Capitalizing On The Crisis: Strategic Decision-Making in an Uncertain Economy


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Capitalizing On The Crisis: Strategic Decision-Making in an Uncertain Economy

  1. 1. Capitalizing on the Crisis Strategic Decision-Making in an Uncertain Economy current corporate portfolio of business units and investments By Mazen Skaf based on: Strategic Decisions Group Sound analysis of the underlying value drivers and the F ormer Federal Reserve Chairman Alan Greenspan, ranges of uncertainty associated with these value drivers testifying before House Committee on Oversight and The exposure of the corporation to those uncertainties Government Reform, called the current economic crisis a “once- resulting from the corporate strategy and investments in-a-century credit tsunami.” For companies across industries, access to credit has certainly been an acute near-term concern. In this context it is critical to distinguish between uncertainty But as governments and central banks act to ease credit markets, and risk exposure. One may be uncertain about the direction of corporate leaders must now make larger strategic decisions – prices of a certain commodity like natural gas, for example. under conditions of extreme uncertainty – that will determine However, risk exposure is determined as a result of the strategy, how well their companies fare against the strongest economic asset investments, and contractual obligations of an entity or headwinds in decades. corporation and how they are driven by an uncertain parameter. As part of evaluating any new investment opportunity, decision- Astute business leaders realize that the current environment will makers should demand rigor at three levels: open significant opportunities for their companies to benefit 1. Thorough assessment and understanding of the relevant from the dislocations across industries. To identify and uncertainties capitalize on these opportunities in the face of significant 2. Analysis of the risk exposure to the specific uncertainties uncertainty about the length and depth of the current crisis, resulting from the contemplated investment, taking into decision-makers should take an integrated approach to strategy account the corporate portfolio of assets and contractual and risk management. Specifically they should: obligations 3. Evaluation of the risk-return profile of the contemplated Reassess the risk-return profile of their corporate portfolio new investment and comparison with the risk-return as well as new investments under consideration profiles of other available alternatives Develop strategies and contingency plans to shift the payoff profile towards greater upside and limit the In the making, timing, and resourcing of strategic decisions, downside leaders face a deeper and broader set of uncertainties than they Build and maintain strategic maneuverability have likely ever faced. Consider just a few of those uncertainties: Reassessing the Risk-Return Profile The depth and length of the crisis: Predictions of the The current financial crisis has triggered a repricing of assets magnitude of the current economic crisis range from across several asset classes and has brought about significant several quarters of recession to doom-and-gloom scenarios volatility in commodity prices and financial securities. Asset of prolonged worldwide depression. While forecasters may prices across several classes of assets may decline in a very long differ on the length and depth of the current crisis, the real process and may overshoot on the way down just as they challenge lies in developing a robust strategy with overshot on the way up. contingency plans. In addition, several industries are witnessing fundamental shifts The effect of government intervention: Just as the Great in underlying value drivers ranging from freight rates to energy Depression ushered in the New Deal, the current crisis is prices to availability of credit. Companies in these industries likely to see a fresh wave of government actions, including should therefore rigorously reassess the risk-return profile of the regulation, stimulus packages, global trade restrictions, or ©2008 Strategic Decisions Group International LLC. All Rights Reserved. No reprint or dissemination without SDG’s permission.
  2. 2. at least skepticism about free trade. Certainly, few people would have predicted even a few months ago that the U.S. would not only be bailing out financial institutions but also taking Cumulative Probability an equity stake in them. Increased regulation may slow recovery, and various forms of Improvement in economic stimulus may favor some industries performance through risk management and over others, but the consequences of these contingency plans interventions – intended and unintended – remain unknown. Lower cost of capital The impact of deleveraging: With some $600 trillion in derivatives contracts outstanding Reduction in probability and consequences of downside worldwide, perhaps $10 trillion in mortgages in the US, and $60 trillion in credit default swaps Shareholder Value in the US, the unprecedented level of leverage Figure 1: An integrated approach to strategy and risk in the economy will take a long time to unwind. This management lets business leaders shift the total distribution of deleveraging is leading to the repricing of different shareholder value toward greater upside (to the right) while assets classes and recalculations of risk. Further, as reducing the downside risk. asset prices across several asset classes decline during a very long process, it’s possible that they fundamental flaws in the models used by such financial services will overshoot on the way down just as they overshot on firms, and their mispricing of risk, the root cause may lie in the way up. incentive structures that rewarded short-term performance without weighing the impact on long-term shareholder value. Developing Strategies and Contingency Plans Seeing Opportunity Where Others See Only Risk Taking an integrated approach to strategy development and risk management enables decision-makers to shift the payoff profile Just as stock volatility presents savvy investors with rich of an investment or the overall distribution of shareholder value opportunities for gain, the current economic uncertainty offers towards greater upside while limiting the downside (Figure 1). similar opportunities for enterprises that know how to make strategic decisions. For example, distressed assets are likely to In a military context, it is often said that “the mission comes be available at a bargain as some companies are forced to raise before safety;” otherwise, no one would leave the barracks or cash to reduce debt. Opportunities for mergers and acquisitions base. The parallel in a business context is that strategy comes will also be plentiful. In specific industries, uncertainties will before risk management. Usually, that is the case and strategy create “white space” where companies that comprehensively sets the structure and provides the context for the best approach understand value and risk can prosper. For example, in to risk management. However, in times of great uncertainty and petrochemicals, with slowdowns in the U.S. and China and significant volatility, organizations should take an integrated decline in feedstock prices globally, attractive opportunities to approach to strategy and risk management to limit the downside acquire capacity or companies may appear in late 2009 and exposure and increase the potential upside in the case of 2010. favorable market conditions. Opportunities are likely to be even greater for companies in The types of bets that organizations should consider or pursue industries that do not require a great deal of leverage or debt are ones with limited downside yet with significant or unlimited finance. In addition, in some industries there may be upside. (As an analog, this is similar to buying a call option on a opportunities for smart companies to leapfrog the competition stock, or negotiating an option with a contractor for expanding a and take the industry lead. Again, the key will lie in knowing factory that would be exercised in the case of a market how to comprehensively understand risk and value in reaching turnaround). Unfortunately, many of the financial services strategic decisions. companies that ran into trouble were doing just the opposite: aggressively selling instruments that exposed them to unlimited downside risk for a small fee upfront. In addition to the Capitalizing on the Crisis For more articles and perspectives, visit 2 of 2
  3. 3. Risk Profile of 2010 Cash Flow from Operations 1.0 Building and Maintaining Illustrative 0.8 Strategic Maneuverability Probability 0.6 During periods of steady growth and expansion, it 0.4 is easier to foresee how conditions will evolve 0.2 (though no less important to comprehensively 25 50 75 100 125 150 0 understand uncertainty, value, and risk). In times of Debt Paydown 175 200 225 great uncertainty, conditions can evolve much Uses & Strategic Interest Dividends O&M CapEx of Cash Flexibility $ millions more unpredictably, with wide swings, sudden impact, and lingering effects. Such times offer Credit 3 x Interest Coverage Quality great opportunity, but safely seizing those 0.25 x Debt Coverage Coverages opportunities requires strategic flexibility and maneuverability, not bet-the-company gambles. Economic Breakeven Cost of Capital Value Added The current downcycle may take several quarters to several years to play out, but strategic Figure 2: Building a cash reserve and managing cash flows to maneuverability can enable a company to outlive ensure a cushion above cash obligations provides significant strategic maneuverability. the downcycle. sequence of smaller investments. Those smaller investments One key source of strategic maneuverability lies in building a enable learning and contingent responses as conditions evolve – cash reserve (Figure 2) and securing access to credit for when it the essence of strategic maneuverability. is needed in order to judiciously capitalize on attractive acquisition opportunities. We are seeing deals with attractive Conclusion fundamentals selling at a fraction of book value or with very attractive earning yields. However, acquirers need to keep three Given the scope, magnitude, and unpredictability of today’s things in mind: uncertainties, leaders can be forgiven if they find the challenge More attractive deals may materialize in the future. Keep of making sound strategic decisions extremely daunting. The some buying power in reserve to take advantage of those spread between best-case and worst-case scenarios can be vast deals. and so can the consequences of strategic miscalculation. The fundamentals themselves may change given the Further, traditional approaches to strategic decision-making strength of the underlying trends. Several industries are confuse risk with uncertainty, resulting in sub-optimal decisions. going through seismic shifts and earning projections may But by understanding uncertainty and risk, identifying prove too optimistic to attain; in addition, valuation opportunities, and maintaining strategic maneuverability, benchmarks and multiples may be further revised. leaders can do far more than simply steer clear of danger. They Even for very attractive deals that pass due diligence, make strategic decisions that harness today’s economic inching into the full investment position in a specific sector headwinds to take their companies forward. may be advantageous. Use a rigorous analysis of the sequential decisions and the uncertainties related to asset *** valuation to understand the overall risk-return profiles of various investment alternatives. Dr. Mazen Skaf, partner and managing director of the Europe and Middle East Practice of SDG, is Over the course of the current downcycle, entire industries, an expert in strategy development and evaluation, markets, and geographies may be transformed. Banking has portfolio management, decision analysis, and risk already been profoundly changed. In the face of such tectonic management. Dr. Skaf splits his time between the shifts, strategy development should not only encompass a full Palo Alto, Calif., and Beirut, Lebanon, offices of Strategic understanding of the risk-return profile of any strategic Decisions Group. alternative but also how best to split the investment into a Capitalizing on the Crisis For more articles and perspectives, visit 3 of 3