Coping with the new economic reality

Ernst and Young's Michel Driessen tells readers why senior executives must rethink their strategies to meet the new economic age

Senior executives need to review their business plans, investment and growth strategies in light of the new economic reality. The world has faced challenging economic conditions since the beginning of the financial crisis and following nearly five years of constrained growth, corporate confidence has understandably declined.

Ernst & Young’s bi-annual Capital Confidence Barometer revealed company executives were far more pessimistic about the current state of the global economy than they were a year ago, but nearly 80 percent of respondents expect a recovery within two years.

This combination of short term pessimism and longer term optimism has led to many UK businesses biding their time waiting for a significant and sustained recovery before engaging in investment and mergers and acquisitions (M&A). This risk aversion and inertia has led to an accumulation of – £700 billion (AUD$1.06trillion) of cash on the balance sheets of UK companies – nearly 50 percent of GDP. While most economists believe that there will be an economic recovery, the world is not going to return to the pre-crisis boom. Our view is that in waiting for a significant upturn some corporates have failed to recognise that low economic growth is in fact the ‘new normal’.

With their vision clouded, some businesses are using outdated decision making criteria, developed in the pre-crisis decade, to plan for the future. This means they are at risk of deploying their capital inefficiently. In light of this, we are urging companies to re-evaluate their portfolios. Pre-crisis norms will no longer provide a reasonable benchmark of portfolio performance or growth opportunities, both in terms of markets and products.

With growth across the Eurozone set to be slow for the next decade, gaining a foothold in new markets across the BRICs (Brazil, India, China and Russia) and beyond is becoming a strategic imperative for many companies.

Sector and product performance analysis should also be on the agenda as former ‘star performers’ may now be underperforming in the new economic world. A critical look at your portfolio could cover gaps that could be filled by acquisitions in high growth markets. Equally it could reveal non-core assets for divestment that would free up cash to invest in higher growth geographies and sectors. Business models should not escape scrutiny either. Is your cost structure and operating model sufficiently flexible for a low growth world with more pressure on margins and price conscious customers? Is there a case to outsource more production overseas or perhaps even relocate production back to your home market?

As the recent E&Y ITEM Club report on business investment outlined, companies have been “hoarding” labour in the hope that there will be a significant uptick in economic activity. With no significant improvement in sight businesses may need to adjust staffing levels to reflect the fact that growth may not return for some time. The workforce should be flexible enough to meet the demands of the business and be in the right place to service its growth markets.

Companies need to be realistic about their forecasting and hurdle rate targets set for their investments. While a return on investment (ROI) of, say, 20 percent was realistic three years ago, in the current climate this could be unachievable. Realistic returns have to be set in the context of the economic environment otherwise there is a danger that businesses will be more inclined to sit on their cash and miss out on potential positive returns.

Businesses need the right financing strategy to provide access to capital when they need it. Currently the bond markets are open but these are unpredictable and the window to access this source of capital can close rapidly. Bank finance is a more reliable source but can take more time to access. Therefore having the right balance of finance is a must so that when acquisition opportunities present themselves executives can act quickly.

In this environment it can be even more important than ever to have an pro-active M&A strategy. In a low growth, inertia-bound market, there is less competition for deals but unless there is an active opportunity assessment programme then these deals can be overlooked. In a weak market, there is a real opportunity for the well positioned players to a steal a march on their competitors by snapping up prime assets.

Critically, businesses need to be in an informed position so they effectively utilise the capital at their disposal. Simply sitting on cash in the hope of an upturn is a short sighted approach and will leave many struggling to survive. Value and growth are not going to be created by waiting for a major upturn that is a long way off. Good things don’t necessarily come to those who wait.

Michel Driessen is the head of Ernst & Young’s operational transactions services practice.

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