A few months into 2021, middle-market companies are eager for growth and sense unique opportunities, including the chance to profit from pent-up demand and the momentum of a rebounding economy — and, for some, to take share from or acquire a weakened rival. The International Monetary Fund is forecasting U.S. economic growth at 6.4% this year; companies would be foolish not to position themselves to catch that kind of tailwind.
But how can they fund the growth they seek? Even in normal times, middle-market companies are reluctant to dilute equity and anxious about getting out over their skis by taking on debt. Today, almost half of middle-market executives say that coping with Covid-19 has made them more risk averse than before. Many drew on lines of credit last year or got federal Payroll Protection Plan support; they would prefer not to call on their banks again. But without capital, they risk missing out on a historic growth opportunity.
Many of these companies have the solution at hand but don’t know it. Data and research from the thousands of members of AchieveNEXT’s CFO Alliance show that middle-market companies can fund much of their growth through efficiency. Indeed, increasing productivity and efficiency, our 2021 Sentiment Study shows, is the number-two strategic priority for middle-market CFOs, just after growth. The trick is to make them work together, rather than have the pursuit of one handicap the other. Ours and members’ experience shows that growth and efficiency can be allies, not antagonists. Properly managed, the push for efficiency can free up capital and direct it to where it will create revenue, generate strategic growth options, and increase enterprise value.
One of our CFO Alliance members faced that challenge from their position overseeing finance for a midsize trucking company with a fleet of more than 500 tractors and upwards of 1,500 trailers. As an essential business with broad diversification of customers across industries, it grew moderately in 2020 and entered 2021 with ambitious plans, supported by strong demand. The company had enough capital, but not enough human capital thanks to a shortage of drivers — a problem which affects the whole industry and has been intensified by increased regulation and the introduction of the Drug and Alcohol Clearinghouse. But the impact and imperative are the same: The company cannot reach its growth goals without big gains in productivity and efficiency. Every dollar lost to inefficiency is a dollar that could be used for growth.
Often, however, companies look for efficiency by cutting costs in ways that actually defund growth and leave an enterprise anemic and stressed. This member’s experience has revealed three approaches that feed efficiency and growth at the same time.
Attack all the variables in the productivity equation.
In many companies, the search for productivity growth becomes a cost-cutting exercise. But productivity is simply outputs divided by inputs. And inputs aren’t just labor inputs, but also capital equipment, inventory, technology investments, materials, and more. Looking at the complete productivity equation encourages leaders to discover opportunities to maximize outputs, as well as reduce inputs, and to get more from all their assets, not just the workforce.
One way the trucking company gets more from less is to focus on profitable customers. Marginal customers syphon off a surprisingly large amount of time, energy, and assets and deliver less to the top line. The company now separates customers into “strategic” and “transactional” groups and makes sure the former gets first call on its resources. By linking sophisticated load-planning software with its ledger of customer commitments, the company is able to ensure that customer service teams don’t inadvertently tie up capacity that could create more value if it were used for a different opportunity.
Raise your working capital game.
The cheapest capital you can get is money that’s tied up in bills you pay too soon, receivables you collect too slowly, and inventory you don’t need. Middle-market companies underestimate how much working capital they use. Data for publicly held middle-market companies reveals a four-times performance difference between the 25th and 75th percentiles in payables, receivables, and inventories. For example, a $100-million-in-revenue materials company that moves from the median to the 75th percentile would free up more than $17 million in capital every year — interest-free money to use for expansion or any other purpose.
Mismanaged working capital can starve a company. We know one company that decided to pay its bills in 25 days instead of its usual 40 as a favor to pandemic-stressed suppliers. They soon discovered that they were running out of cash. Middle-market executives often fear that they’re at the mercy of trading partners — forced to accept discounts in return for timely payment from big-company customers, for example. In fact, middle market companies have more leverage than they think, especially if they’re providing critical components or raw materials.
Understanding how these levers work may stretch the skills and knowledge of CFOs and their teams. It’s no wonder CFOs in the AchieveNEXT 2021 Sentiment Study told us that financial planning and analysis is their number-two skills gap in their departments, just after critical thinking. Global enterprises often have teams of hundreds doing this kind of analysis; in the middle market, the job might fall to the CFO and an overtaxed analyst or two. In addition, if the finance team lacks the right capabilities and tools, it can spend a significant amount of time on fixing data issues, creating reports, undertaking strategic planning, and explaining variances after the fact instead of driving real-time analytics for stronger insights and more informed business decisions.
Seize the moment to get creative about costs.
This year offers three unique cost-management opportunities. First, take a look at all the improvisation and adaptation the pandemic provoked (“pivoting,” in the jargon du jour) to see what to keep, what to toss, and what to clean up. (Does anybody know how many Zoom accounts your company has?) Sales teams chafed at pandemic travel restrictions, but many have adapted brilliantly to virtual selling and new modes of lead generation, realizing both sales gains and reduced customer acquisition costs. Among clients of Delancey Street Partners, an investment bank focused on the middle market, many CFOs are having serious discussions with sales and marketing departments to determine if these new practices can be retained or expanded in an attempt to capture a meaningful portion of these savings permanently.
Second, rethink real estate needs and act fast on what you learn. According to the McKinsey Global Institute, in the third quarter of 2020, office vacancy rates in New York were 32% higher than they had been a year before; they were 23% higher in Chicago and 12% higher in Los Angeles. Now is the time to negotiate lower rents, but, more important, it’s a chance to examine long-term real estate needs — before the market rebounds in landlords’ favor and your employees settle into a less-than-productive “old normal.”
Third, get more strategic about digitalization. Many middle-market companies are stuck in what we call “first-generation digitalization,” such as automating routine work. But there are at least two other stages. One is digital integration across functions, allowing companies to optimize operations, HR, logistics, marketing, and other systems as a whole. For example, by tying together IT stacks that once were separate, the trucking company is now able to coordinate customer commitments, load planning, and route optimization — and even buy commodity hedges on fuel costs. Optimizing the whole system generates productivity gains far above what can be attained by improving each element alone. Not long ago, tools like these were out of reach for middle-market companies; today, one out of seven middle-market CFOs see cross-functional IT integration as the biggest challenge and opportunity they face.
Even bigger productivity gains can be found by imagining how digitalization can transform your business model and balance sheet as well as your income statement — for example, by offloading assets like warehouses and fleets, IT servers, and swing production capacity.
Each of these approaches to productivity improvement can feed and fund growth more easily than mere cost cutting. They have an additional advantage: They significantly enhance enterprise value, which will put your company in a better position if you choose to fund expansion with outside capital, or if you choose to enter the M&A market as a buyer or seller. Capturing productivity gains, working capital management efficiencies, and other operational improvements are best done well in advance of approaching the capital markets. In Delancey Street Partners’ experience, clients that are able to show several quarters of enhanced profitability due to material changes in productivity, working capital efficiencies, etc., are more likely to get credit for these improvements during a sales process or capital raise. The ability to evidence two to three quarters of improvement gives potential investors and buyers confidence that these efficiencies are sustainable and not short-term practices put in place as transaction-related window dressing.
None of these things can be done in a vacuum or by functional leaders acting by themselves. Whether managing working capital, reshaping cost structures, or driving digitalization, CEOs and CFOs from middle-market enterprises must overcome misalignment among leadership, build buy-in across their organizations, and organize this effort for growth by focusing on change management. Achieving buy-in is not a one-time exercise for them, either. They must communicate to all stakeholders the growth strategy, the value drivers of change, the phases of the digital journey, and the expected outcomes. They must clearly demonstrate and communicate success through validation points along this productivity journey. The long-term and ongoing culture change activities and interventions that will come will help shape a culture that celebrates cost management and growth simultaneously.
by Nick Araco, Jr. and Steven Higgins