From Risk Management to Growth: Preparing for Economic Turmoil

I recently summarized the uncertainty in the current macroeconomic environment and emphasized the importance of proactive planning without overreaction. While a recession may not be inevitable, preparing for one is essential for any organization. For some companies, preparations are needed simply for survival. For many others, the preparations are equally, if not more, focused on taking advantage of opportunities to further accelerate growth and thrive in the long term.?

In this article, I leverage the many lessons I learned in the years covering the Great Recession and the Covid-19 pandemic, at both McKinsey & Company and JPMorgan Chase, and explore strategies and best practices that companies can adopt to proactively prepare for economic uncertainty and potential recession. Companies will need to tailor their approach based on their unique circumstances and industry dynamics, but by taking proactive steps and staying ahead of the curve, businesses can mitigate risks, identify new opportunities, and emerge stronger from any economic downturn. A 2018 report by Bain & Company showed that the winners in any recession set themselves up before the slowdown to act aggressively when the storm hits. The time before a recession is when companies need to strengthen their core, align on strategy, and prioritize the three or four initiatives that will enable them to thrive as others struggle.

Conduct Scenario Planning

In uncertain times, scenario planning is more important than ever. By forecasting different scenarios and testing them with probability analysis, companies can prepare for potential challenges and ensure they have the resources they need to weather a potential recession. According to McKinsey & Company, 90% of CFOs of leading companies indicated using at least three scenarios to support their planning, adding “we have observed a sharp increase in the number of organizations applying scenario-based planning approaches to manage the uncertainty of the current situation and ensure they have sufficient cash reserves.”

• Complete and internally consistent scenarios are essential. Companies should think about the key macro drivers impacting them and the key macro drivers impacting their customers and identify economic scenarios where all these key drivers are included and make sense together. While scenario planning with financial forecasting, it shouldn’t stop there. Companies should also think about what their competitors, suppliers, or other market players might experience as well as how regulators, investors, banks and other partners might react.???
• For companies that are more sensitive to the macro environment, considering severe conservative cases is critical. These scenarios may be very unlikely, but they can help to identify potential risks and ensure companies are prepared for a worst-case scenario. This "stress testing" is what larger banks model as part of the CCAR (Comprehensive Capital Analysis and Review) process, which is designed to ensure they have sufficient capital to withstand a severe economic downturn. While the CCAR process is notoriously painful, it can also be extremely helpful.?
• With a mental model of what the world looks like in each scenario - including their financials, liquidity, capital, customer needs, competitor and supplier health - companied can then identify the best tactics and strategies to pursue, including prioritizing resources, making informed decisions about how to allocate capital, and perhaps even get ready for an acquisition or market expansion if the opportunity presents itself.

Can companies foresee, model, and prepare for every scenario? Of course not. Companies like Procter & Gamble, which prepare for a multitude of scenarios, could not forecast and prepare for the COVID-19 pandemic and resulting supply chain crunch. Scenario planning, however, is a muscle, and the more companies use it the better equipped they will be to detect patterns and identify the right levers to pull.?

Focus on Cash?

It is a cliché, cash is king in the current economic environment. To prepare for a potential recession, companies must find ways to preserve cash without hurting themselves in the long term. Needing to raise cash when the equity or debt markets are closed is a risk no company should be willing to take. The earlier companies think about cash preservation, the more likely they are to identify healthy levers to pull, avoiding the need to aggressively cut costs if a recession actually hits.?

• Companies should continue to invest in research and development (R&D), marketing, technology, or capital, in order to avoid suffering long-term damage and giving competitors a leg up. However, they can consider raising the bar for these investments to ensure they are generating the necessary returns, introducing for example a more demanding business case process. They should also evaluate investments based on payback period in addition to the transitional NPV evaluation. This allows them to prioritize investments that will generate cash flow in the short term, while still considering long-term growth opportunities.?
• Companies should also assess the viability of large investments planned, such as capital expenditures or acquisitions, in the context of scenario planning. Investments may be extremely lucrative in a base case scenario but become a loss leader in a conservative scenario. Such an investment may be a good candidate to put on hold or slow down pending more clarity on the macro environment. Alternatively, companies could attempt to find sources of funding for the investment that don’t drain its own balance sheet, such as project financing or a joint venture.?
• Cash management processes become critically important in uncertain times. Companies should strengthen their cash monitoring processes and ensure their cash is well protected and easily accessible. They should work through their Accounts Receivables, invoice their customers promptly, ask for extended payment plans from their suppliers and creditors, and consider renegotiating contracts where needed, asking for pricing changes and more favorable payment terms.
• Companies should also look at their products and services and consider phasing out unprofitable lines or focusing sales on faster payback, simpler products. This product portfolio review should of course be approached strategically and where possible focus should be on “revolving-door decisions,” which can be relatively easily reversed if conditions change.
• And of course companies should look for efficiencies - but carefully. They should look for opportunities to reduce external spend, optimize inventory (cautiously, given the lessons from the pandemic!), automate as much as possible to reduce costs and increase efficiency (as long as payback periods make sense), cut down on bureaucracy, and streamline processes to become more agile, and look for opportunities to outsource or partner with other companies to share resources (e.g., building industry utilities for functions that are not core to the company’s value proposition).?
• There are situations where hiring freezes and layoffs are inevitable, as we are currently seeing with big tech firms that had over-hired following the pandemic. Layoffs should be approached, however, with an eye towards the future. Many companies that laid off employees in 2020 found themselves short-staffed soon after, unable to meet their customers’ expectations. A study of public companies by Ranjay Gulati and his colleagues, as referenced in the Harvard Business Review, also showed that the companies that emerged from the Great Recession in the strongest shape relied less on layoffs to cut costs and leaned more on operational improvements.Companies should look for ways to redeploy (e.g., from underwriting to collections), reduce hours, or furlough staff whenever possible before laying them off. If scenario planning points to inevitable layoffs, moving quickly and humanely can maximize the opportunity for impacted employees to find new roles. The way companies approach layoffs can have a long-lasting impact on their attractiveness to existing and new talent.?

Review and Optimize the Capital Structure?

Capital structure is crucial to ensuring that companies have the necessary liquidity and flexibility to navigate potential risks and challenges. This involves reviewing and adjusting the mix of equity, debt, and cash on hand based on the current economic environment and potential scenarios. Conducting scenario planning early may give companies sufficient time to take action before markets close up, supplementing cash preservation measures. Consider these questions:

• Should the company repurchase shares? Should it issue equity? Scenario planning should give companies a good indication. Acting early though is important - the closer the recession, the less likely equity will be available.
• Should the company raise additional debt financing to meet short-term liquidity needs or finance long-term growth opportunities? Is it able to sustain its current debt levels? Debt can provide critical capital to the business. In early 2000, Amazon.com, then five years old, sold $672 million in convertible bonds, and these funds were key to its survival while many tech companies collapsed a few months later. Highly leveraged companies, however, tend to be particularly at risk during a recession due to the cost of servicing the debt and the constraints around it. Unless debt is necessary, deleveraging is generally preferred before a recession. Today’s environment is particularly difficult for debt financing, both from an availability perspective and a cost perspective, so it’s a lever to be used carefully.?
• Is the company's capital structure aligned with its strategy and goals? Public debt and equity markets, VC equity and debt providers, PE investors, and bank creditors, for example, all have different priorities and may be more or less appropriate depending on the company’s aspirations and business focus?
• If cash position seems precarious in some scenarios, what are the company’s contingency plans for potential liquidity shortfalls or unexpected capital needs?
• What are the risks to the capital structure from interest rates or currency risk moves?

Strengthen risk management practices

Given the uncertain economic environment, it is important for companies to have a robust risk management framework, including policies, procedures, and controls, in place to ensure that potential risks are identified and mitigated.?

• Regularly reviewing the company's risk appetite and risk management policies to ensure they remain appropriate in light of the current economic environment.
• Enhance stress testing or scenario planning models to include different economic scenarios and stress factors, depending on the company’s key drivers (e.g., interest rates, currency fluctuations, bankruptcy rates, unemployment rate, supply chain disruptions)
• Develop contingency plans for potential risks, such as liquidity shortfalls, regulatory compliance, supply chain disruptions, and cyber attacks.
• Establish key risk indicators to monitor emerging risks and take proactive measures to mitigate them. Credit risk in particular, if relevant to the company, is critical to monitor and manage.?

Communicate with Key Stakeholders?

Effective communication with key stakeholders - customers, employees, investors, banks, regulators, partners-?is crucial during periods of economic uncertainty. By keeping them informed of its plans and strategies, companies can help to maintain confidence in the business and potentially reduce the impact of negative events.

• Healthy companies should emphasize their financial strength, particularly their balance sheet, liquidity, and customer base. In the current environment, proactively mentioning the financial strength of the company’s banks and key partners is also a good idea.?
• Larger customers and partners will want to know they are in safe hands, and communicating proactively with them is a good idea if the company is in a particularly macro-sensitive industry. Conversely, companies can learn a lot by talking to their customers to understand how they are impacted as well as their needs and plans. This knowledge can help inform scenario planning, better forecast revenue, and possibly generate ideas for new products and services to support customers.?
• Investing in strong relationships with investors and banks is critical during periods of economic uncertainty. Companies should consider organizing regular meetings with key investors and bankers to update them on the company's progress and plans, and to solicit feedback on market conditions and potential risks. While it is generally true that companies - particularly public companies - should be conservative in their guidance to the street, conservatism is particularly important in a challenging economic climate. For example, if the company is experiencing a slowdown in sales due to market conditions, it may be necessary to lower revenue projections and adjust earnings guidance accordingly. By providing realistic guidance, companies can avoid setting unrealistic expectations that could damage their reputation in the long term. Investor communications are more nuanced for private companies, and the bar tends to be a bit higher than with public companies on when to communicate lower guidance to private investors, but the specifics vary case by case.?
• Employees will look to their companies for transparency and honesty. Companies often mistakenly assume employees are aware of their health or lack there-of, but the larger the company, the higher the likelihood of misinformation and rumors. Leaders should be proactive and thoughtful in internal communications.?
• Talking to business contacts and other players in the industry can be an important source of information. Companies could for example see delinquencies going up in adjacent segments and infer upcoming delinquencies in their segment. They could learn about liquidity or regulatory issues faced by competitors and prepare for repercussions. In uncertain times, companies should look as much outwardly as they do inwardly.???
• Lastly, companies should also maintain open and transparent communication with regulators?- where relevant - to ensure that they are aware of potential risks and can take appropriate actions to address them. Regulators may provide guidance or support to help companies prepare for potential challenges.

Remember Talent?

During times of economic uncertainty and the risk of a potential recession, having the right talent in place can be critical to companies’ ability to weather challenges and capitalize on opportunities. To ensure that the company is well-positioned to succeed, companies should consider the following strategies:

• Not every leader will have the appetite or ability to pivot in an uncertain economic environment. Identify gaps in skills or experience in key talent (e.g., experience operating in a downturn, or with M&A if the company believes it will have opportunities) and consider supplementing (or in some situations replacing) some existing talent with consultants or additional staff with the needed profile.?
• Emphasize learning and development to build a resilient and adaptable workforce. This can include offering training opportunities, mentoring and coaching programs, and access to industry conferences and events.
• Develop retention plans for top employees, who might be demotivated or out of the money if the company’s valuation is severely impacted. Developing retention plans that include financial incentives, professional development opportunities, and other perks can help keep top employees engaged and committed to the company.
• Foster a culture of transparency, accountability, compassion and gratitude. Open communication can help identify potential issues and challenges early on, allowing the organization to take proactive measures to address them. And when employees know that they will be held accountable for their work, they are more likely to take ownership and responsibility for their actions, avoiding some of the bad behaviors that often arise in troubled companies. On the other hand, leaders must demonstrate compassion and gratitude to retain and motivate employees employees in difficult times.?
• Lastly, great talent often becomes available during recessions due to layoffs and business closures. Companies that have the cash to afford it, should take advantage of the labor market to upskill and augment their workforce.?

Diversify

Diversifying sources of revenue away from cyclical or nonessential sources is also a wise idea to reduce companies’ exposure to economic fluctuations and mitigate risk. This diversification may involve exploring additional customers (for companies highly exposed to a few customers), new customer segments, geographic regions, product lines, or partnerships, including suppliers. The specific diversification needed may be identified as part of the scenario planning exercise, through a systematic concentration risk assessment, or simply by talking to customers to understand their spending plans, needs and habits. Companies that have the cash to support it should not shy away from starting or buying businesses to diversify themselves.?

Recent examples for the need of diversification abound. Lyft’s recent troubles are directly linked to concentration - while Uber expanded to food deliveries and global markets, Lyft was overly exposed to pandemic shutdowns in the US. Clear quickly realized the importance of diversification when airports effectively shut down during the pandemic, and added a line of business focused on identity verification much more broadly. Most startups in the US hurried to diversify their banking partners after the collapse of Silicon Valley Bank. Lastly, during the 2008 recession, Lego decided to expand in Europe and Asia while the U.S. faced economic distress.

Address Underlying Assumptions

To prepare for a potential recession, it is critical for companies to address underlying assumptions in the company that may no longer hold true in the current economic environment. This may involve questioning long-held beliefs about market trends, customer behavior, and other factors that could impact results. Failing to address underlying assumptions can lead to missed opportunities and decreased competitiveness. Outdated assumptions can prevent companies from pivoting quickly to adapt to changing market conditions, which can lead to loss of market share and revenue. On the other hand, by challenging long-held beliefs, companies can identify new opportunities for growth and competitive advantage. This can involve exploring new markets, products, or business models that were previously overlooked. Additionally, questioning assumptions can help companies to better understand the needs and behaviors of their customers, which can lead to improved customer satisfaction and loyalty.

Questioning underlying assumption should be part of any long-term strategic exercise - think Blockbuster's failure to question the assumption that customers would always want to rent DVDs in-store, or Kodak's failure to question their assumption that film photography would remain the dominant technology - but during economic downturns, additional assumptions may come to light. For example, during the 2008 financial crisis, many banks failed to question their assumptions about the housing market, leading to massive losses on mortgage-backed securities. The airline industry's assumption that business travel would always be a reliable source of revenue was challenged during the COVID-19 pandemic. Most recently, Meta’s assumption that changes in consumer behavior coming out of the pandemic were permanent (including the focus on the metaverse) proved painfully mistaken.?

Economic uncertainty and potential recessions can pose significant challenges for companies, but they also present opportunities for growth and innovation. By adopting proactive strategies, companies can prepare themselves for potential risks and emerge stronger from any economic downturn. From conducting scenario planning and focusing on cash preservation to optimizing the capital structure and communicating effectively with stakeholders, the strategies outlined in this article can help companies mitigate risks, identify new opportunities, and thrive in the long term. Ultimately, it's the companies that prepare themselves before the storm hits that will be best positioned to weather any economic downturn and come out on top.