After this year's presidential campaign, private equity and certainly Bain Capital, will likely be the last entity that those pandering to populist agendas will go to advice over the future of the business cycle in broad terms, and the future of US labor, most certainly including outsourcing, in narrow terms. And Goldman - that staunch defender of the superiority of capital over labor - will hardly be confused as ever taking the role of workers in any discussion. Which is why we read the following interview by Goldman's Hugo Scott-Gall with Bain Capital partners Michael Garstka and Alan Bird on such topics as corporate restructurings and the future of outsourcing with great interest, as it is very much unlikely that any of the conventional media sources would carry it. And while one may have ideological biases in whatever direction, the truth as presented previously, is that US private equity is a massive "behind the scenes" juggernaut, whose portfolio holding companies account for a whopping 8% of US GDP, and is directly and indirectly responsible for tens of millions of currently employed US workers! At the end of the day, it may well be that what private equity firms such as Bain think about the future of US labor prospects is the most important thing that matters for the future of the so very critical US unemployment rate. Which is why we present, for your reading pleasure, the somewhat unorthodox interview below...
From Goldman's Hugo Scott-Gall
Michael Garstka is a Partner at Bain & Company in London, where he is a senior member of the firm’s global Telecoms, Media and Technology Practice and its Energy and Utility Practice. He has previously worked across Asia for a decade, being based out of the firm’s Tokyo and Singapore offices. He has worked with senior executives and shareholders on strategy-driven corporate transformations and turnarounds.
Alan Bird is a Partner at Bain & Company in London and Johannesburg and the lead partner for the UK’s Organisation Practice. He also heads the firm’s global Mining Practice and has over 20 years consulting experience across a wide range of industries and geographies. His particular focus has been on growth strategy, broad-scale transformation and organisation effectiveness, with a special interest in performance and effective leadership supply.
Hugo Scott-Gall: Do you think the time is ripe for restructuring?
Michael Garstka: Yes. What we are seeing in our work with clients is an increased recognition of the need for and appetite for major, structural change in their businesses, be that strategically or operationally in nature. This is driven by an number of factors impacting companies simultaneously. Some of these factors are very cyclical in nature, and the macroeconomic environment, particularly here in Europe, continues to be challenging. But there are more significant, longer-term secular trends that are driving major disruptions across multiple sectors, and these are being amplified by the cyclical environment.
These include technology evolution, regulatory and government intervention, demographic and geopolitical changes.
For example, a government policy agenda of driving lower carbon emissions in many markets is not just leading to major investment shifts in generation to renewables from fossil fuels, but is also driving significant investments in smart meters, “connected-homes” technologies, smart grids, and even loft and wall insulation. Multi-decade long trends such globalisation and demographics are still opening up lower-cost labour pools in different parts of the world, impacting labour-intensive industries, their location and competitive dynamics.
So while the cyclical trends are increasingly forcing change in the short term, it’s the undercurrent of these longer-term secular trends that is going to impact value creation and value destruction. Take the media sector for example. The ongoing shift towards digitisation is significantly impacting the traditional print media. Newsweek, the 80-year old flagship media brand in the US announced last month that it would stop producing its print edition and instead move towards a wholly digital platform. Yes, revenues and earnings were aggravated by the cyclical downturn in print advertising, but this was less significant that the impact on print media profit pools of online advertising. This trend is hitting magazines, newspapers and yellow page companies.
In consumer electronics, the Apple-led shift to a software platform led mode vs. a hardware-centric mode within handsets has completely changed the market dynamics in favour of Apple and Samsung (which has enthusiastically embraced the Google Android platform) and away from Nokia, which just 4-5 years ago enjoyed disproportionate share of market and profit pool. In mobile telecom equipment, technology shifts such as IP, a shift to common global standards vs. national standards, and the entry of Chinabased low cost players ZTE and Huawei have come at the same time. The cyclical softness in telco capital spending has been challenging, but is not the major story. Rather, this has exacerbated the changes in the industry.
Today, at one end of market we have Ericsson that continues to be successful, and at the other end we have insurgent competitors like Huawei which are leveraging their lower cost structure and taking share from the bottom, while companies in the middle such as Nokia Siemens Networks and Alcatel-Lucent are facing pressure on both margins and operating cash flow.
So, it’s usually secular trends prodded by cyclical factors that drive restructuring, and this accounts for a lot of what we’re seeing right now.
Hugo Scott-Gall: And what about in the resources sector?
Alan Bird: While the underlying trend in commodities is for future growth, the headwinds encountered over the last 12 months as demand has slowed in China and elsewhere have accentuated investor demands for immediate cash returns - patience has run out for "jam tomorrow" promises. This has driven a significant emphasis on restructuring, broadly on three levels. First, companies are reshaping their portfolios (witness Gold Fields’ announcement this week of its intent to unbundle its legacy South African assets), rationalising their asset mix and getting rid of some non-core assets. This has led to the entry of some unusual and new players, including private equity firms, into the industry. For example, BHPBilliton recently sold its Canadian diamond mine (Ekati) to Harry Winston Jewellers, which also has share in a diamond mine with Rio in Canada. Second, mining companies are reviewing their growth projects on a cash generation and quality basis. A good example of this is BHPBilliton's shelving of its US$40 bn Olympic Dam expansion project in Australia. Third, increased price volatility is driving a shift in the profit pools in some sectors (for example, thermal coal) away from asset owners to traders.
Traditional miners in these sectors need to rethink their business models.
Hugo Scott-Gall: How hard is it for corporates to restructure today, particularly in Europe?
Michael Garstka: There is a clear difference in the pace at which you can drive change, depending on the country in which you are based. It’s not that you can’t drive change in less liberal labour market economies as in Mediterranean Europe, it’s just that you have to follow a different route. The legal, trade union and government engagement is different, as is the out of pocket cost.
So what takes a couple of months in the UK or some of the Northern European countries, could take more than six months cost you more in the South. Not being able to restructure quickly is a constraint, but not should not prevent you from taking these tough choices.
Overall, we don’t see it getting harder. In fact, the imperative to restructure is getting stronger, but what we are seeing in our work with clients is a shift in the way companies think about what they need to do to drive growth. There is a strong emphasis on the growth portfolio, not just in the BRICs, but increasingly in the next tier of Africa, Mexico, Indonesia, especially among the consumer products companies. Instead of trying to increase their presence more broadly, our clients are increasingly allocating capital to a limited number of attractive growth markets. In order to win there, they also want to grow domestic talent rather than relying on expat talent pools. And so, while it isn’t significantly harder nor easier for companies to restructure now, the type of measures they are taking is changing quite significantly.
Hugo Scott-Gall: How do you restructure a company that’s facing a structural decline in its business?
Michael Garstka: You first need clarity on the path forward and then you need the confidence, and frankly the courage, to make uncomfortable decisions. Many companies built sets of assets, often through acquisitions during the boom years, but have made only limited efforts to rationalise their portfolio of businesses, product lines, manufacturing facilities or suppliers. When you are facing these secular trends, however, you need to approach this in a quite dispassionate way, and accept that there are parts of the business that are not going to earn desired returns or even survive.
Of course, there maybe exit barriers or high costs in some cases, like large liabilities, labour contracts and pension obligations. But it is increasingly dawning on executives that they need to make these decisions sooner rather than later, because they are facing an extended period of slow or no growth, which will only make it tougher to get out of these businesses. At least in Europe, there is no “V-shaped” recovery that is going to let them off the hook.
Hugo Scott-Gall: Does that mean that there’s a reasonable amount of restructuring that has been put off and therefore still needs to happen?
Michael Garstka: Broadly, I think that’s correct. Most executives don’t wake up and come into the office wanting to make a decision to exit a product line or a factory that they’ve operated for decades.
Few executives enjoy having to take 20% plus out of their cost structure, or wants to fundamentally change the way they’ve always manufactured their product or approached the market. These decisions are hard, and successfully executing on them is even harder. So executives often convince themselves that their market conditions are temporary and there will be a bounce back, and hence there is a tendency to delay some of these tough decisions.
But as it becomes increasingly clear that we are either having a series of very short cycles or an extended down cycle, the secular issues tend to become more important. And in a number of sectors, we will see restructuring that has been delayed come back under focus.
Alan Bird: The shorter term, cyclical actions typically get more attention at first, because they are immediate and more easily addressed. They broadly relate to multi-industry type solutions like supply chain rationalisation, cutting administration expenses, realigning R&D portfolios etc. Then there are industry-specific actions which many companies have been pursuing, such as ringfencing toxic assets in the banking sector. The more challenging actions for companies to take are those industry breakout or industry reshaping strategies which are unique to a specific company in a specific industry. This is typically the heartland for our consulting services and we are increasingly seeing our clients move towards seeking these breakout restructuring opportunities.
Michael Garstka: So to answer your question, more restructuring is coming and it will be greater in some sectors versus others. But the key question that companies will focus on will be how to position themselves to take advantage of the underlying secular trends we have discussed. Not all companies will make those decisions and not all of those that do will s successfully execute such more radical restructuring. But those that do will come out in fundamentally stronger positions five to ten years down the line.
Hugo Scott-Gall: How can we identify companies that can execute restructuring well?
Michael Garstka: It’s important to pay attention to what management is actually saying when they meet with investors, analysts and the press. If the conversation is focused only on things like supply chain, R&D levels and admin costs like Alan mentioned in the previous answer, it is worth pausing for a moment. That’s appropriate for a company in an industry isn’t facing any secular changes, and their primary issue is the macroeconomic headwinds.
But if you realise that there is some fundamental technological, regulatory or demographic change which management is not considering, then that is not enough. In these circumstances, when the focus is not on a 3-5 year horizon, but rather on what can be done for the next couple of quarters, that is watch out.
On the other hand, companies that are considering taking actions that would really take their company forward or those that are trying to understand how they are performing versus their direct competitors irrespective of being in a boom or a doom time, are the ones that can lead the industry in terms of costs and create genuine value. Typically it’s the number one or number two company in the industry, but there are other sources of leadership economics too, whether it’s through superior customer loyalty,platform control or intellectual property.
Hugo Scott-Gall: Given rising wages in Asia and associated transport costs and IP theft risks, do you think there’s a strong enough argument for some types of manufacturing to come back to the West?
Alan Bird: There are two competing trends here. The first is improving the quality and cost-effectiveness of products and services from these 'low-cost' locations. I have had the privilege recently of visiting some of these outsourcing locations in places such as India and the degree of sophistication they now provide is simply amazing. The second trend is for developed markets to reassess their supply chains to enable greater agility by returning to source more locally and in the process becoming more green. On balance, the overall trend is still towards outsourcing to lower-cost countries, but it will be interesting to see how this play out.
Michael Garstka: And it goes beyond just labour arbitrage. Now it is increasingly about a shift in channels. The activities handled by call centres that initially moved to low-cost locations for cheaper employee costs are now moving online. An increasing number of customer segments now prefer shopping, paying their bills, and managing “self service” online.
Especially with smartphones penetration, which is providing customers internet access everywhere, the shift to online platforms is very real and happening quite quickly. This is fundamentally driving companies’ unit costs down while also improving customer service. We are working with clients on this major transition in the telecoms, financial services,
utility and retail sectors in most major geographies. So, it’s no longer just about a shift in the physical location of labour, because you are substituting labour for online. Similarly, manufacturing is seeing an increased amount of intelligence in the form of automation, robotics and 3D manufacturing which are all increasing the intellectual and capital content of manufacturing, making relative labour costs the less determining factor in location. And this remains a major secular trend.
The most forward looking companies are looking at the total cost of their value chains, which includes the issues of security and stability as opposed to just the traditional elements of cost. For example, if a company had all of its memory chips being made in one province of Taiwan, an earthquake could disrupt production significantly. Intellectual property rights security is another concern that a number of companies have raised, particularly in some of the Asian markets.
Historically, the more labour intensive functions are the ones that have moved to offshore locations , but another major issue today, especially for Europe, is the relative cost of energy. Companies in energy-intensive industries are increasingly concerned about the emerging gap in relative energy prices across geographies, and particularly with the dramatic fall in energy costs in the US resulting the shale gas boom. Labour cost arbitrage was the story of the last ten years, but “energy cost arbitrage” could be a major differentiator of national competitiveness going forward.
Hugo Scott-Gall: Is a private equity-owned company easier to restructure than a publicly listed one?
Alan Bird: I don’t really see a major difference between the two. It really is down to the calibre of the management team and the confidence and the decisiveness of action. I don’t think being publicly listed creates a massive impediment in terms of restructuring.