May 27, 2015, by John Colley
Strategy briefing – Transient or Turbulent: Does it Really Matter?
The life span and volatility of a particular industry will provide some clues as to the strategic approach which may be appropriate for competing businesses.
This article considers transient and turbulent industries and the extent and circumstances of financially engineered risk which a business should carry. I also relate my own recent strategic experience of a particular business and its position in the industry cycle.
Turbulent industries are typically volatile to the extent that demand can halve in the downturn years but will eventually recover over a cycle.
This may take anything from 3 to 10 years. These industries are often referred to as cyclical, and may include construction markets, commodities such as paper, steel, furniture, soft furnishings, cars, etc.
These industries may suffer significant losses during downturns when only the strongest survive. Industry recessions usually result in the multinationals (with deep pockets, scale and scope economies, big brands and market shares) surviving and acquiring the smaller independents that do not have the reserves or a low enough cost base to survive.
As a consequence the industry tends to concentrate to few players. This in the longer term is likely to result in higher profits for the surviving oligopolistic players.
It suggests that businesses in these industries strategically should maintain liquidity and keep borrowings and rental/lease costs to a minimum; providing a low risk capital structure (Sull, 2009).
Transient industries have a relatively short lifespan and then disappear completely. This is typical of the technology sector where developments move so rapidly that product and technology quickly become obsolete.
One example might be the personal music industry which started with personal transistor radios, replaced with cassette players, then CD players, followed by iPods then iPhones, and now various wearables are appearing. Each technology almost completely destroys the previous offering rendering the manufacturing, music mediums, players, and often the distribution obsolete (ask HMV, Fopp, Virgin Megastores and many others).
This results in bankruptcies and redundancies. However some businesses are agile enough to survive and reinvent themselves.
IBM was originally a mainframe and operating system producer but following the relatively sudden collapse of this industry has been able to evolve into technology service providers of consultancy and software. Most technology industries suffer these threats to some extent.
How can a business in rapidly changing transient industries combat these changes? The answer lies in minimising asset investments and outsourcing as much as possible.
Examples of outsourcing include hiring temporary office space, temporary staff, leasing equipment, and outsourcing overhead functions (such as HR, Finance, IT and Marketing) and even production. There is an immense industry providing outsourcing services and as a consequence limited need to invest directly.
In transient industries there needs to be heightened and structured surveying of industry developments so that wind down can start early enough. In this way transferring investment and resources smoothly from declining industries to growing markets can be facilitated by maintaining strategic agility through being ‘asset light’ (McGrath, 2013).
Therefore we appear to have clear strategies of going ‘asset light’ in transient industries but ‘asset heavy’ in turbulent industries retaining major liquid resources to fund the downturns.
But is it so simple? Industries which do not fully exploit their resource base to limit cash invested may be at risk of someone willing to take greater risks and bet on the stage in the turbulent industry cycle.
Last year I spent much of my time organising and negotiating to buy a business at a price of around £28M. The characteristics of this industry would fit with the criteria of ‘turbulent’.
The purchase process has been in progress for around 12 months so far and I would estimate another 4 months to completion. Why so long?
The deal is complex in a number of ways including the nature and sources of the funding as well as transferring an onerous final salary pension scheme to the Dutch holding company. It is a Management Buy Out (MBO) from a European multinational which in turn is owned by private equity. We are using typical private equity techniques to fund the deal. This involves selling and leasing back the property and land to raise £16.5M, factoring (borrowing against) the debtors for another £5M, and extending the raw material creditors by negotiating 60 days credit against the current 30 days raising £1.5M. The remaining purchase price we are raising from private equity of £5M most of which is strip debt. We (the MBO team) will own 60% of the business.
The objective is to minimise the cash injection from the management team and maximise funding from any assets in the business. This results in high effective borrowings as almost the total purchase price is borrowed with high debt service charges. In turn, this means high risk should the market collapse or a major customer is lost and the entire business could be jeopardised. Of course we have a plan to improve results by reducing materials usage, buying from cheaper sources than the previous owners stipulated, and marketing new products. Nevertheless we are at the whim of the market and taking a major bet on the current stage of the industry cycle. We anticipate over the next two or three years the industry will keep growing when our borrowing costs will be at their heaviest.
The point is that having significant investments in assets and working capital may reduce risk against downturns in turbulent industries but increases the risk of predators and really does not make best use of cash which could be released and invested elsewhere.
Constant monitoring of the future direction of the industry is critical in both transient and turbulent industries so that appropriate action can be taken to wind down involvement or strengthen the balance sheet for a cyclical downturn.
Strategy is essentially determined by the nature of the industry, the stage in the product lifecycle or industry cyclicality and appetite for risk.
Although businesses with a higher appetite for risk may both outperform and, indeed, threaten your business.
Dr John Colley is Director of MBA Programmes at Nottingham University Business School. He was previously Group Managing Director of a FTSE 100 business, and Executive Managing Director of a French CAC 40 business. He currently chairs a listed Plc and is non-executive director of several private equity businesses. John is an ESRC/FME Senior Fellow.
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