Every business owner and every CEO finds it necessary to make financial and other decisions with some frequency that depend upon one’s macroeconomic view of the world. This article argues that the likeliest scenario is simply volatility – potentially wild or crazy gyrations – over the coming few years.

To put it more graphically: the world has been lurching from financial crisis to financial crisis over the past few years. There are enough time bombs ticking on the horizon, that one might expect the world to continue lurching from crisis to crisis for the foreseeable future. So what are some of these ticking time bombs?

Euro-zone issues: Greece is currently at the epicenter of the euro zone crisis, but there are broader issues. While the euro zone has a common currency, and the European Central Bank has the power to print money, there is no body empowered to issue euro bonds. Nor is there a central government that can carry on a common fiscal policy for the European Union or for the euro zone.

In an organization such as the euro zone, there are always likely to be one or two countries lacking fiscal discipline, who may bring instability to the entire euro zone (as Greece does today). If this were to be a larger country such as Italy or Spain, this would even more severely test the will of German taxpayers to bail out the union. Questions are becoming increasingly frequent as to whether the euro zone, in its current form, is sustainable.

There was once a revolution fought over the principle of “no taxation without representation.” German taxpayers are now footing the bill for decisions made in Greece years ago, where they had no say. The only workable and sustainable quid-pro-quo is for the Germans and wealthier European countries to take responsibility for all of Europe (what Germans refer to as a “Transfer Union”), in exchange for which the more profligate countries submit themselves to a common fiscal discipline.

As any banker will tell you, he who pays the piper calls the tune. A more integrated euro zone would issue euro bonds and have a common budget and fiscal policy. Until then, there is every likelihood that the euro zone will lurch from crisis to crisis. The crises may serve to catalyze integration, or may weaken the euro zone, by causing one or more members to drop out. And given the lack of political or popular will for integration, integration is far from pre-ordained.

US debt and money supply: While federal government debt in the US seems tenable (in the range of 70-80% of GDP), and easily within the capability of the US government to service, when you add state debt, municipal debt, private and corporate debt, according to Federal Reserve estimates, total debt is in the range of 370% of GDP. This is an ocean of debt! And this does not include unfunded pension liabilities, liabilities with respect to Medicare/Medicaid, etc. While in the 1990s, the US demonstrated that it could rapidly convert a deficit to a surplus, the degree of political will or consensus necessary to fight deficits does not seem to exist today. The crisis with respect to raising the debt-limit experienced last summer gave a graphic illustration as to the current polarization or lack of consensus in the US.

US money supply has been expanding at an alarming rate over the past five or six years. While the rapidly expanding money supply, large deficits and debt overhang would predispose the US dollar to a major devaluation, the demand for US dollars from international investors seeking refuge in US treasuries, for want of a better repository of value, remains unabated. How ironic. And how unstable!

In addition to the two major systemic risks in the global financial system above, there are also a host of other risks bubbling under the surface:

• A major terrorist attack could disrupt markets. (Remember how 9/11 disrupted financial markets?)

• What if Fukushima turns out to be a much larger problem than most people realize? Larger swathes of Japan might require evacuation, radiation detected in the US has also been attributed to Fukushima.

• What if China’s development becomes unstuck (remember how the collapse of the Soviet Union caught us by surprise)? Remember, Chinese banks are still largely state-owned, doing a huge amount of lending to state owned enterprises. A country that has not seen a recession in decades may face a very serious downward adjustment when a recession does come.

It will take years for the US and Europe to work through their issues, and the other risks described above are unlikely to go away quickly as well. So expect volatility to be with us for years to come. If you accept my prognosis for volatility, what should a business owner or CEO do? This will be the subject of my next column in two weeks.

Businesspeople frequently talk of mergers & acquisitions (M&A), but the emphasis is usually on acquisitions, with relatively little thought given to mergers. Yet in today’s financial markets, it may make even more sense to consider mergers.

Why is this the case? Consider the following (very common) scenario: due to anemic economic conditions, two companies in the same industry may both be hurting. Both of them may be experiencing much lower than usual profitability and cash flow, perhaps even a loss. Both of them may be experiencing a liquidity crunch. Both of them may be reluctant to exit at what would most likely be very low valuations. Furthermore, lack of liquidity would make it difficult or impossible for one company to acquire the other.

In this type of scenario, a merger may be the perfect solution: with a cash-free transaction (e.g. a merger), two marginal or unprofitable companies may combine to form a profitable company, with greater market share, economies of scale, and rationalized costs. This is the definition of synergies: 1+1 = 3. Because investors prefer to invest in larger entities, a merged entity may also be a more saleable entity in the longer term. Hence corporate value is enhanced, in preparation for the day when financial markets (and valuations) improve.

Sounds too easy? While the upside in such a scenario is more often available than business owners realize, there are also numerous potential pitfalls. Allow me to enumerate some of these pitfalls, both with respect to doing a merger transaction, as well as pitfalls with respect to making the merged entity work.

A merger is often a much more complicated transaction than an acquisition:

• Each party must perform a due diligence and valuation of the other (as opposed to the case of acquisitions, where only the acquirer values and performs a due diligence on the target company). It is often very tricky for the parties to come up with the relative valuation that each party will obtain in the new merged entity.

• How will the owners of the merging companies share the governance of the new entity? Will they be equal partners? Will one or both have veto rights? Will there be rights of first refusal, put or call options?

• A party may need to give up control of his or her company, without receiving cash in the transaction. This often gives at least one party to the merger cold feet.

• How will the loans of both merging corporations be handled? Will banks become joint lenders to the merged entity? Or will there be a refinancing? Banks of both merging entities will likely need to approve any merger, or be paid off on or before the merger closing. Banks may be afraid of the risks associated with the merger, for example, whether management will be capable of realizing the merger synergies.

   

Pitfalls in making the merged entity include:

• Joint management of any company, among people who have typically been used to being sole CEOs, can be very trying.

• The realization of synergies may prove elusive. For example, on paper it might appear simple to rationalize expenses, in practice there may be resistance from within the organization.

• The two organizations may have different corporate cultures, which may create difficulties in implementing any merger. A merger seldom if ever works unless the corporate cultures are fused into one.

It requires enormous expertise to successfully execute a merger. The potential upside of a merger may be huge; but the potential pitfalls and risks are also great. In times of recession a merger is nevertheless one of the best ways that “financial engineering” may create corporate value.

The European Private Equity & Venture Capital Association (EVCA; www.evca.eu) has recently published a special report providing an excellent statistical snapshot of the private equity and venture capital industry as of 2010. It provides a detailed breakdown on sources of capital raised, investment activity, investment per sector and per country, etc.

While it is not possible to do justice to the entire report in a short article, I’d like to focus on some of the interesting statistics that came out of this report:

• Annual investment value peaked at €2.5 billion in 2008, declining slightly to €2.4 billion in 2009, falling to €1.3 billion in 2010.

• Poland was by far the largest market in 2010, accounting for €657 million of investment (44 transactions), more than 50 percent of the regional total in 2010.

• Only 3 percent of private equity funds raised in Europe were devoted to Central Europe in 2010.

• With the exception of 2009, in most years venture capital and private equity investment as a percentage of GDP was considerably less in Central Europe compared to Europe as a whole. For example, in 2010, it accounted for 0.119 percent of GDP compared to 0.314 percent of GDP in Europe.

I interviewed two people for comments on the EVCA report: Robert Manz, managing partner and member of the board of Enterprise Investors, a private equity firm, and chairman of the EVCA committee that produced the report, as well as Kai Koppen, managing partner for CEE for Riverside, a private equity firm.

My questions addressed to both gentlemen pertained to the overall state of the private equity market in Central Europe. In this day and age when we talk about faster growth in Central Europe and convergence towards Europe, should there not be a higher private equity to GDP ratio in Central Europe compared to Europe?

According to Kai Koeppen, the answer lies in risk management of institutional money. The UK has traditionally been the dominant market, with a 40 percent share of the European private equity market, where private equity firms have developed excellent relationships with managers of institutional money. The UK is followed by the Nordic markets and France. It will take time for Central European firms to develop a track record and relationships with institutional funders, even though there might be more room for growth in Central Europe than in the UK.

According to Robert Manz, private equity in Central and Eastern Europe still has tremendous room to develop. The private equity industry has only a 20-year history in the region; it is still less-widely used and accepted in Central Europe compared to more developed private equity markets. In Central Europe there are fewer sizable deals, the markets and countries are smaller, in short, markets are less developed. This includes the lack of readiness or preparation of companies to take in financial investments. There has been an “equity gap,” that is to say there has been more demand for equity capital than supply, and the equity gap is larger in Central Europe than in Western Europe.

According to Mr Manz, there is a healthy balance between demand and supply of equity capital, and that everything is going in the right direction: there has been a steady upward trend in the number of deals and the value of deals. (Deal flow has increased by a factor of five since 2003.)

With respect to obtaining leverage for private equity deals, banks were generally unwilling to lend in support of private equity deals until 2003. Bank lending increased nicely until the Lehman crash, where obtaining leverage for private equity deals became extremely difficult. It is now once again no problem for good deals to obtain debt financing.

My own personal view as financial advisor is that many more companies would like to receive private equity financing than are able to obtain it, and the single largest reason for this shortfall is their own lack of preparation or suitability to receive private equity funding. This explains why private equity funds invest in only a very small percentage of the deals they examine.

Running a small business is arguably more difficult than running a large one. I have done both, and that has certainly been my experience. When running a large company, you have resources: specialized staff, better systems, in general, more resources to solve problems as they arise. When running a small company, it is often difficult to afford high-powered staff. A small company might be lacking certain functions altogether, such as controller, HR director or in-house counsel. If a small company loses a key staff member, it usually leaves a gaping hole; where a larger company loses a key staff member, one can more often promote someone from within. In a small company, the CEO often has to be a jack-of-all-trades, chief cook and bottle-washer, filling several operational functions at once.

But this article is not so much about managing small companies, rather about doing transactions with small companies, whether raising equity or selling the company or, as will be discussed below, merging two small companies. It is also much more difficult to do transactions with smaller companies than with larger companies, for the following reasons:

• The greater difficulty of managing small companies, as explained above, makes them higher risk, and hence less desirable, to investors.

• Ironically, it is often easier to find buyers for larger companies than for smaller companies. Strategic investors and private equity firms prefer targets that “move the needle,” that have a certain critical mass.

• It takes just as much time and effort, sometimes more, to buy or sell a company valued at €2 million company than €20 million.

• As an owner of a small company (say €1-2 million revenues), it is often difficult to afford an experienced law firm for a transaction, let alone a good financial advisor, who might be used to earning a success fee of several hundred thousand euro.

• For buyers, investing in a small company, that often has a very “thin” management team, can be a high-risk proposition. If one or more members of such a thin management team leave, or turn out not to meet expectations, the entire investment may be at risk.

• Small companies often lack audited statements, or any kind of management accounting.

• In any transaction involving a smaller company, it is often challenging to obtain timely and quality information, due to lack of systems, specialized staff (such as a controller), etc. This can cause enormous strain on the management team of a small company, as well as in the negotiations between the parties.

Furthermore, the valuation of larger companies is often more advantageous than for smaller companies, often commanding substantially higher multiples of revenues, cash flow, EBITDA (earnings before interest, tax, depreciation and amortization), etc.

So what can a small business owner do in order to improve valuation and chances of doing a transaction? Become a larger company:

• First, growing the company organically to a larger size, so long as that growth can be done profitably and without endangering the financial health of the company, might be one approach.

• Acquiring other companies might be another way of growing – obviously, the acquisitions should be value accretive rather than diminishing value.

• Merger is another option to increase size. This is an option which is perhaps not applied as often as it might be. It is entirely possible to merge two smaller loss-making companies and create one profitable larger company. This requires careful financial engineering, and a good mix of management skills and human resources.

• Qualitatively improving the small company, to have it run more like a large company (e.g. with a high-quality management team, better systems, better corporate governance) can help at least partially to dig the company out of the trap.

In a nutshell, doing a first transaction with a small company can be even more challenging than managing a small company. Finding expert legal and financial assistance that is capable of working within the budgetary constraints, is also an important ingredient to success.  

Companies often underestimate the need and rationale for having a board of directors. The typical model for SMEs in Central Europe is to have a strong owner-manager who makes all decisions single-handedly. This certainly has the advantage of speed of decision-making, and having a clear, unambiguous line of authority.

However, there comes a time in the development of a company when a board of directors should be considered. This article deals first with the issue of why to have such a board, and second, what kind of board members should be appointed.

The rationale for having a board

There is something to be said for the collective wisdom of a well-selected group of individuals being greater than the wisdom of any single individual. Psychologists have shown that where a decision-making body functions harmoniously, the group actually consistently makes better decisions than would normally be made by any individual in the group. The collective IQ of a harmoniously functioning group is greater than the IQ of any participant in the group. Often, the mere process of dialogue or debate allows additional dimensions of a decision to be explored, which otherwise might not have come to light.

In a board, it is possible to select individuals who represent different perspectives and have different competencies: industry experts, finance, marketing, legal, etc. Having all of these perspectives represented when decisions are made may result in better decisions.

While a strong owner-manager is usually quite capable of running the business, should such owner-manager become incapacitated or pass away, a board can play an invaluable role in assuring the continuity of the business. Often a member of the board may act as an interim manager, or the board may appoint an interim manager, and then work on the issue of appointing a new manager. Having a board that is capable of acting on matters of succession diminishes or brings under control an important source of risk regarding the continuity of the business.

Should a company seek outside investors, or where a company has multiple shareholders, a board is usually the preferred structure by investors and shareholders for decision-making. Two of the greatest inventions of modern capitalism are the invention of the corporation and the separation of the roles of shareholder and management. The board is the means by which the shareholders may exercise their control of the corporation. (As the chairman of a board of a company in which I was involved once told the CEO: you are the chief executive officer. That means you must execute the directions of the board). Creating a board is often a condition precedent to having a private equity or strategic investor invest in a company. Investors place a premium – and are often willing to pay a premium – for companies with a well-functioning board of directors.

Composition of the board

Board members are appointed by the shareholders, and it is perfectly natural to have at least the most important shareholders of a company sitting on the board. There are at least two potential additional categories of Board members:

• Management: Where the CEO or other senior managers such as the CFO are not shareholders, shareholders may consider appointing the CEO, or even additional senior managers as board members. This may improve the quality of decisions, and ensure continuity in the implementation of decisions taken by the board. As an alternative, the board may invite the CEO or other managers to participate in all or parts of board meetings as observers. One should nevertheless be careful to observe that the distinction between the role of shareholders and management is maintained.

• Independent shareholders: There may be different reasons for bringing independent shareholders to the board. First, they may have specific expertise. For example, a lawyer may help ensure that the company by-laws are maintained, and that the company operates fully according to regulations and the law. An investment banker might help assure that the company is moving towards its objectives of achieving financing, or an eventual exit by shareholders. Independent shareholders may add prestige or lobbying power to the board (e.g. when a former senior politician is appointed to the board). And independent board members are often individuals who are capable of identifying opportunities for the company, and are used to asking hard questions or at least the right questions, keeping the board and management on their toes.

Ownership in a limited private company is one of the most illiquid forms of investment. Having good corporate governance, including a strong board, is a way of both enhancing corporate value and liquidity.