shift to offense, what is the playbook for business owners to ready their companies for opportunities that arise? We think that owners do need to undertake a shift in mindset—prioritizing liquidity over cost of capital. Post-crisis, access to capital will be a key differentiator and necessary to take advantage of market circumstances.
Throughout the bull market, we have seen companies focus on cost of capital, eschewing opportunities where the cost was perceived to be too high. All indications point to an increase in the cost of money across the capital stack to account for risk. If owners remain steadfast in their “cost first” mentality, opportunities are likely to pass them by, and risk may increase if there is a second wave of virus-induced economic contraction.
The first action item for company owners is to evaluate liquidity and all of their debt capital options. Most companies are doing an in-depth cash flow review to forecast cash requirements in various scenarios over the next eight to twelve weeks, and then through the remainder of 2020. This exercise will situate them well to review their cash and debt capacity from a defensive view to ensure they are well-capitalized for base and downside cases.
Once this effort is complete, you can shift to offense and review debt capital options for growth and acquisition. The lowest-cost capital will be a term loan from a bank. Bank interest rates have increased recently, so rather than re-opening your full debt capital stack to repricing, it will be advantageous to take on new tranches of incremental debt, keeping your current lower-rate capital in place.
Next, you could explore mezzanine debt. While more expensive, it can be an attractive capital option for company owners, as it is more expeditious, has no control features, and is substantially lower-cost than equity. Importantly, mezzanine debt can be extremely flexible on amortization terms, even with interest-only balloon options, that could be attractive to maximize cash flow in the forthcoming months and years post-crisis.
Additionally, if the prospects that arise are compelling enough, the cost of mezzanine debt will be trivial compared to the opportunity cost of not being able to take action. Finally, mezzanine capital is short term, relative to traditional debt or equity. We often consider it “rental capital,” which can be repaid once you execute on the opportunity, again keeping you with the equity upside.
The next level down the capital stack would be to consider minority equity. There can be two specific rationales to consider this as a company owner. First, if you have “repriced” your perspectives on personal risk, having all your eggs in your private company going through this period, you could consider a minority equity recapitalization to take a substantial (25-49%) minority partner, using the proceeds for liquidity for your family. This will allow you to diversify your portfolio, and you can select a value-add partner.
Minority equity investors seek to assist in creating value to make their capital more attractive, including such things as establishing new customer relationships, providing acquisition experience, or helping to design and implement operational improvement strategies.
There is also the option to use minority equity for growth capital, in addition to personal liquidity. This may be a consideration if you want to avoid or limit debt from a personal risk threshold basis, or if, due to the growth and cash flow aspects in your business, debt is not an ideal capital solution.
Finally, a hybrid option to consider is a combination of equity and debt capital, to address both personal liquidity and growth, along with acquisition capital opportunities. This is less dilutive than the all-equity option. Notably, a minority equity investment may allow you to source more attractive senior or mezzanine debt, as the additional equity capital often provides lenders greater comfort in a new credit.
We believe the post-crisis opportunity set will begin to come into focus over the next 60 to 90 days. First, the Fed has instructed banks to proactively work with companies to alleviate near-term balance sheet challenges. This is taking the form of three-to-six-month interest-only loan modifications, re-terming with one-to-three-year term extensions to augment company cash flows, and borrower-friendly modifications to allow time for normalization of financial results.
That said, it is likely that this hiatus will not last, so companies with fundamental balance sheet issues will start to go through formal restructuring, bankruptcy, and asset sales likely starting this summer. For the companies that have taken the action to shore up their liquidity, there will be some compelling acquisition opportunities as this plays out.
Again, having capital in place will be the critical factor in positioning your company to convert on these opportunities. If you commence a capital discussion at the point of having an acquisition opportunity, you are unlikely to be competitive from a timing perspective versus other cash buyers. If you anticipate these opportunities will be there for your company, you should start the process of vetting capital markets alternatives sooner rather than later.
In conversations with capital providers in the coming weeks and months, it will be important to share information and commence preliminary diligence to ensure you will be well-positioned. While the downside is some lost time and extra effort, the risk and opportunity cost of not being in a position to capitalize on an opportunity is likely higher. To be clear, you do not need to consummate a transaction, as it is not advisable to take on capital without visibility into a specific use of funds. The key, rather, is readiness.
Your focus in the coming weeks will likely be on ensuring your company is well-positioned to weather this period, securing and employing the capital from the Federal stimulus programs (if you have elected that route), engaging with your bank or current lender to proactively communicate and agree on a game plan, and rightly securing your customers, suppliers, and employees.
While these are the right focus areas now, it will be critical to start looking down the field and considering what opportunities may become available to you, and ensuring you are well prepared to take advantage of them.
If you then believe there will be actionable opportunities, preparing your company sooner rather than later will ensure you are in the right and optimal position. As Ferris Bueller once said, “Life moves pretty fast. If you don’t stop and look around once in a while, you could miss it.”
For more information or to speak with one of our team members, please contact us.