Leveraging Lazy Balance Sheets in Turbulent Times has been saved
Leveraging Lazy Balance Sheets in Turbulent Times
In times of crisis a strong resilient balance sheet is an investor’s friend
Authors: Daryl Elliott – Consulting Director & Jo Mitchell-Marais – Associate Director
Corporate South Africa’s response to the March 2020 lockdown as a result of the COVID-19 pandemic resulted in reactive, crisis management measures to generate and preserve balance sheet liquidity and protect their cash positions. This was done in order to navigate the uncertainty of the recovery timeframe. But now, as companies seek to recover and thrive in an uncertain future, lazy balance sheets may prevent companies from taking advantage of growth opportunities.
Our 2021 Deloitte Restructuring Survey highlighted that the main actions taken by companies at the start of the pandemic were to achieve ‘quick-wins’ through requests to extend repayment terms with financial institutions, dramatic cost reduction initiatives and the deferral of non-essential and major capex projects.
Those companies that made rapid decisions and were able to implement cash-preserving strategies have been able to successfully navigate the COVID-19 fallout through the first lockdown and beyond. They have been able to increase the cash and cash equivalents on their balance sheets to the extent that the risk of the creation of ‘lazy balance sheets’ has become a reality.
What is a lazy balance sheet?
Lazy balance sheets are the result of carrying excess cash and cash equivalents and result in the notion that these assets are not ‘working’ efficiently (other than earning bank interest) and thereby creating wealth. By not taking advantage of efficiency in the capital structure – and ensuring that excess cash is invested in assets that can generate a return greater than bank interest, the balance sheet is not optimised and is weighted with missed opportunity.
Excess cash is essentially that cash that is over and above sufficient working capital needs, together with a buffer for current market conditions. This excess cash is what needs to be put to ‘work’ for shareholders.
A further indication of a lazy balance sheet is one that does not make use of the power of leverage, especially if the strength of the balance sheet is such that it could support highly favourable lending terms. This is not to suggest that organisations should shift to heavy debt positions, especially in turbulent times, but and unleveraged balance sheet possibly represents missed opportunity.
Courage to Thrive
The challenge to those companies that carry excess cash or very low gearing, is to capitalise on the strategic or disruptive opportunities that are available and should not necessarily be ignored. The ability to deploy excess cash into return generating assets, and potentially leverage that return through debt enhancements, creates a platform for against-the-cycle growth.
The investment strategy, however, needs to be very clearly and meticulously understood. This requires target companies to be well-defined and the benefits,
synergies and disruptors appreciated. Available cash (both excess cash on the balance sheet and potential additional debt facilities) needs to be well articulated and agreed to allow for swift action and response to possible targets. The execution of strategy is paramount as cash leakage through inefficient execution compounds the cost of the lazy balance sheet.
It is important to mention that the ability to negotiate more favourable funding structures and terms is now – at the bottom of the cycle. We’ve moved from a
covenant ‘heavy’ framework pre-COVID through to covenant ‘light’ during COVID and these structures are prevailing. The cost of credit is also at a low point and therefore suggests significant opportunity to raise cheaper capital to be deployed to enhance the return of assets.
A prudent approach to recovery from a crisis such as Covid-19 is advisable, but if you remain too cautious for too long, some significant value creation opportunities could pass by unnoticed.
Putting your cash to work: Organic or Inorganic Growth?
All companies, regardless of size, location or sector face a common challenge: how to fund real options for growth in their businesses to boost earnings and enhance value of their shares; or fall into the trap of being risk averse, focussed on funding organic growth to exploit the skills and capabilities that have stood them in good stead in the past.
Funding organic growth is of course a less expensive way to grow as accountability for improvements can be delegated among managers and firms typically pay a premium for acquisitions. Yet studies have shown that only 29% of managers of major companies are highly confident that they can reach their organic growth targets – leaving any step-change or aspirational growth target firmly on the back burner and the “Business of Tomorrow” growth prospects at risk.
This is echoed by the fact that larger incumbent companies are finding fewer and fewer organic growth opportunities inside what have historically been “core” business areas, which have become increasingly mature and competitive. The result is lower overall market growth, fierce competition for market share and more consolidated industries, all of which restricts the ability to grow in existing markets.
The irony is that growth opportunities have never been more numerous for companies that are able to look outside of their historic paradigms of what is “core” to their business, and take advantage of the growth opportunities that are being created by, amongst other things, the rapid emergence of disruptive market innovations and widespread industry convergence. This allows new entrants to into markets to leap-frog incumbents that hold on to the notion that what has historically helped them to succeed will continue to work into the future. An example of this is the increasingly blurred lines between telecommunications, financial services and retail, a convergence enabled through the ubiquity of mobile phone technology.
The obvious dilemma is that of funding opportunities that are perceived as “non-core” and “not invented here”. The other question growth-hungry companies will be asking themselves is how to appropriately structure and capacitate the organisation’s growth engine, without losing the focus of line management on existing business operations. In considering the answer CEO’s understand the traditional option of developing the capability internally or outsourcing to external investment partners that both offer companies some advantages and disadvantages. Yet a third option exists that combines the best attributes of both models.
Growth driven from within the organisation
Driving investment in growth from within the operating structures of the organisation introduces both opportunities and challenges. Clearly the benefit of an internal growth engine lies in a close alignment of investments in new revenue areas to the overall business strategy, and the ability to leverage existing assets with the business – including skills, intellectual property, customer bases and physical assets – to ensure maximum value creation.
In Deloitte’s experience of managing growth engines for corporate clients, a critical driver of success lies in developing a dedicated and stand-alone growth function that does not divert the focus of line-management from the “business of today”. In developing this growth engine, the structure, governance and investment criteria must be put in place early to provide a protected environment in which new opportunities can be incubated, developed and commercialised. This provides some challenges for companies looking to capacitate an internal growth engine without the skills and experience required. An internal function will also tend to see the world, and opportunities it presents, through a very specific lens that is determined by the nature and scope of “business of today” operations. This often prevents the ability of seeing the adjacent or even disruptive market opportunities that are emerging from unconventional spaces and limits the growth potential of the company.
There are examples of companies that have become skilled acquirers and have developed stand-alone internal merger and acquisition (M&A) capabilities to drive acquisitive growth. The danger with these “serial acquirers” is that the M&A function, once built, continually requires feeding and acquisitions can become the strategy rather than an enabler of the strategy.
Growth driven by third party professionals
At the other end of the spectrum are professional fund and investment managers that are not involved in business operations, and drive investment returns through a structured process of identifying opportunities and managing investments loosely defined as private equity transactions (PE). These firms typically bring a team of highly skilled and experienced investment professionals to drive growth through investment. Their expertise, market research capabilities and market networks position them well to source and develop opportunities across multiple industries and markets.
However, what PE fund managers lack, when applying them to a company’s need for revenue growth, is the access to operating assets that can be leveraged to significantly increase the value of a transaction, and the alignment of the investment strategy to an overall strategic direction of the business. So while outsourcing growth requirements to a professional investment manager may provide attractive returns on investment without diverting the focus of management, it is unlikely to yield the new revenue streams that are strategically relevant as the portfolio of future business operations.
Captive Growth Funds – combining investment experience with strategic relevance
A solution for companies looking to drive sustainable growth investments while sticking to their knitting in existing operations, is the Captive Growth Fund.
The Captive Growth Fund is essentially a ring-fenced investment pool dedicated to fuelling a company’s corporate venturing process that is tailored to the strategic and financial criteria of the company. Managed by an external fund management team of experienced growth specialists, the company gets access to an investment vehicle with a unique and compelling combination of the skills, experience and focused attention on growth usually reserved for the more passive private equity investment space, together with a clear strategic and operational link to the core-business and active investment involvement that is usually the domain of an in-house M&A team. In this way, the Captive Growth Fund bridges the divide between 3rd party PE funds, and internal growth and M&A engines and brings the best of both models to bear on driving sustainable
The operating fundamentals of a Captive Growth Fund
1. Building the platform for growth
A first and critical step in any corporate growth programme, and particularly when managed through a Captive Growth Fund, is to define the objectives, criteria and operating structures of the process upfront with clear buy-in and support from senior leadership and board members. This process will provide the investment mandate and governance process that the Fund Manager will use to drive opportunity development and decision making throughout the investment process.
2. Maximising return on effort
The Captive Growth Fund uses a tried and tested approach that combines investment banking, strategy consulting and corporate finance techniques to identify and systematically develop investment opportunities. An in-depth internal analysis of the organisation’s current capabilities and assets, and an external market intelligence function unearths relevant target growth opportunities. A Fund Manager should bring both the process experience and skills, together with expertise and networks that span multiple markets and industries in order to maximise the value from this process.
To maximise return on effort in the investment process, only the most attractive opportunities should be developed through to a stage where the investment case can be presented for the ultimate investment decision. This systematic development and filtering of opportunities creates an internal atmosphere of competition for the scare time and resources available to the Fund Manager, and ensures that only the most attractive investments reach the investment committee.
3. Actively managing value creation
Following a decision to invest, the Captive Growth Fund employs an active management strategy for driving value creation both in the target investment, and in the integration of this into existing operations. The focus here is on growth through cash flows generated by operations rather than the more passive PE investment approach that relies on purchasing under-valued assets and balance sheet restructuring to deliver value.
4. Fund Structure
The structure of a Captive Growth Fund is extremely simple. The investor company retains complete ownership of the fund and veto rights on investments through the Investment Committee, and benefits from the returns generated through the fund. The Fund Manager will drive the investment process and will usually generate fees based on the funds under management, and be incentivised through a performance carry in the fund return.
5. The Captive Growth Fund overcomes several of the downfalls of other growth models
- Introduces a stand-alone growth engine with dedicated funding that combines the operating capabilities and strategy of the company with external professional management, allowing the company to drive relevant revenue growth while maintaining a focus on existing business
- Provides a company with rapid access to proven investment capabilities without the time and cost of developing this capability internally, allowing for rapid deployment of tailored growth programmes;
- Provides a partnership with a team of specialised and experienced growth investment professionals with extensive opportunity sourcing networks, a capability that would be extremely difficult to develop internally;
- Eases the purchasing decision to acquire these investment skills as fund manager fees typically come as a percentage of funds under management and thereby soften investment returns rather than creating an additional cost burden;
- Utilises existing and proven investment and governance structures to execute on the growth strategy;
- Ensures, through the opportunity filtering process, that the best opportunities are presented for investment. This is in stark contrast to many corporate investments in opportunities that “land” on CEOs desks and trigger reactive or opportunistic investments.
- Allows for periods of high-growth investment followed by operational integration and embedding. This natural growth cycle is a requirement to sustainable growth and is often prevented by costly internal functions that cannot lie under-utilised.
The Captive Growth Fund is one of many options available to progressive managers in order to put their lazy balance sheets to work. Inaction should not be the strategy of choice during these turbulent times.