“There cannot be a crisis next week. My schedule is already Full.”
–Henry Kissinger
Because the current world-wide economic crisis is still likely in its early stages and its full magnitude uncertain, boards may understandably feel at a loss for the right response. Unlike periods of economic stability or steady growth, when market conditions change more slowly and the future is relatively easier to foresee, today’s turmoil offers no such clarity. Decisions are tougher and the consequences are potentially enormous. And putting off a decision is itself a consequential decision.
In the face of this uncertainty, when inaction is not an option, boards can find their way forward by asking themselves a simple, double-barreled question: When we look back one year from now will we be satisfied that we protected our companies against the risks inherent in the current situation and that we have taken advantage of what may be once-in-a-lifetime opportunities?
The answer will of course differ by industry and by company. But by framing the challenge in this way, boards can help their management teams strike the right balance between downside defense and upside offense and pre-empt an unwelcome jolt of future shock a year hence: profound regret about inadequately mitigated risks and deep frustration about missed chances.
Five Critical Areas
Boards can ask the one-year-hence question in virtually any area of their interest and responsibility, but five such areas offer particularly rich veins of opportunity and risk. The areas addressed below are clearly the responsibility of management – the board cannot and should not run the company. But the board does represent a wealth of knowledge and counsel surrounding these issues and has an obligation to ensure they are appropriately addressed. And the board needs to act as a kind of “flat mirror” to ensure that the influence of chaotic day to day conditions does not distort management’s view of the coming world.
1. Strategy.
Great economic uncertainty potentially presents threats and opportunities across the entire spectrum of strategy: pricing, products, brand, customer segments, acquisitions, and more. Boards should therefore consider whether their companies’ foundational assumptions regarding the nature of their markets, customers, and business economics are changing and, if so, the implications for strategy. It may be difficult to differentiate a permanent change (which requires a change in strategy) from a short-term dislocation due to conditions in the marketplace. However, there will be companies whose underlying strategies are no longer valid.
In consumer durables, for example, companies that have expanded at the high end of their product lines may find that many tightly squeezed customers are moving to lower-tier products – perhaps for some time to come. There could be an opportunity to develop new products that are not as fully featured but are substantially less expensive, enabling the company to make up through volume what has been lost at the high end and to position itself better vs. competitors. But how does the company protect the perceived value of the brand? And what are the implications for the company if such a strategy retains volume but at far lower profitability?
Companies that provide financial services to facilitate customer purchases, both retail and industrial, offer another example of the kind of risk/opportunity balance that boards now face. These financing programs worked well when credit was cheap and potential borrowers enjoyed sterling credit ratings. Today, however, credit is expensive or frozen altogether; some industrial customers face liquidity issues; and many consumers are leveraged to the hilt. Companies must therefore consider whether their financing programs will be an advantage or a source of even greater risk in the future and how they might be adjusted.
Acquisitions present another strategic opportunity as well as risk. As the economic crisis deepens, many distressed assets and companies are likely to be up for sale. This could be an ideal and relatively inexpensive opportunity to acquire troubled competitors or to consolidate a fragmented market. From a risk perspective, however, these potential acquisitions may be the most difficult to turn around and integrate and from which to achieve full value.
As all of these examples suggest, a great many basic assumptions are changing for many companies. The task for boards is to understand whether their company has realistically assessed its environment and, if so, how the results of the company’s strategic responses will look a year from now.
2. Operations/Organization.
A sudden drop in volume or a great increase in price sensitivity on the part of customers could dramatically affect operations. Boards can make sure that scenarios have been tested under several different assumptions of sharp volume and pricing changes of, for example, 10, 15, and 20 percent drops in volume and a pricing decrease of 5 percent. They can then consider how the company might be reconfigured in each case and determine whether it would be advisable to make the changes now rather than later. The more extreme scenarios may be the most useful; they will force the most radical thinking regarding the structure of the company. Boards may also find that they can convert what looks like a liability – reduced scale – into an opportunity by resolving to run the company at a reduced scale even with the current volume.
Further, now may be the best time to implement any structural changes that were under consideration before the current economic situation developed. The necessity for making those changes is likely much clearer and the company’s people are therefore more likely to work to achieve the benefit. Such changes could also include sorting through the capabilities of members of the extended management team and their future roles in the company.
Boards should also consider what changes should be made to the planning process and success metrics. That means having a high-level discussion of how they will define “poor,” “good,” and “great” performance under a variety of future conditions. But it doesn’t mean simply adjusting the numbers, but defining various levels of performance under different scenarios.
In addition, the board should understand the risks and opportunities presented by the economic challenges of the company’s customers. Which customers are at risk, either of defecting, extending their receivables to the company, or of failing outright? For companies with thousands of customers, a gross analysis will have to suffice. Companies with only scores of customers can undertake more specific analysis.
It’s also likely that there are customers who are much less profitable to the company than the average customer. Do they pose an even greater profit risk now? This may be the time to shed or reprice them. In addition, there may be contractual arrangements that could legitimately be redrawn, given the current economic environment.
As with the other areas discussed here, operations need not be a zero-sum game strictly ruled by economic conditions, but an area that offers opportunities for creating value.
3. Balance sheet/liquidity
The consideration of various operational scenarios should also look at whether the liquidity of the company is sufficient under each set of assumptions. Three key areas here for board consideration are:
- Risk in the bank group for the company’s revolving credit line. The current economic crisis has already taken down some banks; others may follow; and still others will be shaky and hyper-cautious. Boards should therefore be aware of the health of each bank in the company’s bank group. In the event that one or more of the member banks proves unable to live up to its commitments, the board should also know whether the lead bank and remaining banks are obligated to take up the slack.
- The circumstances under which the company might be in technical violation of its debt covenants. Because violations of debt covenants can set in motion events that lead to bankruptcy, the board should understand the specifics of those agreements, the company’s standing on each measure (such as keeping the company’s net worth at a certain level or its cash flow high enough in relation to its interest payments) and the risks of noncompliance. Although many banks grant waivers to companies that are in violation of their covenants, they may be far less likely to do so in today’s environment. Boards should therefore have in place early warning systems for detecting even minor technical violations. The earlier the warning the better, because as companies inch closer to violations their room to maneuver shrinks accordingly.
- The funding of defined benefit pension plans. If stock prices do not recover relatively quickly – that is, within about a year or two – companies could find their defined benefit plans substantially underfunded, even under multiyear smoothing assumptions. An immediate funding requirement, obligating the company to write a big check to fund pensions, could imperil liquidity.
4. Compensation
Because the current environment presents compensation committees with unique problems and will continue to do so for some time, they will have to consider whether and how to modify the compensation system. Among the challenges:
- What to do if the majority of previously granted stock options are under water. With stock options under water, the pain that executives feel will be aligned with the pain that shareholders are feeling. But compensation committees may have to ask whether this puts any executives at retention risk. The likely best answer is that “it is what it is,” and the committee should therefore do nothing. In any case, the board should not simply pass lightly over the topic without understanding the strain the situation puts on the team.
- The reaction of employees, shareholders, and the financial community to 2009 proxy disclosures of 2008 compensation. Because company performances for most of 2008 went well, it’s likely that incentive payouts could be high while the stock price at the time of the proxy disclosure is down substantially, upsetting many constituencies. If the downturn continues through 2009, such negative reactions could be even more pronounced. Satisfying everyone could require a delicate balancing act on the part of compensation committees.
- How to grant equities in the first quarter of 2009. If stock options are under water, Black-Scholes valuations would indicate the granting of far more options for the future at a lower strike price (this is likely to be true even if stock price variability is higher). However, shareholders may dislike such grants, especially when they, too, are suffering from the low stock price and enjoy no such remedy. This may be a good time to convert more of the equity grants to performance shares as these will likely have multiyear targets and require issuance of fewer shares than would the equivalent value in options.
- How to set performance levels for 2009 under great economic uncertainty. As with defining “poor, “good,” and “great” performance for planning purposes, should there be differing definitions of performance for differing economic scenarios? Are there non-financial metrics that might play a bigger part in 2009? Also, step back and take an outside view of your executive compensation. How will it be perceived in the current political climate?
- What to do if the depression of stock prices causes executives to fall below stock ownership guidelines. Although the meeting the dollar-value requirements for stock ownership has historically been relatively easy for executives, plummeting stock prices could cause them to fall below required ownership levels during the downturn. Compensation committees should at least have a projection of such a situation and consider the likely implications.
5. Enterprise Risk Management (ERM)
Now is certainly the time for boards and management teams to think about how to integrate ERM into the short- and long-term planning processes. ERM should of course include sufficient early warning systems – order flow/backlog of current customers, increased delinquencies, and the like – for various downside risks. But boards and management can also expand risk management to encompass the identification, likelihood, and measurement of upside opportunities. Such a top-down ERM system can institutionalize the underlying principle of this argument – the integrated management of downside defense and upside offense. You should not only be able to answer the question of where your responses to risk and opportunity will leave you one year from today, but have the means to answer it as accurately as possible on each succeeding day.
The One Certainty
No matter what decisions or actions boards approve, one thing is certain amid all the uncertainty: times of great economic stress call for increased communications – with employees, customers, shareholders, debt holders, and the public:
- Employees, shaken by the hits to their savings and almost daily reports of widespread layoffs at every level, need to know if the company is healthy, prepared for risks, and equipped with a clear plan for navigating through the environment
- Customers of B2B companies, too, need similar information. Even if your company isn’t in crisis, some of your customers’ companies may be. The knowledge that you are prepared to weather the storm could help steady them.
- For customers in relatively good health, such communication could be crucial for retaining their loyalty through a time when other customers may become casualties of the economy.
- For consumer-oriented businesses with multitudes of customers, the communications challenge may be greater. And depending on the business, the need to communicate may be more acute. For example, it has been widely remarked that consumers don’t mind purchasing a seat on a bankrupt airline, but they will likely balk at buying a car from the big three with no assurance that warranties will be honored and service available.
- Shareholders and debt holders, as the company’s lifelines, also want heightened communication. A board that can regularly and realistically communicate that the company is on top of risk and opportunity can go a long way toward mitigating the risk of losing the confidence of those constituencies. The watchword is realistically: debt holders and many shareholders will be especially savvy at reading between the lines.
- The public – including lawmakers, regulators, and lay people – can be a valuable ally in times of stress for companies that are understood to be forthrightly addressing risk and opportunity.
Communications with each of these constituencies by the board or management will of course vary in detail, emphasis, and medium. But, as with board oversight in critical areas, they should be premised on a simple question: how will they sound a year from now?
About the Authors
Neil S. Novich (left) serves on the boards of W. W. Grainger, Inc. and Analog Devices, Inc. He is the former Chairman, President, and Chief Executive Officer of Ryerson Inc., a major metal distributor and processor.
Theodore L. Dysart is managing partner of the Americas for the board of directors practice of Heidrick & Struggles, the international executive search firm. He serves on the board of Trustees of Worcester Polytechnic Institute and the National Board of Governors of SmileTrain.