Yogi Berra was credited with saying, “It’s like déjà vu all over again.” The market rout this afternoon (Tuesday, August 25, 2015) felt a lot like 2008. How should a business owner react?
While the 2008 crisis was triggered by credit issues in the United States, today’s crisis trigger is China and a plunge in commodity pricing. Some of the commodity price pressure was also caused by a China slowdown, so at least for now, China is the epicenter of the crisis, rather than the US.
If you are a business owner considering selling some or all of your business, or if you want to raise equity or debt capital, what does this mean to you??
If we go back and look at a variety of financial calamities, there is one common denominator. Whether it is the Russian debt crisis, the Asian currency crisis, the 1987 market meltdown, or the more recent 2008 Lehman Brothers, Enron financial meltdown, or last month’s Greece default and China today, investors step back to see what will happen next. In stock investing, one learns not to try to catch a falling knife – it can be painful.
Banks always react after the crisis is out of control. Prior to the crisis, bank lending practices have been relaxed to the point that leverage multiples are sky high, covenants are nearly non-existent (or meaningless) and banks will seemingly finance any business.
This access to capital can stop in a heartbeat.
When banks have been overly aggressive, the aftermath can be very painful. Companies will see good line of credits cancelled. Term loans may be called. And good businesses, with solid cash flow can find themselves out of business as liquidity evaporates.
The private equity community acts similarly. When deals are plentiful and banks are lending, valuations go very high. Between the peak and trough valuations, private equity firms generally invest about the same amount of their capital in any given deal. The difference in valuation is generally the amount of leverage that can be added. If a bank will lend 2x EBITDA, then the company probably trades for 5x EBITDA. If, however, the company can borrow 6x EBITDA in a combination of bank and mezzanine debt, then the company probably gets sold at about 9x EBITDA. In both cases, private equity invests 3x.
How about today?
While we are very early into this meltdown, we are already seeing investors pulling back, unwilling to take on additional risk. That’s true whether the investor is trading stocks or whole companies.
In my view, there are more risks today for big financial shocks than in 2008. This time around, the Federal Reserve can’t lower interest rates, and unless they want to flood the markets with more QE, the Fed is nearly out of bullets.
Also the Fed has been the primary buyer of bonds, so if there is real selling pressure in bonds, who is the buyer?? If not the Fed, then prices will collapse for lack of liquidity and every financial institution that owns bonds will have to write down their portfolio to the market … thanks to Congress in a post-Enron world. The write-down could make good companies insolvent, busting through debt covenants.
The world’s central banks have created the largest financial experiment in history, and no one knows how it will ultimately unravel.
If you are a CEO/Business Owner, there are 3 actions that I think you should take immediately.
#1 – Review your lending documents immediately. Know what rights the bank has to call your loan, reprice, or reappraise the assets that collateralize the loan. If you are dependent upon the bank’s continued financing to stay in business, put together an alternative plan to raise outside capital. When we advise companies, we want to look at all alternatives, from financial partners to strategic partners to pre-selling products or services for cash. Act like your company has a liquidity crisis well before it develops.
#2 – If you are considering selling some or all of your company to a strategic buyer, immediately take steps to hire an investment banker and get the company into the market. It is still unclear how long, or how bad, the current meltdown will be. There may be time to put together a deal on very favorable terms with a strategic buyer. Financial buyers will be much more likely to pull back activity, lower prices and slow down deal execution.
#3 – If your company needs additional equity capital, immediately take steps to raise the minimum amount of capital your company will need to ride out the next 2-3 years. Yes … 2-3 years. Recall that the 2008 crisis kept most companies out of the M&A, debt and equity markets until 2010 or 2011. Existing investors may be the best and quickest way to raise the additional capital. They should think of it as buying an insurance policy.
The current turmoil is very new and very uncertain. This morning it looked like the collapse in prices was over. Yet by the close, this notion was damaged at best.
Take a serious inventory of what you need to do, not only to survive should the worst unfold, but also how to position yourself and your company to come out the other side stronger and with a much higher valuation. Be the company that shines in times of distress.