May 19, 2010 Danger in early recovery by Anthony Holmes Story link: Danger in early recovery This is a strange recession. Few people expected that it would take the shape of a narrow ‘V’ and, despite the hope that recovery will continue there is still a residual fear that problems remain. Given the level of corporate debt and the depth of decline many people predicted that there would be more corporate failures than has been the case so far. So has corporate debt impairment been significantly less than we expected? Empirical evidence confirms that corporate financial distress has not been dramatically less than predicted but that widespread collapse into bankruptcy has been averted through a combination of collaborative lenders and low interest rates. This suggests that problems are being held in abeyance until either borrowers trade their way into a more comfortable position or collateral values increase, the market for distressed assets becomes more liquid and lender balance sheets are able to absorb the negative impact of recovery shortfalls. In previous recessions the peak of corporate collapse occurred in the phase of early recovery that follows the resumption of economic growth so it may be that the anticipated level of corporate distress is yet to come. So what might change over the next year that increases the risk of corporate financial distress and what can be done? Firstly, recessions are not simply about ‘decline and rebound’. They have more structure than this and, arguably, the most dangerous phase is that of early recovery we are currently experiencing. This is the period that follows the resumption of economic growth and ends when three or four quarters of growth have been experienced at or in excess of the long-term trend average. This is a phase in which asset values may begin to increase, which reduces the financial risk somewhat, but in early recovery the principal risk changes from financial to managerial. The latter is a type of risk that lenders are not equipped to evaluate because appraisal orthodoxy places too much reliance on previous financial data as evidence of managerial aptitude. Early recovery is not a time of improving credit risk. It is a period when the profile of risk within the loan portfolio changes, sometimes in unexpected ways. At the root of these changes lies the way in which management deals with uncertainty and turbulence and previous financial metrics offer no guidance. Probabilistic risk assessment is undermined by uncertainty about the extent to which recent performance is indicative of future behaviour. The conditions that will prevail during this ‘dangerous’ early recovery phase are different from those preceding the recession and therefore financial data that period is not a reliable guide. Neither is recent performance indicative of managerial competency in a dissimilar situation. The unreliability of quantitative analysis and the invalidity of concluding that the survival of a company is evidence of a management team’s effectiveness is founded on the flawed presumption that operating in early recovery is less challenging than managing the decline phase. Lenders need to adopt a credit appraisal methodology that differs from that employed at every other phase of the credit cycle. Lenders must evaluate a management team’s awareness that conditions are unlikely to return to those prior to the recession and their cognisance that early recovery phase poses particular challenges. The hazard lies in the fact that after a period of imposing tight financial controls with no objective other than survival corporate management is not oriented to the changing conditions. Uncertainty about the strength and continuity of the recovery can create a reticence to release the constrictions and invest. If this decision is incorrect then healthy survival will be converted into competitive disadvantage. If management’s scepticism about a robust recovery is right but they suppress this and adopt an expansive policy, then the healthy survival may turn into financial disablement. In some cases there can be a tendency to overtrade and in others to under-trade an opportunity. The need to identify and migrate to a new strategic location and, often, adopt a new business model, is often too radical a notion given recent experience. The task is often beyond the capability of managers whose dominant skills are control and incremental progress within a given model. More suited to this task is a transitional leader, a dispassionate specialist who brings specific expertise in implanting change and moving a company from A to B. Most companies facing collapse have no such expertise in place. There is a clear distinction between management and leadership and, especially as damaged companies exit the recession, their recovery can be impaired by the maintenance of the managerial controls designed to constrain their activity. These controls and the managerial mindset that was developed in times of stability are no longer sufficient to steer the business and the ‘managerial toolkit’ will no longer function effectively. In turbulent times, conventional risk appraisal can prove ineffective. In early recovery more innovative approaches are required to ensure that lenders are not exposed to unnecessary write-downs. Anthony Holmes is a corporate turnaround specialist and transitional leadership expert. |