Renewal Through Restructuring

There is no doubt that COVID19 is causing significant disruptions across our economy. This is a time of elevated fear and uncertainty, not least because many businesses may struggle to remain open. Many businesses will likely shut down or require restructuring.

In modern Capitalism, Restructuring (or bankruptcy) has become a dirty word. Restructuring is often associated with job and income loss and disruption and eventual collapse. While all of these negative effects can and do happen, Restructuring is usually only the messenger and final acknowledgment of a problem, not the cause of the underlying rot. The cause is almost always a weak underlying business or business model that was already prone to disruption.

When done correctly, restructurings should be beneficial and should lead to a renewal of a previously struggling or poorly positioned business.

While the current economic disruption due to COVID19 is likely to lead to significant restructurings across the US (and global) economy, Capital Flywheels believes that it will ultimately lead to more robust economies. There will be tectonic shifts across the business landscape, but ultimately change is good. Fires not only clear excess, but also make way for improvements that will ultimately lead to economic reinvigoration, greater economic efficiency, and improved outcomes for all stakeholders including capital and labor providers.

It may seem crazy to you that this should be the case, but a couple of simple examples should make it clear.

To start, restructurings and bankruptcies almost always happen because of debt. The only way that a business would shut down when debt is not involved is if the underlying business is so poor that operating margins are negative. For example, a lemonade stand selling $1 lemonade when a lemon costs $1.5. There is no way to keep this kind of business running even if there is no debt / interest cost layered on top of that when the business outright loses money on every transaction. Such a business is unlikely to (and shouldn’t) remain open.

For most businesses, operating margins are positive. For example, a lemonade stand selling $1 lemonade that costs $0.5 to make. While such a business is far from excellent, it is still a viable business. Most businesses are like this – good / viable but not excellent. The real trouble comes when there is debt involved. Many businesses will have some loans (either from banks or bondholders) taken out during good times for expansion that ultimately become unsupportable in a downturn. This is almost always the reason for a restructuring. When a downturn comes, the debt / interest cost becomes unpayable because the underlying business was only average to begin with. While disruptive, a restructuring is ultimately good for the business and for society.

To restructure a business like this, what usually happens is that the business owner and lender negotiates a reduction of existing debt. However, the lender won’t just lower debt for no reason – they will want something in return. The lender may end up with some of (or all of) the equity/ownership of the underlying business.

While this is bad for the owner of the business (the owner ends up owning less or none of the business at all), it is ultimately neutral / good for the business itself. With lower debt, the business can be reinvigorated and pursue growth without having to divert cashflows to pay interest. The cash generated by the business can be used to hire people instead of paying interest. The cash generated by the business can be used to open new stands instead of paying interest.

The act of restructuring, when done correctly, should only result in a change of hands of assets and ownership. But too often, society assumes that restructurings lead to deterioration of business and or asset destruction. If demand / customers for lemonade is still there, and the lemonade stand is still there, and the lemonade stand can still make a cup of lemonade for $0.5 and sell it for $1, the reduction of debt and transfer of ownership is actually good.

Note that labor is not affected in anyway. A restructuring only changes the capital structure. A restructuring doesn’t even necessarily impact the business or business model. In fact, with lower debt levels and a reinvigorated business, labor can actually benefit from a return to growth.

But, wait, hold on…why has this not been the case for all the restructurings that have happened over the last few years? Why have restructurings led to so many layoffs and eventual business closures?

While many would like you to believe that the act of restructuring is dirty, in every single case where a restructuring led to layoffs and eventual business closure, the real reason is because the underlying business model was broken.

If the lemonade stand can sell $1 lemonade that costs $0.5 to make, a restructuring is good. But if a lemonade stand can only sell $1 lemonade that costs $1.5 to make, restructurings will obviously lead to layoffs and eventual business closure.

This brings me to what has been painfully obvious to me for many years. America was built on the shoulders of entrepreneurialism and Protestant work ethics. America created the greatest economy in the world because our foundation of liberalism, freedom, and capitalism unleashed the full power of entrepreneurialism in a way the world had never seen. America allowed people to create businesses and work for businesses that best suited their talents unlike the Old World that dictated that you end up doing what your ancestors did. Your father was a carpenter? Well, the Old World assumed that you would be a carpenter, too. But America challenged that – You can and should do what you are best suited to do.

But in recent years, this uniquely American dynamism has been repressed. Too many people, and too many businesses resist change. Too many people and too many businesses are operating in businesses that have become weak. Too many people and too many businesses want to keep doing what they’ve always been doing, not unlike the Old World that demanded you do what your parents do.

Retail is a painfully obvious area. Of course, restructurings in the retail space have led to massive layoffs. This is not because restructurings are inherently bad. The layoffs and business closures simply reflect the fact that retail business models that have not evolved with the times are fragile and have become irrelevant. While layoffs and business closures are disruptive, it is ultimately good for society to reallocate talent and capital. As with our above example, no matter how much you may want to protect the lemon juicer that works at a lemonade stand trying to sell $1 lemonade that costs $1.5 to make, wouldn’t it make sense to get that person a job in a business with a business model that ultimately works in the long run?

The sooner that society does this, the better it will be.

Is Amazon a fearful business? Certainly. Has it disrupted the retail sector immensely? Absolutely. But don’t let that stop you from seeing that Amazon now has close to 1 million employees with wages that exceed what struggling retailers pay.

Returning to the current situation, restructurings will likely happen. But it will be a time for change. And it will be at time for renewal. People fear losing their jobs, and it will be important for society to collectively figure out the best way to help people during such transitions. If it was a good business to begin with with real demand and real assets, layoffs should only be temporary. These businesses will undoubtedly need to rehire people once customers can leave their homes again and visit their favorite stores. If it wasn’t a good business to begin with, then restructuring will be beneficial for society as a whole as those resources get reallocated elsewhere.

But there should be no doubt that when we come out of this, the economy will be far more robust and far less fragile, but only if we let the economy adjust and help people through it.

Capital Flywheels continues to believe that owning stocks in the greatest businesses, the greatest American enterprises is the best course of action.