In early 2000, a five-year-old online bookseller called Amazon.com sold $672 million in convertible bonds to shore up its financial position. One month later, the dot-com bubble burst. More than half of all digital start-ups went out of business over the next few years—including lots of Amazon’s then-rivals in e-commerce. Had the bubble burst just a few weeks earlier, one of the most successful companies ever might have fallen victim to that recession.
Recessions—defined as two consecutive quarters of negative economic growth—can be caused by economic shocks (such as a spike in oil prices), financial panics (like the one that preceded the Great Recession), rapid changes in economic expectations (the so-called “animal spirits” described by John Maynard Keynes; this is what caused the dot-com bubble to burst), or some combination of the three. Most firms suffer during a recession, primarily because demand (and revenue) falls and uncertainty about the future increases. But research shows that there are ways to mitigate the damage.
In their 2010 HBR article “Roaring Out of Recession,” Ranjay Gulati, Nitin Nohria, and Franz Wohlgezogen found that during the recessions of 1980, 1990, and 2000, 17% of the 4,700 public companies they studied fared particularly badly: They went bankrupt, went private, or were acquired. But just as striking, 9% of the companies didn’t simply recover in the three years after a recession—they flourished, outperforming competitors by at least 10% in sales and profits growth. A more recent analysis by Bain using data from the Great Recession reinforced that finding. The top 10% of companies in Bain’s analysis saw their earnings climb steadily throughout the period and continue to rise afterward. A third study, by McKinsey, found similar results.
The difference maker was preparation. Among the companies that stagnated in the aftermath of the Great Recession, “few made contingency plans or thought through alternative scenarios,” according to the Bain report. “When the downturn hit, they switched to survival mode, making deep cuts and reacting defensively.” Many of the companies that merely limp through a recession are slower to recover and never really catch up.
Decentralized firms were better able to adjust to changing conditions.
How should a company prepare in advance of a recession and what moves should it make when one hits? Research and case studies examining the Great Recession shed light on those questions. In some cases, they cement conventional wisdom; in others, they challenge it. Some of the most interesting findings deal with four areas: debt, decision making, workforce management, and digital transformation. The underlying message across all areas is that recessions are a high-pressure exercise in change management, and to navigate one successfully, a company needs to be flexible and ready to adjust.
Deleverage Before a Downturn
Rebecca Henderson (of Harvard Business School) likes to remind her students, “Rule one is: Don’t crash the company.” That means, first and foremost, don’t run out of money. Because a recession usually brings lower sales and therefore less cash to fund operations, surviving a downturn requires deft financial management. If Amazon hadn’t raised all that money prior to the dot-com bust, its options would have been much more limited. Instead, it was able to absorb losses in its investments in other start-ups and also launch Amazon Marketplace, its platform for third-party sellers, later that year. It further expanded during and after the recession into new segments (kitchens, travel, and apparel) and markets (Canada).
Companies with high levels of debt are especially vulnerable during a recession, studies show. In a 2017 study, Xavier Giroud (of MIT’s Sloan School of Management) and Holger Mueller (of NYU’s Stern School of Business) looked at the relationship between business closures and associated unemployment and falling housing prices in various U.S. counties. Overall, the more housing prices declined, the more consumer demand fell, driving increased business closures and higher unemployment. But the researchers found that this effect was most pronounced among companies with the highest levels of debt. They divided up companies on the basis of whether they became more or less leveraged in the run-up to the recession, as measured by the change in their debt-to-assets ratio. The vast majority of businesses that shuttered because of falling demand were highly leveraged.
“The more debt you have, the more cash you need to make your interest and principal payment,” Mueller explains. When a recession hits and less cash is coming in the door, “it puts you at risk of defaulting.” To keep up with payments, companies with more debt are forced to cut costs more aggressively, often through layoffs. These deep cuts can impair their productivity and ability to fund new investments. Leverage effectively limits companies’ options, forcing their hand and leaving them little room to act opportunistically.
The extent to which high levels of debt pose a risk during a recession depends on various factors. Shai Bernstein (of the Stanford Graduate School of Business), Josh Lerner (of Harvard Business School), and Filippo Mezzanotti (of Northwestern University’s Kellogg School of Management) have found that companies owned by private equity firms—which often require the companies they finance to take on debt—fared better during the Great Recession than similarly leveraged non-PE-owned firms. Companies with lots of debt struggle in part because access to capital slows to a trickle during a downturn. PE-backed firms emerged in better shape, the study suggests, because their owners were able to help them raise capital when they needed it. Issuing equity is another way companies can avoid the burden of debt obligations. “If you issue equity in the run-up to a recession,” Mueller says, “the problem of defaulting will be less pronounced.”
The reality, of course, is that many companies have some level of debt going into a recession. Mueller’s study found that the average debt-to-assets ratio among firms that had increased debt levels in the run-up to the Great Recession was 38.3%. Among the group that had deleveraged, it was 19.5%. Although there’s no magic number, modest levels of debt aren’t necessarily a problem, research shows. Nonetheless, Mueller suggests that if a company thinks a recession is coming, it should consider deleveraging. McKinsey’s recent recession research supports this: Firms that emerged in better shape from the Great Recession had reduced their leverage more dramatically from 2007 to 2011 than had less successful ones.
When it comes to deleveraging, it helps to start early, says McKinsey’s Mihir Mysore. That means reducing debt levels before it’s clear the economy is in recession. “You need to take a hard look at your portfolio,” Mysore advises, because shedding assets can be a way to reduce leverage without necessarily cutting core aspects of operations.