Let’s start with the good news: the last U.S. recession ended almost ten years ago. So for nearly a decade, family businesses have been operating in a climate of sustained (though rarely flashy) economic growth, which has helped contribute to strong balance sheets, revenue and profit growth, and investments in innovation.
Now the bad news: the next U.S. recession is closer than it has ever been. We are not professional economists, and we make no predictions regarding when the next recession will commence. However, we do not believe that the business cycle has been repealed, and that another recession will eventually occur. It may or may not be in 2019 (for the record, we hope it’s not), but one is eventually coming.
As a director, now is the best time to think about how your family business is positioned for the next recession, whenever it comes. In this post, we review some ways family business directors can prepare their companies to survive (and perhaps even thrive during) the next recession.
Operating Efficiency
Sustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business.
One of our family business clients told us a long time ago that it’s easier to make good decisions when you don’t need the money. We have always thought there was a lot of wisdom in that. Sustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business. When business is going well, it can become easy to put off hard decisions regarding expense management. But today, when you don’t “need” the money, is the time when you are likely to make the best decisions in support of the long-term sustainability of the family business. If you wait until you are feeling the pressure in the heat of a downturn, it will be harder to make appropriate expense management decisions.
- Are there areas of your business that are not operating efficiently? Right now, before the next recession strikes, is the best time to evaluate vendor relationships, human resources, and operating procedures with a view to making sure your family business is in fighting trim.
- Are there underperforming business lines or territories that need attention? When consolidated profits are strong, weak business units can avoid scrutiny. Are there business lines that you should consider divesting while it’s still a seller’s market?
Balance Sheet Strength
Managing the balance sheet is a continual trade-off between efficiency and flexibility. We often write about the perils of “lazy” capital in family businesses, yet some measure of financial flexibility can help sustain family businesses during economic slowdowns. Balance sheets can be fortified in advance of a recession by shedding underperforming or non-operating assets and using all or some of the proceeds to reduce outstanding indebtedness. Bankers prefer to lend money to those who don’t need it, so now could be an optimal time to expand borrowing limits on lines of credit, re-negotiate loan covenants, etc.
- Has your family business accumulated non-operating assets during the economic expansion that are limiting the company’s financial flexibility?
- What are the sources of capital available to your family business? Does the company have unused capacity on revolving credit agreements? What covenant provisions could potentially impair the company’s ability to access undrawn financing or otherwise limit financial flexibility during a recession?
Competitive Dynamics
An economic disruption may present opportunities for patient family businesses.
One oft-touted benefit of family businesses is the ability to maintain a long-term focus and avoid the short-termism that can afflict non-family public companies. Taking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity. You don’t have to outrun the bear as long as you can outrun the other hunters. Now is the time for management teams and boards to do a careful assessment of competitive and industry dynamics with a view to identifying what opportunities might arise for the family business to solidify its long-run competitive position during a recession.
- If your industry were hit with a recession, which players would be most negatively affected? What strategies would be appropriate for your family business if competitors were to experience financial distress?
- Would a prolonged recession prompt one or more of your competitors to consider selling assets? If so, do you have an acquisition “wish list” for the next buyer’s market?
Operating Leverage
Operating leverage refers to the prevalence of fixed (as opposed to variable) operating costs in your family business’s capital structure. When revenues are expected to increase, operating leverage is everyone’s friend since the earnings impact of a growing topline is magnified by expanding profit margins. Unfortunately, the magnification effect also works in reverse, as stagnating or shrinking revenues at family businesses with significant fixed operating costs will trigger more dramatic declines in profitability as margins contract.
- What does your family business’s operating cost structure look like? Are the company’s operating costs primarily fixed, or do they vary somewhat proportionally with revenues?
- Has your family business benefited from operating leverage during the economic expansion? Are there available opportunities to shift to a greater emphasis on variable costs?
Revenue Cyclicality
The cyclicality of revenue refers to the sensitivity of a family business’s revenue stream to overall economic growth. Companies that sell non-discretionary goods or services exhibit less revenue sensitivity since customers need such products and services regardless of the economic environment. Demand for food, personal care products, healthcare, and similarly situated industries can soften during a recession as consumers trim budgets, but the sensitivity is muted relative to that for discretionary goods and services (automobiles, home renovations, leisure goods, etc.) that consumers can more readily forego or defer when belts need to be tightened.
- How sensitive is your family business’s revenue to the economy?
- If your company operates in an inherently cyclical industry, are there any strategies available to reduce the company’s revenue exposure to an economic slowdown?
Conclusion
We sincerely hope that the next recession doesn’t start for a long time. Whenever it does start, though, you need to be prepared. As a family business director, you will probably never be able to make your business “recession proof” but now is the time to evaluate what steps are prudent to prepare for the next downturn. Our family business advisory professionals have lived and worked through several recessions (and have the scars to prove it). Give us a call to discuss positioning your family business for the next one today.
