SO FAR the credit crunch has only affected the UK financial sector. But as the squeeze tightens and the ripples spread, there is likely to be a sharp rise in corporate failures among companies in the wider economy whose management shortcomings have been disguised by the loose credit conditions of the past few years.
This is the diagnosis of risk consultancy Kroll, which as business’s enforcer, as it were, is well placed to spot early signs of distress. With its businesses in risk management, security, investigations and forensic accounting, Kroll is a company ‘you come across on a bad hair day’, in the words of its founder Jules Kroll, and in a recent report, ’20:20 vision: Boom, bang or bust’, it highlights some of the impending hangovers from the UK’s years of easy money.
Thus, the counterpart to the long period of stability the UK has enjoyed since the early 1990s is that managers are much less well equipped to deal with volatility and failure than their forebears. Managers (and shareholders) of weaker companies have certainly benefited from generous credit, but they have only put off the day of reckoning. ‘When the music stops and the bright lights come on,’ says Kroll, ‘it’s a bit frightening what you see… the party’s over, and there will be significant fallout as a result.’
Among a number of things becoming scarily clear as liquidity dries up is that in the more challenging times ahead, managers will no longer be able to rely on their – and the City’s – preferred method of improving perceived performance: doing deals. They will have to do it the hard, old-fashioned way: through operations.
However, not only is there no sign that managers have conquered their traditional weakness in operations, the refinancings of recent years may have made improvement more difficult by lumbering companies with soaring debt levels. Kroll calculates that the ratio of corporate interest payments to operating surplus is at its highest for 15 years. If profitability dips, for some companies these levels will not be sustainable.
Moreover, the fact that corporate (as opposed to individual) insolvencies are at an all-time low may not be the good news that it first appears. The low insolvency rate is likely to be the result of lenders’ willingness to allow firms to refinance themselves out of trouble rather than a product of good management. In other words, there may be a corporate sub-prime bubble out there waiting to be pricked.
Vulnerability is only increased by two other main trends of the past 20 years: technological advance and globalisation. Information technology has certainly played an important role in London’s success as a financial centre, enabling deregulated institutions to invent dizzying new financial instruments and lend ever more aggressively. But it also has downsides that are now becoming apparent, in complexity and lack of transparency that make it hard to estimate the magnitude of risk or where it finally lies. They are also contributing to the mushrooming of white-collar crime.
By multiplying complexity and interdependencies, globalisation adds another dimension to risk. Are UK companies agents or principals for the wall of money passing through London from rich but murky emerging economies such as Russia? Most may be agents, but it’s hard to know. The combination of globalisation and complex debt structures makes restructuring, disposals and debt recovery a harder (and more expensive) job than ever before. Kroll describes one corporate refinancing that involved simultaneous restructuring in 11 different jurisdictions.
One of the big questions now is whether languishing companies will go to the wall or will continue to be propped up. With refinancing more difficult, the likely outcome is a wave of distress selling at every stage and size of the corporate food chain as firms try to unwind rash mergers and bring debt levels down to manageable levels. These will be bargains for sounder corporate citizens with the resources and confidence to undertake industry consolidation.
Although to some extent today’s conditions can be viewed as a natural correction to past financial exuberance, there is unlikely to be a swift and easy way out. The management weaknesses – resistance to change, lack of information, poor rationale and implementation of mergers and acquisitions – that Kroll’s report identifies as a persistent handicap and cause of business failure are likely to become more evident, not less, as capital markets continue to contract.
‘We’ve been nervous for a while about the direction,’ says Kroll. In the interconnected, globalised world, predicting where and in what shape the next bout of turmoil will occur is impossible. But that it will happen is almost certain. ‘Are we seeing more insolvencies yet? No,’ says Kroll. ‘But is the telephone ringing more? Yes.’
The Observer, 9 Decemberr 2007