Macroeconomic data does not always align with ground-level market intelligence, but when the two converge, it should be taken as a strong signal that a broad trend is in progress. The middle market is currently in the midst of just such a broad trend, the implications of which will be felt across the financial ecosystem (among capital providers, financial advisors and management teams) throughout the U.S.
In short, the “New Normal” that Pimco has coined is here, now, and we are living in a no/low revenue growth environment, with no sign of higher growth on the horizon.
No Growth and Profitability Challenges
A recent report put out by the Georgia Tech Financial Analysis Lab, “Cash Flow Trends and Their Fundamental Drivers: Comprehensive Review (Quarter 1, 2011),” highlights the paucity of growth opportunities for middle-market companies. This report, which analyzes the performance of 3,126 non-financial companies with market capitalizations over $50 million, provides a broad-based snapshot of trends in the middle market.
- Revenue growth remained elusive, with an increase of only 0.56% for the 12 months ended March 2011 (see Exhibit 1).
- Days Sales Outstanding decreased 0.30% from the prior period and at 52.80% is currently 2.25% below its long-run average.
- Inventory Days Outstanding inched up, 3.17% percent to 23.14%, though that value is still a worrisome 13% below the long-run average.
- CAPEX as a percentage of revenue, at 3.01% in the most recent period (an increase of 3.8% over the prior period), is approximately 24.5% below its long-run average.
In short: revenue growth is elusive, A/R are likely to tick up, and both inventory and CAPEX remain at unsustainably low levels (and so could be expected to at some point rebound strongly). This is, obviously, a recipe for a severe liquidity squeeze.
Further support for the thesis that growth is not just around the corner comes from the August ISM numbers showing the Backlog of Orders, New Orders and Production indices all in contraction territory (see Exhibit 2).
Implications of a No-Growth Environment
The facts as they stand now indicate the American economy is set to endure, for at least the next three to five years, true stagnation and limited, if any, growth. What does this mean, then, for the for the lending and debtor markets?
As we enter this prolonged stagnation, it is vital for lenders to recognize (and the sooner, the better) that pre-2008 rates of organic growth for their portfolio companies may be unattainable going forward. The “magic bullet” of growth will not save faltering middle-market companies (in aggregate, there will always remain high-growth niches). Management teams, working with their lenders, will need to remain cognizant of the negative liquidity impact of chasing low-probability growth opportunities and adjust themselves to an environment of diminished organic growth. The next few years in the middle market will require tight discipline and focus on profitability and liquidity. The end goal of profitable existence has not changed for middle-market companies, but the means are changing.
So what does that mean for lenders? Absent robust growth, lenders should discuss opportunities to proactively explore performance improvement initiatives with the management teams of any company that shows early signs of stress. The attractiveness of add-on acquisitions as a means of generating true top-line growth is likely to migrate from the private equity arena to independent middle-market companies, with all the opportunities and challenges such a shift entails. Management teams will need to adjust themselves to working with a far lower margin for error: expansion initiatives will need to be more robustly planned ahead of time, and management must appreciate that initiatives that threaten liquidity in service of the search for elusive growth will not be tolerated.
It is vitally important for all parties active in the middle market to understand that the American economy is now simply a thread (though still the largest thread) interwoven throughout the global economy. Since the end of World War II, the American economy has existed almost “above it all:” an economic powerhouse that set the tone for global economic shifts, not a victim of them. Things have changed. Moving forward, it is vitally important that middle-market companies as well as their lenders and advisors understand that “what happens over there, can hit us over here.”
More effort will need to be expended to sustain and (hopefully) increase profitability. In the absence of sales growth many of the less glamorous strategies for profit maximization will shift from becoming stop-gap necessary evils to the order of the day, such as:
- Regular gross margin analysis by product;
- Sales force compensation rationalization;
- Zero-based budgeting;
- Detailed forward-looking forecasts including liquidity impact; and
- Rigorous analysis of expansion initiatives.
This change in focus for middle-market companies will come about in part through the demands of lenders and in part through the enlightened self-interest of owners and management. In terms of execution, existing management teams will always be the first group looked to, but nimble turnaround advisors able to engage in impactful short-term engagements where necessary will be valuable weapons in the arsenal of every lender tending to their portfolio.
Concepts in Action
Recently, a Chicago-based, boutique turnaround firm was retained by a manufacturer and distributor of craft and office products. The company had increased gross margins but struggled to keep sales roughly level over the past few years. Over time, the diseconomies of scale were slowly causing it to lose valued customers. Due to persistent liquidity constraints, the company had been unable to pursue a number of attractive growth opportunities, and the management team was understandably frustrated. The company’s revolving line of credit was maturing, and management, uncertain of its ability to attract another lender, proactively retained a turnaround advisor.
The turnaround advisor was able to quickly take charge of this precarious situation and set the stage for a positive outcome for all stakeholders. A cash-flow forecast was created and received management buy-in. An extension of the existing line of credit was negotiated, with the lender having been satisfied that management had taken the appropriate steps to resolve its situation and being impressed that it had proactively, retained a turnaround advisor. After a series of frank conversations with the management team, all parties agreed that the company was too small to remain a stand-alone company. An orderly, but expedited sale process was launched, targeting strategic buyers in the market for an attractive add-on acquisition.
Initially the company in question faced severe challenges. However, acknowledgement of an untenable situation by management, flexibility of the company’s asset-based lender and a versatile performance by the turnaround advisor allowed for a successful outcome in spite of the challenges.
Middle-market companies in the U.S. are facing a protracted period of low (organic) growth. Lenders active in this market must be aware of the challenges facing borrowers and be alert to liquidity pressures likely to arise should a double dip recession occur. Value maximization in the current economic climate will require flexibility and knowledge on behalf all parties. The world has changed, and as a result the strategies and tactics that best equip companies to thrive have changed as well. Lenders, management teams and turnaround advisors have before them the challenge of finding ways to continue to increase enterprise value in the absence of organic revenue growth.
Margaret Bogenrief and David Johnson are partners with ACM Partners, a boutique advisory firm focused on distressed lower middle-market companies in the U.S. Bogenrief can be reached at 312-505-0700 or via e-mail at email@example.com. Johnson can be reached at 312-505-7238 or through e-mail at firstname.lastname@example.org.
Exhibit 1: Revenue Trends
Exhibit 2: ISM Indicators