Preparing for a Downturn: An Interview with Markus Lahrkamp and Jeffrey Klein

To take advantage of the next downturn, companies must position themselves now, say Alvarez & Marsal managing directors Markus Lahrkamp and Jeffrey Klein.

How imminent do you believe a downturn to be?
Jeffrey Klein: If we knew when the market would turn we would be making a killing in hedge funds, or already retired! But clients do believe a downturn is on the way and that can become a self-fulfilling prophesy. Private equity firms and their portfolio companies are becoming more conservative and we are starting to see broken deal processes once again. That is a reflection of investor sentiment.

What challenges are manufacturing and distribution businesses, in particular, facing at this point in the cycle?
Markus Lahrkamp: They primarily face challenges around web-enablement and changes in consumer behaviour – the Am Amazon affect – as well as the demand for mass customization. And they have to be able to respond to all these challenges, while also dealing with the prospect of a cyclical downturn.

So, how should companies in these industries, and their private equity owners, be preparing?
ML: The emphasis neexs to be on shoring up balance sheets and ensuring sufficient levels of liquidity. It is important that fixed costs are kept down and that capex plans are carefully considered and potentially deferred. It can be a tough message, but human capital costs also need to be looked at. We see a lot of companies that don’t have the right HR policies in place.

What about managing a sales force in a downturn?
ML: Companies will often try to minimize sales force costs in a downturn, turning variable compensation into fixed. But you need a highly motivated sales force in a difficult economic environment.

JK: One of the problems we encounter in the software and business services sectors is that sales forces are not compensated on margin, but on dollars sold. That can be problematic because salespeople are often allowed to run amok and create contracts and pricing structures that are inconsistent with the company’s ability to deliver. Ahead of a downturn, it’s a good time to look at your quote-to-order process, and at the profitability of the deals going through.

How else do the challenges facing services businesses differ from those faced by the manufacturing sector?
JK: A lot of the traditional levers that exist in the manufacturing environment don’t exist in software and business services. Where you have hard assets, you have inventory, the ability to throttle production and the ability to convert fixed costs to variable. Software and business services are primarily based around people and so the levers are different. It is very important to understand the total cost to serve. A lot of these companies track significant costs in the corporate structure, rather than allocating them down to a product or customer level. That results in the perception that services and products are profitable when they are not. It creates a vicious cycle where you are potentially renewing unprofitable or barely profitable clients, increasing the velocity of negative margin.

There is also an expectation in software and services that contracts will fall. As we enter a downturn there will be pricing pressure. It is vital, therefore, that our clients truly understand that total cost to serve.

Many private equity-backed businesses in these software and services sectors are still at a growth stage. Are they particularly vulnerable?
JK: When clients are buying into high growth companies, they tend to get lazy about cost management. They don’t have the visibility around cost to serve that is required to know where and when to slow down. It’s also important to get serious about which products are at scale, which might achieve scale and which are sub-scale. While it is a difficult conversation to have, you need to look at the pipeline and say, if there isn’t a clear path to productivity in 12-18 months, alternatives may need to be considered. One of the best alternatives is to monetize those assets, selling them or selling the customer base. You can then use that funding to push products that are scaling to where they need to be. The move from growth at all costs to profitability at all costs can be a difficult cultural shift.

Q: What steps should businesses be taking to ensure they are investing in the right places?
JK: It’s usually a function of gaining control of product development, R&D and sometimes sales. That will generally mean someone in the C-suite taking greater ownership of the roadmap.
The challenges are particularly acute for the software sector, because a lot of companies are in the process of moving into the cloud and transitioning from a purchase license and maintenance model to a recurring ‘software as a service’, or SaaS, model. That creates difficulties from a cashflow perspective.

Moving into the cloud is costly, and at the same time you are losing the large capital infusions that sales of software bring. Good communication between management and sponsor is needed to avoid a cashflow crunch, which right now might be revocable but could be irreparable in a downturn.

ML: The other issue for private equity-owned companies in general is that multiples have been astronomically high over the past few years and debt has been cheap. Now, with the prospect of a downturn, as well as all the other structural challenges above, you have a perfect storm. In terms of how businesses should be approaching this, you have to look at where you are making money and what needs to be cut.

Q: Are there not litigation risks associated with cutting services?
JK: Manufacturing companies have the opportunity to choose not to ship product if clients represent a credit risk or are in arrears. But the situation is less clear cut for our SaaS clients. With so much now being run in the cloud, you can create significant economic damage by cutting service. Most SaaS companies have not been through a downturn before and don’t necessarily have well-established processes for how to escalate matters before services are terminated. The time is right, ahead of a possible recession, to review those policies and make sure the decision making is elevated to the right level.

Q: What would be your final piece of advice for minimizing the risk that a potential downturn may bring?
ML: It is important to remember that alongside risk, a downturn also brings opportunity. Companies that are prepared and have strong balance sheets will emerge as winners. The problem, at the moment, is that too few recognize this need for preparation. With no clear sense of when the cycle will turn, many prefer to focus on the next acquisition, or major investment, instead.

JK: You need to get serious about total cost to serve and margins. Don’t spend a year trying to fix sub-scale or nominally profitable assets that will prove difficult to maintain. Liquidate them and use that cash to take advantage of weakness in the market and to buy companies as they start to fail.