Recession Risk, The Ultimate Risk Paradigm Of Modern Business Operations (#business, #risk, #recession, #management)

Recession Risk, The Ultimate Risk Paradigm Of Modern Business Operations (#business, #risk, #recession, #management)

The business cycle rotates periodically between boom and bust. This is one of the inevitable consequences of centrally planning the economy’s interest rates and forcing them below their market equilibrium levels. Because it is inevitable, it is “predictable” and thus every business person must conduct their affairs in light of the fact that at some point in the future they will be faced with a recession. The key measure of risk for a business person operating in a central bank-managed economy, then, is “How will I feel when the recession comes?”

If a recession poses no risk to the financial structure of his holdings and he is positioned in his operations to weather a storm, he may be termed “low risk.” If instead a recession represents an existential threat and/or the potential for severe hardship for his operations, he may be termed “high risk.”

As an ideal, a sufficiently low risk operator should eagerly anticipate a recession as it will represent a cheap buying opportunity during which he will consolidate the failing enterprises of his competitors, scooping up their assets at bargain prices and thereby leap ahead of them without the use of leverage or cheap competitive tactics. Conversely, a sufficiently high risk operator will find the economic Sword of Damocles plunging through his neck in a recession, permanently severing the connection between himself and his former assets. How then to manage financial and operational risk so that continued growth can occur in a manner that is sustainable in all possible economic environments?

In terms of financial risk, we could sort our assets in two ways, by asset quality and by financing quality. The asset with the highest asset quality is the one which has the largest earnings yield relative to its current value. The asset with the highest financing quality is the one which is cheapest to own (ie, annual interest cost).

Practically speaking, sorting assets by asset quality and financing quality and then selling low quality assets and paying down outstanding debt would move an organization toward a more favorable balance between asset quality and finance quality, with an emphasis on equity in the balance sheet. The capital that is freed up in the process is now available to purchase a higher quality asset in the future.

In a recession, the cash flows from low quality assets dwindle while the finance charges on debt remain fixed; not only does such a mixture create a problem in a recession but it falsifies the true “free cash” position of the company in a boom because, to operate prudently, extra cash must be maintained on the balance sheet to offset the risk this low quality asset and debt represent should a recession appear.

The insistence on focusing on the management of financial risk first offers us clues as to a sound growth strategy overall. To be successful and sustainable through all potential economic conditions, growth must be purposeful and planned and should only occur when three conditions are met: there is abundant free cash on the balance sheet, the organization has people “on the bench” and ready for new opportunities and a good buying opportunity (represented by a fair or discount to fair value price) presents itself.

A debt-laden balance sheet is not cash rich because the cash which may be present is actually encumbered by the debt as an offset in a recessionary environment. When we are talking about a cash rich balance sheet, we’re by implication talking about an unlevered balance sheet. Otherwise, the cash is not “free” but rather is “phantom” cash– it will disappear the moment adverse economic conditions present themselves.

The organizational bench condition may be harder to evaluate objectively, but there is a decent rule of thumb. When people in each position in the organization are sufficiently organized to handle their own responsibilities with time to spare, there is organizational bandwidth to spend on promotions and new responsibilities, such as management of newly acquired assets. In contrast, when people in relatively higher positions within the organizational hierarchy are spending their time doing the work of people relatively lower in the organizational hierarchy, it indicates that there is a shortage of quality personnel to fill all positions and that those personnel available are necessarily being “mismanaged” with regards to how they are spending their time as a result.

Further, it implies the risk that growth in such a state might further dilute and weaken the culture and management control of both legacy assets and those newly acquired. This is a risky situation in which every incremental growth opportunity ends up weakening the organization as a whole and creating hardships to come in the next recession. If it’s hard to find good people, inside the organization or without, and there is a general attitude of complacency about what could go wrong in a recession, it is a strong indicator that underperforming assets should be sold and the balance sheet delevered to reduce organizational risk in the event of a recession.

Growth should be fun, exciting and profitable. If it’s creating headaches operationally, or nightmares financially, it should be avoided. You shouldn’t own or acquire assets you don’t love owning. Perhaps the best rule of thumb overall is to ask oneself, “Does owning this asset bring us joy?” If yes, look for opportunities to buy more. If no, sell, sell, sell!

Ultimately, there are three ways to get rich: randomly, with dumb luck and unpredictable market euphoria for the product or service offered (billion-dollar tech startups); quickly, with a lot of leverage, a lot of luck in terms of market cycles and a lot of risk that you could lose it all with poor timing (private equity roll-up); and slowly, with a lot of cash, a lot of patience and a lot less risk while taking advantage of the misery of others during inevitable downward cycles in the economy.

If you were fearful in the last economic cycle, it suggests your financial and organizational structures were not as conservative as you might have believed. It may be an ideal, but it’s one worth reaching for: a recession represents a golden buying opportunity for a cash rich organization to leap ahead of the competition and continue its story of sustainable growth and success.

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