Viral Prohibition, Eminent Domain, and the Path Ahead
I remember March 5th, 2020 like it was yesterday. While traveling for business, several conversations about the potential of a COVID-19 outbreak in the United States caused the gravity of the situation to sink in. That morning, a thousand miles from home, I sent a note to the executive team at Permanent Equity: “We need to discuss planning both for the businesses and for our families. I'm at a loss on where to start.” Our team kicked into gear, initiated discussions with our portfolio companies, and started planning for scenarios previously unimaginable.
I immediately had tough conversations with my parents, grandparents, and brother’s family. We started taking precautions and stocking up. I’m pretty sure I won the “Doomsday Prepper Award” from my local grocery store a few times.
Since then, things have slid further and faster economically than anyone could have imagined. As of today, we have been spared what was predicted in the more catastrophic medical forecasts, but what started as theoretical and distant feels dangerous and ever-present. I have two friends-of-friends in the ICU with it, the first COVID-19 death in Missouri was in Columbia last week, and you can’t read about what’s taking place in NYC and react with anything other than deep concern.
Prohibition and Eminent Domain
The scale of what we’re witnessing both in the economy and the government’s response would have been unthinkable mere weeks ago. As new information is released daily, we’re trying to digest and update our priors. In an attempt to make sense of what we’re experiencing, two analogies have been helpful to me: Prohibition and Eminent Domain.
Economically, the best analogy for our current condition is Prohibition -- a government-mandated shutdown that forced businesses to hunker down and adapt. Here’s one account:
“Yuengling and Anheuser Busch both refitted their breweries to make ice cream, while Coors doubled down on the production of pottery and ceramics. Others produced ‘near beer’ — legal brew that contained less than 0.5 percent alcohol. The lion’s share of brewers kept the lights on by peddling malt syrup, a legally dubious extract that could be easily made into beer by adding water and yeast and allowing time for fermentation. Winemakers followed a similar route by selling chunks of grape concentrate called wine bricks.”
Many more businesses never made it to the other side, letting factories and fields go fallow.
Another helpful analogy is eminent domain, a legal doctrine recognizing the right of a government or its agents to expropriate private property for public use while compensating the owners. The federal government’s response to date, with its third phase signed into law Friday night, shouldn’t be characterized as a bailout, nor stimulus. In reality, it feels an awful lot like the compensation paid to someone who lost something in the name of public interest. For the sake of public health and safety, the government is paying for schools to close, people to stay at home, and all but essential business to cease.
With that as the backdrop, let’s explore where we are, where we’re headed, and what is yet to come.
State of The Economy
“Global supply chains are also affected, hurting the ability for the city-state to get its supplies, and in turn hurting its exports...I don’t see this problem going away in a couple of months...It will be several years before the virus runs its course." -Singapore Prime Minister Lee Hsien Loong
I’ve been asked and I have asked people far smarter than me, “What does this mean for the economy?”
The short answer is no one knows much of anything with certainty. Duration, regulation, biology, virology, and behavior aggregate too many variables to triangulate with precision. At the same time, we can now say without question that the pandemic has caused an immediate and material retraction in economic activity.
Here’s my best guess on what happens next:
As of March 29th, I believe we’re headed for three phases: Lockdown, Winter, and a New Normal. The more “flattening the curve” that takes place, the less strain on the hospital system, but also the longer a government-mandated and/or self-imposed lockdown will be necessary. Preparing now will be essential for giving your organization the best chance for survival.
Lockdown
Shortly, every state in the country will be under some version of an essentials-only economy. Regardless of government intervention, no organization is sustainable with a 60-100% drop in short/medium-term revenue. And for those with untouched demand, supply chain disruptions will present more obstacles as similar actions are taken in other countries. There’s no playbook here -- try to bring your monthly expenses as low as you can, conserve cash, and take advantage of every local, state and Federal government initiative available to you. Work with your partners, not against them. Even with all the drama of the past few weeks, and despite the recent stock market rise, it’s highly probable that we haven’t yet experienced the “bottom” of this crisis economically.
If you as a business owner are at risk of discontinued operations, create and refine a “mothball” plan for shutting down completely as gracefully as possible and leaving things in the best position to restart on the other side. Have honest conversations with your landlord, creditors, customers, suppliers, and employees. Burn as few bridges as possible and treat people well. These relationships will give you the best shot at a restart when the economy comes out of hibernation.
Winter of Uncertainty
After the lockdown ends and all shelter-in-place and other similar orders are lifted, there will be a period of elevated fear and risk aversion that will persist until a vaccine is discovered, proved effective, and widely distributed. This reality will continue to choke consumer spending and cause long-term projects to remain on hold. In fact, some have predicted “breaks” from the lockdown, only to have it resume when COVID-19 roars back. This scenario of alternating government mandates would further exacerbate the Winter.
For those that mothballed operations, emerging from the lockdown will be an uphill battle and re-starting companies will prove challenging and costly. Before initiating that process, I’d want to feel confident that another lockdown wasn’t coming down the pike. Re-start plans should include a material and sustained drop in demand. I’d guess 40% to 70% of normal demand with revenues even lower due to supply chain, logistics, and communication challenges. Customer relationships will be disrupted and may require re-negotiation. Many executives will stay close and come back immediately, but depending on timeframes, available opportunities and competition for talent, other employees may not. Your restart plan should include a significant recruitment, on-boarding, and training budget. The only “plus” is that there should be a lot more talent available and executives may be willing to reenlist with lower compensation until the company is back on its feet.
For those with longer sales cycles or those only mildly affected, you may be seeing leading indicators of decline, but may not be feeling the pain. I’d encourage you to watch closely how those indicators trend and the medium- and long-term implications. Furthermore, I’d be conservative in cash management and how you consider growth and expansion.
New Normal
My guess would be that 5% of existing companies will remain untouched by the paradigm shift, 5% will feel a tailwind, and 90% will experience at least a medium-term impairment, with 30% no longer having a viable business model due to shifting demand, stop-start problems, and a loss of operating leverage resulting in a high fixed costs burden. This isn’t creative destruction; it’s just destruction.
Speaking frankly, we should expect and plan for a tremendous amount of pain personally and professionally. I believe 20%+ unemployment is inevitable and could rise as high as 30%. GDP seems set to drop 30-50% and I can’t see a recovery being “V shaped,” at least with the right side of the “V” rising to nearly the same level, without lengthening the time scale. Would we call that a backward check mark recovery? In the near term, the average business will experience a catastrophic decline and around a quarter of your neighbors will be unemployed. These are obviously unprecedented times with unpredictable consequences.
When does any variation on the “V” begin to take shape? If there is only one period of global lockdown, after which the medical crisis swiftly comes to a close thanks to a vaccine. Then, re-employment and daily activities will have been materially disrupted, but not permanently impaired. If lockdowns continue or cycle, disrupting many months of life, the effects ripple and are likely to sustainably suppress or constrict every level of economic activity, from banking and credit markets to discretionary goods. As WSJ highlighted, consumer behavior hinges on duration: “The longer it goes, the more it hurts.”
To make matters worse, it’s conceivable that global instability will rise in the coming years as rogue countries and organizations attempt to take advantage of the upheaval. Just look at the latest legislative actions in Hungary. Domestically, we’ll be more vulnerable to hurricanes, tornadoes, earthquakes, fires, or floods, with a taxed infrastructure and depleted attention and resources. As operators, we should assume an environment with sustainably more risk and plan for it with extra caution and insurance where applicable. As E. Hamilton Lee said, "There are old pilots and bold pilots, but no old, bold pilots."
Businesses and entrepreneurs will take what they have learned from this crisis and use it to eventually drive innovation and growth just as we did coming out of World War 2. Some of the knock-on effects I discuss later have the potential to revolutionize our economy. More local manufacturing could bring millions of jobs back to the US. Lower-cost distance learning could open up higher education to a greater proportion of Americans and wipe out the burden of student debt. But none of that is consolation to businesses that will go bankrupt before then or the people who will be out of work until the economy improves.
Government Response and Incentives for Small Businesses
A government-induced problem (even in the name of the greater good) calls for a government-assisted solution. Before I get into the government’s response, here’s what Permanent Equity recommended in our public memo on March 19th:
Government co-pays 80% of small business payroll expense for salaries up to $100,000/year for the next three months. Qualifying employees must have been on payroll as of March 1st and must be back on payroll by April 15th. This gives employers who have already done layoffs the ability to hire back immediately and provides the businesses with the people they need to survive this crisis.
Temporarily suspend the payroll tax on small businesses on the first $100,000 of annualized income, giving both owners and employees more take-home pay and liquidity.
Create a “Small Business Bond” program which will provide temporary financial security and a long payback period. Specifically, this would permit any lender who originates conforming credit to qualifying small businesses to receive a government guarantee of 98% of the principal, provided the following structure is met:
10-year loan term or longer
No principal or interest payments for the first year
3% or less interest
Personally guaranteed by the borrower
$5M maximum per borrower
Create or give banks wider latitude to create temporary loans with inventory or accounts receivable as collateral, giving owners the liquidity needed to make payroll and cover other expenses. Alternatively, create a swap or factoring program that allows companies to sell inventory or accounts receivable to the government at a discount.
Speed is of paramount importance with these last two recommendations, so the traditional SBA process isn’t viable. Government should widen qualifying lenders and could encourage the effort through a small, standard loan origination fee shared by the government and borrower.
This package of relief would keep payrolls intact, but not free, incentivizing owners to rightsize their businesses for anticipated medium-term demand and not for the temporary plunge in revenues. It would provide increased take-home pay with reduced taxation and provide a meaningful mechanism for long-term, low-interest debt to the owner to both meet their short-term obligations and expand the business post-crisis. Additionally, it would give small businesses and their employees time to innovate and adapt to the new reality, which we are confident they will.
Interventions and Incentives
Shortly after our memo was released, many European countries enacted legislation nearly identical to our first recommendation. The U.S. government chose a different path.
Between the Families First Coronavirus Response Act (the FFCRA), which passed on March 19th, and the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act), which passed on March 27th, the U.S. government has heavily intervened and necessarily so. You can read summaries from Permanent Equity about key elements of both bills and their impact on small businesses here, here and here.
The very short version of the combined bills is that paid leave and unemployment have been expanded dramatically, along with some offsetting tax credits and increased interest deductibility, and forgivable loans are now available for certain expenses. That’s welcome news and will provide a temporary respite for some employees and business owners.
The group that will benefit most are SMBs with white collar workers who are moderately hurt, but not shut down. If your employees can work from home and there’s still a “there there,” then this should be helpful in funding your payroll and expenses, regardless if you’ve suffered harm as the result of COVID-19, because the loans are not needs-based.
Unfortunately the drafting of the legislation leaves holes in assistance as well as perverse incentives. Generally, eight weeks of support is unlikely to be enough, and the paperwork, process, and incentives create challenges for responsibly structuring to endure hardship past that period. Said differently, for those who need to adjust capacity to a “new normal,” these incentives delay the inevitable.
If you don’t have a business left, like most restaurants, coffee shops, hotels, events, etc. -- almost everyone in travel, hospitality, or events -- then this relief is of little assistance, since there’s no point in organizing and paying people who have nothing to do. During a total shutdown, this extends to any business that requires a physical presence from its employees, like construction.
With unemployment benefits extended in duration, plus an additional $600 per week added to normal benefits, there is a significant population that is now incentivized not to work, as a handful of senators pointed out prior to the bill’s passage. People respond to incentives and being paid more to not work is highly problematic for projects in the short-term, companies in the medium-term, and relationships in the long-term. To be clear, I am not blaming or standing in judgment of any employee, nor do I begrudge any person who needs assistance while dealing with the real life consequences of this pandemic. However, I find it unfortunate that the government’s response has the potential to create a scenario that could, unintentionally, increase unemployment and harm small businesses in order to provide much needed assistance to their employees.
There are also some unfortunate realities independent of government interventions. Most small businesses don’t carry excess working capital to begin with and will come out the other side of this without the ability to fund a re-start or grow their businesses. To help, the government has provided tax credits for COVID-related time off, but that doesn’t help with short-term cash flow. I don’t know a single business owner currently worried about next year’s taxes. This is likely a source of another necessary government program that is exacerbated by the stop-and-start problem almost all businesses will experience.
Based on anecdotal evidence from owners I’ve talked to, some don’t believe their businesses will recover to the levels previously seen, so they’re weighing closing their doors for good. The decision will likely come down to operating leverage, with higher fixed cost businesses and businesses without personal guarantees shuttering in droves. And some just don’t have the stomach to start over, especially those towards the end of their careers.
Knock-On Effects
Pivotal moments like a global pandemic tend to ripple outward into all facets of life. Flying hasn’t been the same since 9/11, and neither has privacy. We’ve discussed the immediate fallout of COVID-19 at length, but it’s worth contemplating the second- and third-order effects as they will be far-reaching and dramatic. Here’s what I speculated in a series of tweets on March 11th. Unfortunately, some of the expected consequences have already taken place.
Dramatic reduction in just-in-time inventory practices. Wave of bankruptcies and closings of small, highly-levered, or low-margin businesses with high operating leverage. Less available go-forward credit, especially transaction debt. Shift to proximity-based manufacturing.
Rise in distance learning and non-traditional education alternatives. Accelerated last-mile delivery options. Increased adoption of home fitness products/services, as well as cookbooks and culinary education. Renewed emphasis on home storage.
Increased social isolation, depression, and self-medication. Rise of niche online/mobile communities. Remote work has its open office moment. Insurance premiums skyrocket regardless of crisis connectedness. Anything travel-related or group-driven gets decimated.
Accelerated adoption of concierge medicine for the wealthy. Increased political polarization and decreasing government satisfaction. Lower voter turnout. Lack of in-person meetings decrease dealmaking around complex and trust-driven transactions (M&A in particular).
Gun sales in the U.S. skyrocket. Tax cuts, new wave of QE, bailouts. Accelerated bank consolidation. Low energy prices slow adoption of electric vehicles. An already weak physical retail sector gets hammered. Local retailers shutter in alarming numbers.
Construction industry slows and costs increase due to physical proximity rules and cleanliness procedures implemented, as well as a loss of older high-skill labor to retirement and illness. Rise of personal health diagnostic tools. Increased mortality rates for other illnesses.
Solidified bifurcation of media between infotainment and news. Rise of old-school "unbiased" news sources (Just the facts, ma'am). Rise of local, individual hobbies. Decline in all transportation demand regardless of mode. Online dating trends are slowed. Co-working declines.
Conclusion
In light of current circumstances, why would Permanent Equity continue investing and even double-down on partnering with small and medium-sized businesses? In short, because while we’re short-term pessimistic, we’re long-term optimistic. Despite obvious challenges and with plenty of room for improvement, the United States is a magnet for talent, a beacon of freedom, and an engine for innovation. We have tremendous natural resources, a large and isolated land mass, and the world’s reserve currency. We’re long-term bullish on the United States and on the entrepreneurship that built this great country.
Permanent Equity’s role is to be a helpful resource to long-term oriented, family-owned businesses. We believe that if we can help a great business see through this crisis, there are rewards to be had on the other side. Last week we announced Safe Harbor, a partnership for small- to mid-sized businesses that can responsibly utilize at least $3 million and are interested in a long-term relationship. Here’s a quick summary of the program:
Size of Investment: $3M+
Structure: Majority equity, minority equity, debt, or a combination
Location: North America
Cost: Zero application fees, transaction fees, or hidden fees
Types of Companies: All companies are welcome to apply
We will do our best to stay on top of what we’re hearing and seeing and how it impacts SMB owners and operators. If there’s a topic you’d like to see us tackle, please DM us on Twitter or send us an email.
We don’t have all the answers, new information is being released hourly, and our analysis is frequently flawed. The beauty of writing and sharing information is starting a conversation. So if you think we’ve gotten something wrong, let us know and help us all get better in the process.
Whatever the long-term effects may be, we know for certain that today, tomorrow, and the months to come will be full of difficult decisions both personally and professionally. We at Permanent Equity wish you health for yourself and your loved ones, and wisdom as you plan your next steps. We’re cheering for you.
Brent
