Jon Hughes, head of Ernst & Young’s transaction advisory service practice, outlines how businesses can avoid the trap of ‘corporate inertia’.
The business world has faced unprecedented economic conditions since the beginning of the financial crisis. Following nearly five years of volatility, at home, across the Eurozone and beyond, corporate confidence has understandably declined.
Ernst & Young’s bi-annual Capital confidence barometer revealed that company executives were far more pessimistic about the current state of the global economy than they were a year ago, but optimistically nearly 80 per cent of respondents expect a recovery within two years.
Our concern is that this combination of short-term pessimism and longer-term optimism is leading to many UK businesses sitting on hands waiting for a sustained recovery before engaging in investment and M&A.
You only have to consider how much cash UK corporates are sitting on – £700 billion in cash, equivalent to around 50 per cent of GDP – to see that there is a bias towards risk avoidance and inertia.
Back to reality
While most economists believe there will be an economic recovery, the world is not going to return to the pre-crisis boom that ended in 2008. It’s our view that in waiting for the upturn, corporates have not recognised they will be facing a very different environment and the harsh reality is that low growth is the ‘new normal’. There is a danger that in using historic decision making criteria, developed in the pre-crisis decade, these businesses are at risk of inefficiently using stored capital.
We are urging companies to re-evaluate portfolios in light of the new economic reality. Pre-crisis parameters are not going to provide an accurate reflection of portfolio performance or growth opportunities, both in terms of markets and products.
Mature western markets have been core for many but growth across the Eurozone, for example, is set to be slow for the next decade. In light of this, new markets across the BRICS and beyond need to be seriously considered.
Sector and product analysis is also an important consideration, as those star performers may now be underperforming in the new economic world. As a case in point, technology is a sector that looks to be setting the pace at the moment but growth in mining, the high performer of the last few years, appears to be waning. Taking a long hard look at a portfolio could identify prime assets for acquisition in high growth markets. On the flip side it could reveal non-core assets for potential divestment that would free up cash to invest in higher growth geographies and sectors.
Now is the time to undertake a review of business models – businesses need to consider cost structures, rates of inflation, commodity prices and labour costs. Is there an argument to outsource more production overseas or perhaps relocate production back to your domestic market?
As the recent ITEM club report on business investment outlines, companies have been hoarding labour in the hope that there will be a significant uptick in economic activity. But with no significant improvement in sight then businesses may need to consider appropriate staffing levels to reflect activity. The workforce should be flexible enough to meet the demands of the business and be in the right place to service its growth markets.
Corporates need to be realistic about forecasting and hurdle rate targets set for investments. While a return on investment (ROI) of say 15 per cent was realistic three years ago, this could be unachievable in the current climate. Having overly optimistic hurdle rates will stifle investment if, for example, every time an investment is made the ROI targets are falling short. Achievable rates have to be set in the context of the economic environment otherwise there is a danger that businesses will be more inclined to sit on cash rather than risk investing.
The adage ‘cash is king’ still rings true, but businesses need the right financing strategy to enable access to capital when they need it. Currently the bond markets are open for businesses to access cash but these are unpredictable and can close as a source of finance as quickly as they open. Funding from banks is a more reliable source but can take more time to access, so having the right balance of finance is a must so that when acquisition opportunities present themselves executives can act quickly to capitalise.
Closely monitoring the markets in which the business operates to effectively identify opportunities is a must. In a low growth, inertia-bound market, there is less competition for deals but unless there is an active opportunity assessment programme then these deals can be overlooked. In a weakened market, there is a real opportunity for the well-positioned players to a steal a march on competitors by growing inorganically and snapping up choice assets.
Critically, businesses need to be in an informed position so they effectively utilise the capital at their disposal. Simply sitting on cash in the hope of an upturn is a foolhardy approach and will leave many struggling to keep their head above the water, playing second fiddle to competitors.