“When written in Chinese, the word crisis is composed of two characters – one represents danger, and the other represents opportunity” (John F. Kennedy). What the Chinese have apparently known for a long time, may very well be a suitable guiding principle for Western companies today. Covid-19 came as a complete surprise and even several months down the road there is still huge uncertainty about the mid- and long-term impact. As a result, the pandemic has forced managers to think beyond the standard toolset and hitherto existing constraints, both when it comes to the view inside as well as the strategic M&A opportunities that the current environment entails.
2. The view inside: Cash is still king & the operating model requires adjustments
At the outset of the pandemic, corporates’ key focus was to protect their employees, to manage the supply chain disruptions and to gain an understanding about the demand-side risks of their business. Covid-19 led to an economic slowdown affecting not only already distressed companies but also solid and healthy corporates. Many corporates have reacted immediately and looked for ways to make their operating model more flexible and implemented cash preserving measures, most prominently by applying for short-term work and other governmental support programs.
The learnings from the current crisis and the present awareness for the necessity of tough actions should be seen as an opportunity to be better prepared for the post Covid-19 period and potential upcoming crises – not least as the markets are likely to value resilient companies at a premium in the future. Two areas should be in the spotlight based on our experience:
Implement a broad cash culture and underlying governance to strengthen long-term liquidity: The perspective on current and future resource allocation has been sharpened through Covid-19. Many executives have initiated a direct cash flow planning to gain full transparency on their liquidity levels and to identify further optimization measures throughout the cash conversion cycle. As a next step, corporates need to achieve that any manager is “thinking and acting like a CFO” and a cash culture is part of the core DNA of each employee. This requires leadership from supervisors to implement as well as a governance which ensures that effective decisions are made on a regular basis on future capex and opex spend. There need to be clear guidelines as to how a business plan should look like with clear criteria to be met before approval (payback thresholds, return on investment, risks etc.). On top of that we see many corporates running hundreds of projects in parallel without a clear prioritization based on a criteria catalogue and without dependency management. What is required is a close collaboration between a business development institution overseeing the strategic focus of the company and a powerful resource board responsible for central allocation of funds and physical project resources.
Adapt the underlying operating model: Following the financial crisis in 2008/2009, many corporates have reshaped their operating model and have increased their operational flexibility to be prepared for an adequate reaction in an subsequent crisis. Covid-19 showed most corporate leaders in an alarming way that the operating model and the underlying cost structure is still not flexible and not resilient enough. Covid-19 required corporates to rethink and adapt their business and operating models around questions such as: How and where employees should work? How can we still engage with clients, suppliers and other stakeholders? How can we overcome the supply chain interruptions? This is manifested in the following recent developments:
- The digital agenda of corporates was pushed forward in an amazingly short time frame impacting among others the mode of collaboration and the go-to-market model through the push from offline to online.
- The working environment has changed significantly raising questions around future floor space and other infrastructure requirements.
- The strong dependency on suppliers from a single, distant country like China has been proven to be a systematic weakness and might be the opportunity to reshape the supply chains towards a less dependent set-up, including nearshoring considerations.
- There is a stronger buy-in for change from critical stakeholders as almost everybody is alerted and affected by the pandemic (e.g. workers councils might be willing to accept changes easier).
Overall, we currently see a good opportunity to proactively prepare corporates for the post Covid-19 era by streamlining operations, cleaning up corporate structures and investing in cutting-edge technology.
3. Strategic M&A opportunities
3.1. Strengthen competitive positioning: Covid-19 as an opportunity to consolidate
Opportunities also lurk beyond the firm’s boundaries. The study “Roaring Out of Recession” published in the Harvard Business Review, shows that companies that find the right balance between cost cutting to preserve cash and investing to grow tomorrow are typically the winners after a recession. Companies who have built a healthy balance sheet structure during the economic boom, can seize the opportunities to pursue deals that create long-term value and strengthen their business model. Taking a look into the current market we see the following elements offering strategic M&A opportunities:
• Companies with an increasingly restricted set of strategic options and bargaining power as well as declining valuations may become attractive and affordable targets for a wider group of corporates.
• “Zombie companies” who were already in trouble before Covid-19 might get even more pressure to sell assets or the entire company altogether once emergency loans have to be repaid and the suspension (in Germany) of the requirement to file for insolvency is withdrawn.
• Structurally healthy corporates that have been hit hard by the pandemic with a strong shortfall in revenues impacting their liquidity position need to ponder strategic options.
By way of example, car rental company Sixt has bought certain slots at US airports following the demise of Canadian competitor Advantage Rent a Car. Likewise, tour operator TUI is currently mulling strategic options for its hotel and airline operations, potentially offering opportunities for its competitors (Figure 1).
Source: Own illustration
3.2. Rethinking business purpose: Portfolio optimization
Strategic reviews and the subsequent implementation of the envisaged options (e.g. divestments, carve-outs, add-ons, restructuring) have always been a regular component to make companies fit for the future. While transformation has increased in extent and speed over the past decades, the fundamental and lasting impact that the Covid-19 pandemic will have on a large proportion of the economy is unprecedented. For example, demand patterns have changed towards digital offering (e.g. online shopping, mobile payments) and new technologies are gaining foothold in the economy, sometimes pushed by state programs (e.g. H2 technology, electrification). The bifurcation of the tech and non-tech stocks is only one indication that this trend is expected to continue.
Likewise, the negative impact on revenues and the encompassing deteriorating liquidity situation requires many companies to allocate their resources to those activities where the highest return is expected in the future. Non-core activities will increasingly become potential candidates for sale. While some companies have more legroom to refocus on growth areas and prioritize capital allocation to value generating assets, other companies are significantly bound by their financial position. Indebtedness has often increased or will increase to a level that requires companies to dispose of certain assets to bring the leverage to more acceptable levels.
Overall, the requirement to evaluate the opportunities to refocus the company is now as high as never before and companies should use the current momentum to act (Figure 2).
Source: Own illustration
What shall a company do in the current market environment if it has identified non-core assets? On the one hand, companies with a less comfortable liquidity situation lack the financing for making acquisitions and may see themselves pressured to sell a subsidiary sooner rather than later despite the potentially lower sale value that can be achieved in the currently uncertain market environment. This is likely to leave money on the table, but some companies may still be bound to follow that route.
On the other hand, financially more stable companies should not rush to sell non-core assets but rather prepare the company for sale to achieve a higher valuation. Also, they should not fall into the usual trap of neglecting non-core assets that will inevitably result in further value destruction, but rather switch focus from strategic attention to value protection.
Once a business has been identified as non-core, the entity should be subjected to a deal readiness phase to ensure that value is optimized and risks that could hinder a sale are identified and addressed. This entails in particular clear target setting, the planning and implementation of performance improvement measures (especially the “quick-win” opportunities), and carve-out planning. A well-structured deal execution is then the second step. Figure 3 outlines the various considerations that need to be addressed to prepare and execute an exit.
Source: Own illustration
Such a comprehensive approach may incur significant one-off cost for earnings improvements or restructuring – costs that in many cases dwarf in comparison to the potential benefit. Take a company with revenues of EUR 500 million and the target to moderately increase the EBITDA margin by 2% (EUR 10 million). Assuming a constant exit multiple of 10x, this implies additional exit proceeds of EUR 100 million – an effect that in most cases significantly outweighs the necessary restructuring costs. Likewise, it significantly reduces the likelihood of a failed sale process.
This approaches resonates well with a recent survey by IHS Markit and Mergermarket: when asked what actions could have been taken to make their most recent sell-side deal go more smoothly, 87% wished they had organized the company for a sale well in advance of the process beginning, while 77% believed they should have developed a more in-depth insight into potential issues with specific business units.
4. Overall summary
Covid-19 has without doubt changed the market environment within a very short timeframe and nobody can foresee the eventual future impact of Covid-19. Besides the negative side of Covid-19, we see a reasonable chance to use the current situation to implement a sustainable cash culture and underlying governance and to use the current awareness of fundamentally required adaptations and the potentially stronger willingness for change of usually critical stakeholders to adjust the operating model now. In addition, the current environment offers good opportunities for financially healthy companies to be a proactive player in a market consolidation. Furthermore, the current crisis is a good opportunity to scrutinize portfolio companies and to consider strategic options such as a divestment for non-core and underperforming businesses. For companies with high indebtedness and limited financial headroom, a short-term disposal might be the only valid option. For more stable companies who concluded to sell the business should seize the opportunity to thoroughly prepare the M&A process through an exit readiness program. Such a program typically contains the identification and implementation of restructuring measures improving the overall operational and financial performance and leading to higher sales proceeds.