Operating in Limbo, Investing as Usual
TL;DR: Coronavirus and the associated economic uncertainties are and will have a dramatic impact on small businesses. Permanent Equity has a large fund of new, permanent capital, doesn’t rely on bank financing, and is actively pursuing new investments. Said, differently, we’re open for business.
Times like these remind even the most cautious what risk really looks like. Risk takes many forms, and while this form may be novel, this event exemplifies why Permanent Equity is structured for long-term durability. As individuals, we’re praying for, thinking of, and supporting where we can. Life and business is about people. Please let us know if we can be helpful to you or your business.
Denial. Panic. Fear. Intentional action. In uncertain times like these, it’s a familiar pattern and one that we can certainly identify with. Where are you? Where is our economy? Where is our country? Whatever the answer, it doesn’t feel particularly stable, and seems likely that it will feel that way for the weeks and months to come, especially as domestic testing for COVID-19 ramps up and its effects become more widespread and are felt closer to home.
Based on our recent discussions regarding the real world implications of COVID-19, limbo feels like an accurate description for where private company operators find themselves right now. Information is rapidly changing. No one knows what comes next. Could we already be past the actual peak, and just experiencing a delayed media frenzy? Not likely, but possible. Could things get worse? According to public health experts, most certainly. What do we do right now? It’s tough to know with certainty which actions, if any, are the right ones.
Pandemics are not something small businesses plan for. As we have light-heartedly referred to in the past, most businesses are loosely-functioning disasters and small business operators are in a day-to-day knife fight. There is rarely time to contemplate what-if scenarios generally, let alone one as specific, uncontrollable, and seemingly unlikely as a global pandemic. Nobody could have expected the coronavirus or its widespread impact. In fact, to the contrary, based on market dynamics, and our discussions with sellers and those opting not to sell, there was an expectation that good times would keep rolling in 2020 and beyond.
Here’s what we know and don’t know about operating small businesses in light of the global health issue of coronavirus:
SUPPLY & DEMAND
Over the past 6 weeks, supply chain disruption (and the response thereto) has become an early topic of discussion for us with potential sellers. For companies manufacturing in or reliant on components from China, most had significant shipments on the water prior to Chinese New Year. This means supply is not an immediate concern, but no one has been able to articulate if or when to expect reliable shipments in the future, and, understandably given the buyer-seller dynamic, most sellers are not particularly interested in dwelling on this unknown and its potential impact.
As we already own companies manufacturing in China, we know the answer: it’s unknown because capacity and information is changing daily. For most manufacturing-oriented operators, this has been a reality since late January. Up until the last few days, most Chinese factories were operating at fractional capacity because, regardless of the fact that these factories were opened at varying levels throughout February, the migrant workers employed by these factories were not allowed to travel to work. Thus, throughput is not on pace. Chinese operators, trying to keep up strong partnerships, are doing everything they can, but it’s simply impossible to predict fulfillment with a third to a fifth of their normal workforce. And some factories are still shuttered.
Our experience is that the vast majority of US-based small manufacturers who off-shore or contract manufacture do so in Asia. The supply chain issue has largely been viewed through a Chinese manufacturing-specific lens, but manufacturing is stage-based. Many raw materials and intermediate goods are produced in Asia, where virus-based production disruption continues. Shortages in these components can cause supply chain problems even to “Made-In-America” final goods. A proud domestic producer we spoke to last week admitted necessary raw material was likely to become an issue by summertime if current trends continue.
The irony is that supply shortages, where the focus has been to date, will only be the problem if demand persists. We’ve been through such a long economic expansion at this point that most operators are having to dig deep into muscle memory, if they have it at all, to figure out what happens if demand dips significantly. And that’s not just a manufacturing issue.
As exemplified in the amount of large gatherings that have been cancelled over the past week, particularly SXSW, demand can drop quickly and deeply, especially where the loss in demand is imposed on the market. Think about the caterers and staffing agencies and event planning companies and local restaurants in Austin. Hotels and airlines and the companies that clean linens for hotels and airlines. And that’s just one event. Hundreds of large-scale gatherings have been cancelled and many more will follow. Airline demand is reportedly down 20%+ and airlines are flying planes empty just to keep their slots at major hubs.
If more communities begin to experience widespread quarantines, whether government-imposed or self-regulated, it is easy to see how small business operators could fall into panic mode while considering how to fulfill their upcoming AP and payroll cycles in the face of an almost certain material drop in demand.
LABOR CAPACITY
Coronavirus has shown itself to be highly infectious. From a public health perspective, there are arguments for avoidance of physical contact with others. This creates another major pressure for small businesses, especially those that require and therefore employ physical laborers.
Boxes don’t load themselves in small businesses. A plumber physically has to plumb. Construction machinery doesn’t operate autonomously. Many workers don’t produce and perform from a laptop. These are inconvenient realities, and an increasingly real dilemma for small business operators around the world.
Similar to the supply chain disruption in China, small businesses must also contemplate what happens if staff get sick or are preventatively quarantined. This would be a challenge for any business, however, the impact is multiplied and production can quickly spiral when the total labor force is already relatively small (as is the case with most small businesses where staffing is lean and employees often wear multiple hats).
BALANCE SHEETS
We’ve discussed risk amplifying outcomes extensively. In businesses, the greatest long-term risk exposure is based on the balance sheet. It’s akin to an individual living paycheck-to-paycheck versus having savings and other assets. For both individuals and companies, credit lines and term debt have been generously available over the past few years, potentially offsetting asset security. Said differently, you could operate with both less equity and smaller balance sheets. If it all works out, your returns on equity skyrocket. When those lines get pulled and free cash flow exceeds term debt payments or other covenants, a tough situation will quickly become dire. Time will tell how the bets play out.
BEING HUMAN
We’ve always described our portfolio (private equity jargon) as a family of companies (reality for us). That has been intentional. Business, especially small business, is about people. And almost all of our energy is focused on people.
We want people on our teams to be healthy and prosperous. We want their families to flourish. We have people of all ages and in all stages — some with pre-existing health conditions, some battling cancer, some with new babies. And we’re sensitive to how coronavirus may be more likely to impact some families over others, causing planning and changes specific to situations. We are and intend to do what we can to support our teams both as people we care for and as employees we have a responsibility to protect.
We’re also sensitive to the disproportionate exposure many small businesses might face. It is no secret that most small business owners are Baby Boomers or part of the Silent Generation. Many non-owner operators and employees also fall into higher risk categories for the virus. Aging with vitality is one of the great and empowering things we have encountered in meeting company leadership, and it’s scary to hear predictions to the contrary.
Individually, we’re trying to be responsible. We’re not epidemiologists. We don’t have an oracle. We’re just flawed humans with families, too. Perhaps the silver lining of this whole debacle will be a renewed recognition of community, of humility, and of our shared humanity.
LIMBO
What comes next? On a business level, we haven’t felt too much yet. On a human level, the public health math is not comforting. We don’t know how things will play out, but we’ll pray for the best and plan for the worst. Perhaps we’ll all be gratefully learning hard lessons from an overhyped scare in a few weeks, or perhaps we’ll still be dealing with this a year or more from now.
Even absent these circumstances, the truth is that we rarely have enough information to make decisions with 100% certainty. We rely heavily on experience, assumptions, and instinct to guide us. At this point in time, lacking direct experience with such an event, indirect experience, assumptions and instinct are leading our response to coronavirus.
Within our family of companies, this translates into being proactive where we can and defensive where we must. But it’s a balancing act. There are consequences all along the spectrum from naive to panicked.
Financially, we’ve always been intentionally conservative with our companies’ balance sheets, and believe that will serve our companies well. Yet we’ve also reached out to our bankers to make sure everything is in place for our companies to draw on lines of credit if need be and started looking at refinancing or consolidating items such as equipment loans to lower our interest expense at our operating companies and push out maturities.
With regards to personnel, we haven’t stopped hiring -- one of our portfolio companies made a job offer on Friday -- but we are reviewing every new role we budgeted and asking if it’s necessary now or if it can be delayed until we have more information. We’re also having transparent conversations with people who fit the profiles of being more likely to become seriously ill. And we’re communicating frequently, with plans to readdress questions and structures as new information becomes available.
And operationally we are trying to keep in close touch with our customers and suppliers. We neither want to leave one of them in a bad spot nor get left in one ourselves because we were working from different information.
On the deal side, we have a fresh fund of long-term capital. We’re open for business and actively exploring opportunities.
Limbo isn’t a fun place to be. If we can be helpful to your business or your family during this time, let us know how. We’re all in this together.
