Getting It Right When It Comes to Business Resilience


Getting It Right When It Comes to Business Resilience

Five fallacies stand in the way of a company’s ability to hedge against, absorb, and recover from systemic shocks.

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Gaurav Sharma

Partner, India

At a Glance

Five fallacies obstruct a company’s ability to hedge against, absorb, and recover from the unavoidable shocks to its system. 

Most industries have seen an increase in the quantity and magnitude of external shocks, yet the focus on efficiency has rendered companies more vulnerable to shocks. In the midst of COVID-19, more leaders are willing to invest in their company’s resilience. 

According to the index, while excessive risk can result in large returns, more resilient organizations have roughly double the long-term survival rate. Adopting the best resilience strategy necessitates refuting five commonly held fallacies. 

Senior leaders will need to recognize the trade-offs and make decisions about their revenue portfolio and operations. With volatility expected to worsen, strengthening resilience can position a firm to prosper through future crises. 

It’s no surprise that business resilience is all the rage. While the COVID-19 pandemic is horrifying on a social and economic level, it is only the latest in a long line of upheavals that highlight the vulnerabilities or brittle features of unprepared businesses. Major shocks in recent years have included international trade disputes, a drop in oil prices, and a financial crisis, all of which have pulled the rug out from under exposed enterprises. An increasing number of government actions have begun to limit the possibilities of technology behemoths such as Ant Financial, Google, and Huawei. 

Companies are currently being buffeted by the coronavirus pandemic and the subsequent economic slump. The pandemic cut off vital supplies of medicine components from Asia, exposing pharmaceutical companies’ reliance on long-distance supply systems. For more than a decade, pharmaceutical corporations have sought to reduce costs by shifting a large portion of their manufacturing capacity to China and India. This had a direct impact on supply chain reliability in 2020, with production site closures and deteriorating transportation routes immobilizing supply chains and resulting in substantial medicine shortages in several nations while demand surged. 

Resilience is certainly becoming increasingly crucial for businesses across all industries. And the instability is set to worsen as globalization unravels, inequality increases, new technological threats emerge, and the repercussions of climate change become more frequent and severe. However, senior executives and boards of directors do not always understand the dynamics of resilience. We challenge corporate executives to think about the following: 

The majority of your concerns are overly short-term and minor. 

Improving resilience does not have to come at the expense of investors. 

Expanding government controls or restrictions, such as foregoing dividends or stock buybacks in exchange for bailouts, may further limit your options if you don’t get ahead of the task of becoming more robust. 

The destructive obsession with efficiency 

How did we end up in this situation? Recent stability has allowed for the largest growth in profits since the middle of the twentieth century. From 1990 to 2018, the profit pool of corporations in developed nations rose at a rate more than double that of the GDP. During this time, the relative regularity of the business environment allowed enterprises to pursue efficiency, which contributed to the remarkable profit increase. 

However, this emphasis on efficiency has come at the expense of increased structural instability. Firms increased leverage, with nonfinancial corporate debt-to-GDP ratios in the United States rising from around 30 percent in the 1980s to just shy of 50 percent today, and used debt to increase cash pay-outs to shareholders, which have risen from 78 percent of net income in 1999 to more than 100 percent today. At the same time, several companies unified their supply chains in order to acquire greater bargaining leverage, and they implemented just-in-time and redundancy-free processes in order to eliminate waste. 

While having a focused portfolio is important for long-term value generation, it has also produced hidden tension points that make some organizations vulnerable to unexpected changes in circumstances. Spirit AeroSystems, a top fuselage maker that was primarily reliant on a single customer, Boeing, ran into this issue when problems with the 737 Max aircraft prompted a major restructuring. Spirit has lately made moves to strengthen its resilience, including acquiring assets from Bombardier that will help it increase business with Airbus. 

In contrast, Samsung Electronics’ experience demonstrates the growing benefit of a more diversified revenue and profit portfolio. In 2016, the battery in Samsung’s new Note 7 product caught fire in certain situations, jeopardizing the company’s leadership in the smartphone market. The announcement prompted a $5 billion recall. However, the company was able to weather the storm because of the breathing room provided by offsetting growth in its semiconductor and display panel divisions. The structure of Samsung’s portfolio allowed them to devote the time and resources required to address the core causes of the battery failure and produce a new flagship product (the Galaxy S8) with a slew of novel features to reclaim customers. 

The emphasis on streamlining and efficiency has increasingly increased risk at the macro level. When we compared 1980–1999 to 2000–2018, we discovered that the volatility of the aggregate profit pool in developed economies increased by 60%. This volatility coincides with an increased chance of failure at the firm level. In the case of publicly traded US companies, the bankruptcy rate tripled between 1980 and 2018. Both aggregate volatility and firm failure rates would have been far higher if the government had not provided unprecedented levels of assistance. 

The experience of banks in the aftermath of the financial crisis, particularly in Europe, serves as a cautionary tale. Prior to the 2008 financial crisis, European banks not only had fast development, but also a rising return on equity that reached the mid-double digits. Returns have since fallen to the low single digits, substantially below the cost of capital. This is due in part to Europe’s general economic malaise and the lingering effects of bad loans, but it also reflects a huge step shift in the amount of regulatory capital these corporations are now required to keep as a condition of government bailouts. 

As evidence mounts that the conventional organizational risk-management playbook is no longer adequate, senior executives and boards are beginning to reconsider resilience. Even those that were able to survive the epidemic because of the extraordinary efforts of their staff and partners see the need for a more sustainable approach. 

But here’s the rub: Much of the conversation, like the rush to digitize everything a few years ago, fails to analyze what resilience means for each company and what it will take for a company to improve. In recent interviews with business leaders, we’ve discovered five persistent myths that confuse the debate. The first step toward resilience is dispelling these beliefs. 

Myth #1: Resilience removes Volatility

The likelihood and consequences of events cannot be coerced into a neat probability distribution in the modern era. Consider how useless most polling was in projecting recent US elections or the British vote to exit the European Union. 

In such a climate, treating resilience as a virtue that eliminates earnings and share price volatility is both unrealistic and counterproductive. Instead, we distinguish between volatile, predictable variations in every firm over time and genuine risk exposure to a long-term detrimental shift in trajectory. 

In fact, attempting to reduce volatility is analogous to purchasing insurance that protects against the deductible rather than the loss itself. It fails to address the larger goal of ensuring that the inevitable surprises encountered along the route do not permanently harm a firm’s capacity to deliver an appropriate return on capital invested over the cycle. 

Rather than focusing on earnings certainty, management teams and boards can be more effective in determining what the true risks are that they want to hedge against. bankruptcy? Default? Downgrade in rating? A hostile takeover? An activist investor? The original sin in many resilience conversations is a failure to properly define risk appetite. 

Myth No #2: The financial sheet is everything

Business leaders sometimes examine resilience primarily through the prism of the balance sheet, focusing on leverage and liquidity while neglecting other possible sources of fragility. Resilience, in reality, has five dimensions: 

Strategic considerations include absolute and relative scale, demand elasticity, revenue and profit diversification, and cross-correlations. 

  • Financial, such as leverage and liquidity, but also insurance and hedging; 
  • Operational considerations include operating leverage, supplier concentration, and redundancy. 
  • Aspects of technology, such as availability, workload mobility, and cybersecurity; and
  • Organizational resilience, which includes crisis readiness, organizational agility, and human resilience. 

Adopting a holistic view of resilience recognizes the reality that external shocks generally influence firms across multiple dimensions at the same time, amplifying the magnitude of the shock. Accounting for all of these variables enables CEOs to make more informed decisions about where to invest limited resources in resilience. 

Nissan’s experience exemplifies the point. Nissan employed a number of risk-reduction measures throughout the 2000s. These included creating detailed crisis playbooks with clear disaster-recovery plans and regular simulation training; having a more geographically dispersed production base and diversified supply chain than competitors; and taking proactive steps with suppliers to ensure that they had plans for switching production during a crisis. During the 2011 earthquake in Japan, these preparations paid off handsomely, with the carmaker restarting production after around two months. 

Southwest Airlines’ experience highlights the multitude of elements that lead to resilience. During the epidemic, Southwest’s network, business model, and balance sheet allowed them to grow to additional routes while other airlines cut back. This also underscores the company’s systematic approach to making all client groups profitable rather than relying on subsidies from the foreign and premium business segments, which have been the hardest hit this year. The airline’s proactive risk management also served it well during the early 2000s oil price increase, when activities such as hedging helped it avoid the fate of other carriers who filed for bankruptcy restructuring. 

In many circumstances, resilience is also a result of the company model’s overall simplicity and transparency. During the 2008 financial crisis, many banks were brought down by the sheer complexity and opacity of the mortgage-backed assets to which they were so heavily exposed, making effective risk assessment practically impossible. Similarly, during COVID-19, complicated and opaque supply networks exposed many enterprises to shortages of materials or components of which they were unaware were so crucial. 

Myth #3: Past resilience ensures future resilience

When the dust settles from the COVID-19 problem, most businesses will be better equipped to cope with the next pandemic, just as banks are better prepared to deal with the next mortgage crisis. “Black swan” events, on the other hand, resemble recent problems. 

Building true resilience necessitates questioning what could happen that would truly put the firm to the test, rather than relying on past experience. Many firms that have demonstrated resilience in responding to strategic and financial shocks have experienced massive technology outages and cyberattacks, sometimes as a result of the breakdown of just one router or server. As the trend toward digitalization and automation of processes accelerates, technology will introduce new hazards that some businesses have not yet anticipated. 

It is a fool’s errand to try to discover and quantify the universe of all conceivable shocks. Instead, astute leaders will develop the organizational muscles required to assess which shocks matter most (in terms of both impact and likelihood) based on industry and firm-specific economics. Although there are many possible shocks, the number of transmission routes through which they could seriously harm a certain organization is substantially lower. This brief list might include, for example, the price of oil, fleet availability, and travel restrictions in the airline business. Every industry will have its own list, and understanding the main transmission channels for a specific organization is an important step in establishing resilience. 

The structure and weighting of risk are particularly variable. Each company should understand its own risk profile, which is determined by its cost structure, client segmentation, supply chain, route to market, and other factors. In other words, approach risk as if you were a founder who was awake at night worrying about the dangers that could destroy his or her life’s work. 

Myth #4: The risk function should handle Resilience

Too often, risk is viewed as a necessary but depressing box-checking exercise, then relegated to a corner of the business. Accepting this more constrained scope, risk functions may become excessively tactical and blinkered in their risk detection. 

In a more turbulent world, this method falls short. Because many hazards are combinatorial in nature, firms must identify and mitigate risks for the entire business. A piecemeal reduction of specific risks in specific functions and business units is unlikely to provide the overall company resilience required (or at least, not at an acceptable cost). Furthermore, many future dangers will arise from the firm’s ecosystem of partners, and traditional risk-management processes are unprepared for this challenge. 

Firms must instead elevate and integrate risk into the rhythms and rituals of their most essential decision-making processes at the C-suite and board levels. Rather than making decisions based primarily on the upside and protecting against a few discrete areas of risk, business leaders at all levels should embrace an ownership attitude that fully accounts for how decisions will affect long-term value creation across the firm. 

A viable model is suggested by the experience of the Swedish bank, Handelsbanken. Handelsbanken, which was founded in 1871, is the oldest corporation listed on the Swedish stock exchange and a model of resilience. During both the early 1990s Swedish banking crisis and the 2008 financial crisis, it was the only bank in Sweden that did not require government assistance. The bank’s model of empowered local decision-making has played a crucial role in its resilience. The company has only three management layers: the CEO, the regional manager, and the branch manager, and local branch managers make the majority of decisions. Instead of getting bonuses, employees participate in a profit-sharing scheme that has been in effect since 1970, with profits redeemable upon retirement. This structure incentivizes employees to make long-term decisions that add value rather than maximize this year’s earnings. 

Myth #5: Resilience does not necessitate challenging trade-offs

Can a company protect itself from future shocks without jeopardizing current earnings? True, organizations will be able to identify no-regrets initiatives that boost resilience without jeopardizing current profitability, such as increasing supply chain visibility or implementing crisis readiness. Furthermore, as previously stated, a holistic, firm-wide approach to resilience can frequently increase cost-effectiveness. Gaining a real advantage in resilience, on the other hand, frequently necessitates investment and loss of opportunity. 

Business executives will need to broaden their engagement with investors in order to balance short-term and long-term value development. Many investors, for their part, are attempting to strike a compromise between the demand for long-term responsible capital stewardship and the need to avoid committing funds to systematic underperformers. 

One point of contention in this discussion is disagreement about the appropriate measures. To that end, we developed the Resilience Index, a 100-point scale that assesses a company’s resilience based on the statistical relationship between crisis performance and a variety of easily observable metrics such as scale, growth, margin, asset intensity, leverage, liquidity, and geographic and product concentration. While these indicators only provide a partial assessment of resilience, understanding one’s relative position on these fundamental aspects is a good place to start when engaging in fact-based discourse with investors. 

Individual companies in every field exhibit a wide variety of resilience. The bottom half of the resilience index was dominated by enterprises that lacked scale and, thus, economic benefit. During a crisis, this long tail of smaller enterprises generally struggles due to poor cash flow, restricted access to capital, and reduced negotiating leverage. It is difficult for smaller businesses to achieve resilience without first gaining competitive scale. 

Other factors, like debt levels, revenue diversification, or asset ownership options, have a significant influence on larger enterprises with at least $1 billion in annual revenue. From 2000 through 2019, we tracked the shareholder returns of larger corporations that remained publicly traded. Those who took on more risk (with a resilience index below 70) underperformed in years when the overall economy contracted but outperformed in years when the broader economy expanded. As an investor would expect, their higher volatility was compensated for by modestly higher returns across the cycle. 

Firms with inadequate resilience, on the other hand, pay a large price in terms of bankruptcy or acquisition. Indeed, high-resilience enterprises had nearly twice the survival rate of their low-resilience counterparts throughout this time period. In other words, a higher-risk strategy works for those who can stay afloat despite the volatility. The question is whether these benefits outweigh the danger of failure. 

Building resilience necessitates challenging and subtle trade-offs. Many corporations discovered in recent decades that sailing close to the wind offered unambiguous value for shareholders (particularly during upturns), as long as they avoided catastrophic catastrophe. In the future, each company must decide how much to recalibrate and build resilience in order to continue providing value while avoiding the risk of devastating loss. 

Getting Acquainted with the Grey Zones

Once you’ve dispelled these five fallacies, it’s evident that there is no one solution or quick fix, no binary black-or-white options, but rather a series of choices in the grey areas of marginal risk. Creating the appropriate degree and type of resilience necessitates a combination of long-term vision, a thorough understanding of company and industry economics, and a healthy dose of inventiveness. 

Having said that, a simple three-step procedure can get things started. 

Examine your risks. Begin by doing a thorough, fact-based examination of the nature and scope of your primary vulnerabilities. Make use of hard facts to uncover what generates profit in your sector and organization. Create benchmarks to better understand your resilience in comparison to the competition. Use stress-test modelling to define the limitations of your defences and verify that second-order impacts are taken into account. 

Agree on your personal risk tolerance. Align the senior management team and board of directors on a shared knowledge of the firm’s resilience track record, and agree on the amount of risk tolerance in the future. Be wary of generic, half-hearted exercises that persuade leadership teams to settle for a “moderate” level of risk ambition. Insist on defining goals that are informed by the answers to difficult questions. This will almost certainly necessitate some back-and-forth with the preceding phase, and will invariably land in the grey zone of investments to control marginal risks. 

Set your strategy and win over investors. Create a resilience agenda that combines low-hanging fruit and high-gain initiatives. Bring your investors along for the ride by rewriting the equity story to show how the new activities will enhance shareholder value over the course of the economic cycle. 

Starting on the path to resilience will necessitate a commitment from senior executives and board members, who will have to make difficult decisions. They may view this activity as an opportunity to improve their chances of success. Who feels that the recent upheaval will abate? That appears to be a very long shot. As soon as possible, those who think there will be long-term or more intense volatility will be able to take strong countermeasures.

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