The middle market, traditionally defined as covering those companies with revenues of $10 million to $1 billion, is large and diverse in the United States, comprising about 200,000 companies across a host of industries. For these companies, along with the rest of the global economy, 2020 provided an unpleasant tutorial in tail risk as the coronavirus pandemic upended assumptions ranging from the banal to the profound.
The ripple effects of 2020 will continue to be felt for years to come. But from our current vantage point, financial leaders, particularly those in the middle market, can take stock of both what we know to be true and suspect to be true and synthesize those elements into a strategy that will secure optimal positioning for companies.
What We Know to Be True
Capital Availability. The response of developed economies to the coronavirus pandemic has been to substantially bolster capital availability. In the United States, middle-market companies have felt the impact of this policy shift primarily through Paycheck Protection Program (PPP) loans. Many middle-market companies have undeniably benefited from PPP loans. But the structure and intention behind the program are at cross-purposes with the needs of the many companies facing not simply a short-term demand shock but what is shaping up to be a wholesale change to the strategic landscape.
Across the middle market, companies are dealing with a changing world in which their business models need to be rethought, demand drivers are being reset, and the outlook for asset utilization has been radically changed. Financing sufficient to support short-term payroll needs is simply not equal to that set of challenges.
Cost structure. Regardless of whether your company is facing headwinds or tailwinds moving into 2021, the experience of the last 12 months has highlighted the need for finance leaders to reimagine their cost structures. A combination of creativity and diligence will yield multiple opportunities to replace fixed for variable costs and thereby create a structure able to operate profitably at multiple points of equilibria. One cost structure opportunity is presented by reengineering staffing requirements for a more flexible mix of full- and part-time employees supplemented by experienced contractors and consulting firms for special projects.
What We Believe to Be True
Working capital management. Careful attention to working capital ratios, and how they are trending, can be the difference between heroic, value-accretive financial leadership and ignominious dismissal. Middle-market CFOs must invest the time to connect with key customers as well as service and material suppliers to negotiate terms, understand the potential impact of any supply chain shocks, and adjust cash forecasting as appropriate. Communication will go a long way, but for many companies the trends are negative: key suppliers, many facing their own demand shocks, have the leverage to demand improved terms, whereas customers may be unwilling or unable to make offsetting term adjustments. The net effect is downward pressure on cash flow, with all the attendant challenges that implies.
Weakened competition. The effects of the pandemic have not been felt evenly by all companies. Those companies that entered 2020 enjoying strong strategic positioning, robust profit margins, talented leadership teams, healthy cash flow, and abundant liquidity have largely navigated the challenges better than their industry peers. This differential opens up compelling opportunities to spur growth through organic sales gains, opportunistic acquisitions, or a combination of the two.
Strategic planning. The organizational benefit of strategic planning derives not only from the plan but also from the process of planning. Middle-market companies that invest the time and effort in thinking through how to most effectively deploy their resources to achieve a stated goal are much better prepared for challenges both foreseen and unforeseen.
In 2020, the world was collectively awakened to a set of risks that had been fully appreciated by too few of us. It was a year of shock, sadness, and reaction to events. In 2021, the role of business leaders is to definitively move beyond reaction and to steer a course for maximum value creation in the world as it is, not as we wish it to be.
For finance leaders in the middle-market, this means:
- Capital availability. The federal government has made financing available to many companies, both directly through PPP and other programs, and indirectly through a host of policy levers. However, the capital needs of companies do not necessarily align with the policy goals of government-sanctioned financing. Middle-market companies should not hesitate to secure private financing on the best terms they can negotiate to ensure they have adequate liquidity and investment capital for 2021 and beyond.
- Cost structure. While survival is the first goal of any crisis, it is too low a bar. Finance leaders should be aggressively seeking to build flexibility and variability into their cost structures wherever possible.
- Working capital. Many companies are likely to see their cash flow pressured by an unfavorable combination of changes in their working capital ratios. Understanding that risk and forecasting liquidity will be essential.
- Competition. Assess your relative strength in comparison to industry peers. If stronger, what is the path to press that advantage? If weaker, what steps can be taken to mitigate risk?
- Strategic plan. Refresh an existing strategic plan or embark on an expedited strategic planning exercise to set a course given all that is known and suspected about the current state of affairs. Remember, the plan itself is valuable, but the exercise of planning is even more so.
When the economic history of the coronavirus pandemic and its immediate aftermath is written, the story will be one of the tremendous opportunities presented by an unforeseen disruption of global magnitude, and no less so in the middle market.
Value creation on an epic scale will be enjoyed by those companies, and their leaders, with the discipline to objectively assess their situation and lay out the strategy and tactics necessary to succeed in the current environment. Doing so will require acknowledging unpleasant truths and setting aside structures that until recently were in perfect alignment with the strategic landscape. However, the returns for embracing and pushing through this process will be an optimal structure and value creation platform for the current moment.
David Johnson (@TurnaroundDavid) is founder and managing partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle-market companies in transition. He can be contacted at [email protected].