The Covid shock has been extraordinary in so many ways. It clearly has been the most severe shock to the revenues of companies in almost all sectors and can truly be called a black swan event. Especially in the leisure and retail sectors, companies had to cope with revenue declines of 30% or more and struggled to survive. Thank goodness, government and central banks acted swiftly and decisively to help many of these companies survive.
But government support is running out in many countries in the next few months and we may not have seen all the fallout from the pandemic on the corporate front, yet. Nevertheless, both corporate executives and investors should use the coming months to assess how to deal with the next big shock to the system. Because this time, the government was there to help since it was a global shock that affected all of society, but next time, it could be a shock that affects only a specific industry or an individual company. And these shocks become more frequent across all industries. The chart below shows the share of companies in different sectors with revenue drops of 30% to 90% year-on-year (red) and 50% to 90% year-on-year (green).
Share of companies with extreme revenue drops
Source: Christie et al. (2021).
The chart is taken from a study of all companies in the Compustat database globally that investigated how many companies are subject to such extreme revenue shocks, which ones survive, and what drives the chance of survival. So here is the good news. The vast majority of companies (77%) that experience a revenue decline of more than 30% year-on-year survive. Only 23% of listed companies exit the market by being acquired, filing for bankruptcy, or other means. Of the 77% that survive, 44% show positive revenue growth the following year and 33% continue to experience declining revenues. But amongst those companies where revenues rebound the following year, the rebound tends to be weak. Only 13% experienced a strong rebound of 75% or more of lost revenue.
Extreme revenue shocks are typically not a short-term phenomenon but the fallout stays with a company for a long time, even if it survives the direct hit.
The fate of companies after a revenue shock
Source: Christie et al. (2021)
From a corporate perspective, there are basically three ways to cope with such extreme shocks and survive both the immediate impact as well as the following years. A company can have enough cash and liquidity reserves, it can have a high equity capital ratio and increase borrowing, or it can change its operations and become more flexible and leaner.
And when it comes to these three levers, the historical evidence seems pretty clear cut. The only thing that helps a company survive these extreme revenue shocks is access to cash. Companies that either had lots of liquidity at hand or could tap into existing credit lines to increase their cash at hand were more likely to survive and recovered more quickly.
Companies that had low financial leverage and a high equity capital ratio may want to borrow money to raise cash but once the revenue hit has come, banks and bond markets prove remarkably reluctant to extend any new credit to these companies. It’s the classic tale of banks willing to give a man an umbrella when the sun shines but asking for it to be returned when it starts to rain.
That an abundance of equity capital does not increase the chance of survival and that cash at hand does should also be a warning to investors in private equity. LBOs and other private equity strategies rely on an increase in leverage to improve profitability and accelerate a return of cash to investors. But that makes these companies extremely vulnerable to adverse market shocks – more so than listed companies. In essence, many private equity firms optimise their holdings for a sunny day and reduce the resilience of their portfolio companies to a thunderstorm.
Personally, I think this is what we will see in the aftermath of the pandemic as well. If I look at the publicly listed leisure companies in the UK, I find that so many of them are flush with cash. Many of them could survive a full year or more without any revenues. Meanwhile, so many restaurant chains and coffee shops owned by private equity firms had to enter into voluntary arrangements (the UK version of chapter 11 bankruptcy) because they simply didn’t have the liquidity to continue to operate and couldn’t get any new lines of credit.
But what about the third lever available to companies: Making the company leaner and increasing its operating flexibility. This is what so many private equity firms pride themselves on and what so many executives of listed companies try to do as flanking measures besides raising cash.
Well, it turns out that these efforts have hardly any impact on the chance of survival at all. In many cases, increasing operational flexibility takes a long time to achieve, often too long to be a meaningful help for a company struggling to survive. And making the company leaner aka cutting costs aka firing people has its own problems. Typically, it helps a company survive in the short run but reduces its ability to bounce back from the shock in the medium term. By firing lots of people, the company loses institutional knowledge and cuts into the very growth initiatives that could ensure a rebound after the crisis (often, “nice to have” growth projects are the first to face the chopping board in a crisis).
It’s not what managers learn in business school, but cutting costs is in the best case, useless and in the worst case puts a company on a path of continuous decline. Just look at companies like IAG, American Airlines, GM, US Steel, GE, Deutsche Bank, etc. Compared to their international peers and local challengers, they have cut their costs right into a bankruptcy or into market losers.