This is a reprint of an article I wrote along with Neil (Dima) Berdiev of DNB Advisory LLC that was originally published in his newsletter.
With some predictions of the next recession a year or two away, now is the time to work with your portfolio companies in order to minimize the effect whenever it does arrive. I have listed five questions you should consider asking yourself in preparation for the inevitable economic slowdown.
1) When reviewing your portfolio, do you know which of your clients are dependent on a strong economy?
Many businesses do very well during difficult economic times. Years ago, my family owned a leather tannery. The company had its most profitable years during the recessions of the early 80’s and early 90’s. It may seem counterintuitive, but while people stopped purchasing big ticket items like appliances and cars, the sales of shoes, pocketbooks and other leather goods increased as they were a way of “splurging” without spending a lot of money.
DNBA: Although it may seem like most industries are cyclical, some will tank much more than others. Some of the first to go are general contractors, other construction business, and related industries. This includes R/E, especially those spec properties that line up highways we are seeing around Boston and other major cities. To Richard’s point, if leather is not as in vogue as it used to be and more and more younger generations opting not to wear another animals’ skin, there is a new, dynamic market of vegan leather that’s taking off. This could be an opportunity to find new countercyclicals for your portfolio.
For the businesses that are potentially “at-risk” during a recession, you should consider the following questions:
2) Does management have the experience to handle a down market? How well did they deal with the last recession in 2008?
Companies that are able to move quickly to reduce expenses and improve efficiencies have a better chance of maintaining profitability (or limiting losses) during challenging times. I worked for a company that the moment they saw a slowdown, they immediately laid off non-essential employees. Then they reviewed their customer list and tried to raise prices and dropped accounts that were not profitable.
3) Do they have one customer that accounts for over 35% of their income? If this account were to cut back on orders, would it be devastating to the bottom line of the company?
Several years ago, I was unaware that one of my customers had dedicated almost 100% of their production to only one account. Subsequently, when their customer made the decision to switch vendors and move their production overseas, not only did it put my customer out of business, but cost my company over $40,000 in bad debt.
4) Has the percentage of operating expenses grown faster than the percentage increase in income?
Recently, I was hired by a VC firm as interim CEO for a small chemical company in order to prepare it for sale. It was my responsibility to review and improve operational efficiencies and create a strategic plan for moving forward. I found there were abuses within the company which were shocking. A couple of these were: All the employees were using the company credit card to fill their cars. Also, I found they were overstaffed as there were several employees with limited job responsibilities and were unnecessary to the operation. It is not uncommon for expenses to get out of hand during the times when companies are very profitable.
5) Would a potential at-risk company consider setting up a board of directors?
While many business owners might fear creating a board of directors, a board could be set up so that it does not have the ability to remove the owner. The board of directors would work more as business consultants offering advice and oversight, but not having final say in business decisions. As an interim CEO for a scrap metal yard in Chapter 11, the owner set up a board of directors to oversee my effort. The board worked with me to set up an action plan and then set achievable business metrics (KPIs). I reported to the board on a monthly basis to update my progress, set new goals and I used them for advice. With their assistance, the company emerged from bankruptcy in just over a year.
You should not wait until any of your portfolio companies are in distress. You should consider working with them now to develop an action plan for when the recession finally hits.