Memo To Middle Market CEOs: Why The Next Decade Could Undo 30 Years Of Hard Work
Nobody I know who’s running a business would call the last three decades a walk in the park. But ten years from now, we could be looking back fondly on the 1985-to-2015 era and view its many changes as tame stuff compared to what’s in store for us between now and 2025.
That’s the troubling conclusion one reaches after digesting a smart report, “Playing To Win: The New Global Competition For Corporate Profits,” by McKinsey & Co, and from a smattering of stories I’m hearing from clients who say global competition and other headwinds are picking up speed, rather than calming down.
The McKinsey study has a cheery, can-do title, but its message is ominous, both for U.S.-based multinational companies and for middle market companies, regardless of how insulated they’ve felt to date from global competition.
Many founder/owner/CEOs of middle market companies are just now declaring their houses in order after the bruising downturn of 2009. Some have overstayed their intended retirement dates, and pushed back settling on liquidity strategies. I’m writing this to warn many of you that time may be short to consider your options. M&A activity is indeed strong and valuations (more on that later) have crept back up toward pre-crash levels. But this window won’t be open long. And the business environment that awaits us all in coming years could be particularly difficult.
(Yes, I know, you’re accustomed to transaction professionals insisting the time to make a deal is now. I believe my clients know I’ve never operated that way, and in fact waiting to sell has made a lot of sense in recent years. But I truly believe present conditions are nearly optimal for middle market liquidity and that the uncertainty ahead is particularly dangerous to wealth accumulated in operating companies. Owners who choose to stick with their companies during the next decade may indeed be greatly rewarded, but they will also face increased risks.)
To cut to the chase, McKinsey sees four factors leading to a decline in global profit margins that could roughly put aggregate profitability back to where it was 30 years ago:
–Interest rates and taxes can only go up. Central banks are preparing as we speak to raise rates sometime soon, to ward off prospective inflation and try to prevent asset bubbles. Effective tax rates, too, McKinsey says, seem likely to rise after years of multinationals being able to shop for low-tax jurisdictions and governments’ attempts to stimulate their economies (often unsuccessfully) with tax benefits for business.
–Labor costs, measured globally, appear to have bottomed out. That means easy cost reductions from offshoring could be over. And pushing local labor costs down may have reached its practical limits.
–Disruption of existing industries by technologically enabled new ventures, already breathtaking, is only just beginning. Just because your industry hasn’t been disrupted yet doesn’t mean it’s not going to happen. The scale of disruption can be enormous. Skype, for instance, saved consumers (and thus cost telecom companies) globally $150 billion from 2005 to 2013, McKinsey notes. Amazon (AMZN), Netflix (NFLX) and Expedia (EXPE), meanwhile, wiped out whole swaths of the book retailing, video rental and travel agency industries.
–Perhaps most crucially, the rise of large multinationals based in emerging economies threatens corporate growth and profits across the developed world. Chinese and other emerging-market companies are projected to double their share of global sales over the next decade. They’re long-term, market-share-grabbing players. And they’re relentless competitors, and exceedingly difficult on suppliers.
“Corporate profits, currently almost 10% of world GDP, could shrink to less than 8% — undoing in a single decade nearly all the corporate gains achieved relative to world GDP over the past three decades,” McKinsey says.
So, we look ahead to narrowed global profit margins; more of the profit pool going to emerging market companies; and, McKinsey notes, the gap in margins between the very largest companies and smaller companies has widened significantly, and factors would appear to keep that trend going.
If you’ve been running a company the last 30 years, it’s completely understandable if you’re wondering how things could get any tougher. But McKinsey sees these past decades as uniquely good times for developed country businesses. Labor costs have declined. Interest rates and taxes have been historically low. Demand from emerging countries has skyrocketed, and companies from developed countries picked up huge shares of those sales. And technology has generally helped more than it hurt, helping to boost productivity and connect buyers and sellers in ways never before known.
During the last 30 years, many middle market companies I’ve come to know recorded their first foreign sale – and then went on to become companies doing as much business overseas as at home in the U.S. Many clients have also employed technology in surprising and innovative ways, making them more efficient and competitive.
McKinsey may be underestimating the ability of U.S. business to adapt over the next decade. American resilience is truly amazing. But I think, at the very least, a sober reality check is due for most middle market companies.
The good news is that deal activity and valuations are robust. Private equity funds have loads of unemployed capital commitments they want to put to use. And larger companies are sitting on record cash stocks and looking for strategic acquisitions, as organic growth becomes harder to achieve.
Our friends at Middle Market Growth magazine point out: “valuation multiples remain elevated with the median third quarter valuation-to-EBITDA multiple a high 8.5x, greater than any quarter since the start of 2010.”
The McKinsey report, linked near the top of this article, has some great advice for companies aiming to survive and prosper during the next decade. At the very least, I’d recommend you read that report, and update your strategy on an exit plan. Weighing the two paths against each other seems particularly crucial right now.