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John Kelleher and Louisa Greco are partners in McKinsey & Co.'s Turnaround Group; Kelleher is a former private equity partner and CEO, and Greco is a former president of the Canadian operations of a global pharmaceutical company. Kevin Wong is a consultant at McKinsey.

It has been a good decade for the markets. Since the nadir of the financial crisis in 2009, the global economy has witnessed astonishing growth, with one of the longest bull runs in history lifting stock indices to unseen heights. But amid the soaring performance, some economic indicators have investors wary.

Uncertainty in global economies, including storm clouds over Brexit and a softening Chinese economy, are making investors jittery. In 2018, China reported economic growth of 6.6 per cent, its slowest in nearly three decades. Together with record-high levels of household debt, rising unemployment and the continuing trade war, a plunge in the Chinese economy would have ripple effects around the world. Reports indicate that a recession in China could cause U.S. GDP to shrink by 1.5 per cent over two years, an impact that would be acutely felt in Canada.

Across the pond, the International Monetary Fund and Organization for Economic Co-operation and Development have separately warned that a no-deal Brexit would plunge the British economy into a painful downturn. And late last year, Mark Carney, the Canadian governor of the Bank of England, reported that the central bank was preparing itself for the worst. A no-deal scenario, the bank reported, would lead to a diminished pound, accelerating unemployment and inflation and precipitous drops in real estate values.

All together, these conditions have experts worried. Earlier this year, Larry Summers, the Harvard economist and former Secretary of the Treasury, wrote for the Financial Times, “Recession is significantly more likely than not in the next two years.” And even as some more promising economic indicators have since emerged, the IMF’s April economic outlook cautioned that “the balance of risks to the outlook remains on the downside,” warning that “the potential remains for sharp deterioration in market sentiment.”

While economic indicators vary from quarter to quarter, with occasional glimpses of optimism, it is clear that investors and organizations must begin thinking about resilience. At the very least, uninterrupted global economic growth is far from guaranteed. And, alarmingly, many companies are woefully unprepared for the risk of an economic downturn.

If a downturn strikes, limited conventional monetary policy options and a large fiscal deficit will preclude simple solutions. The message is clear: The C-suite must start preparing for when the music stops.

How can executives prepare for the unknown? Taking the perspective of an experienced investor and looking to increase operational efficiency amid an economic downturn allows leaders to identify opportunities for improvement and build resilience, starting now. Executives should design an aggressive investor-style turnaround program to implement ahead of the next downturn.

First, start early

Timing downturns is extremely difficult – as the old adage goes, economists have predicted nine of the last five recessions. That is why strong companies begin planning early, improving resilience before the indications of a downturn appear. These actions pay dividends: McKinsey’s research indicates that the most resilient companies in the 2008 downturn were already deleveraging in 2007, reducing their debt by more than $1 for every dollar of total capital, while their peers were continuing to borrow at nearly three times that rate. These actions not only help companies to weather downturns, but when the recovery gets under way, a better cash position will permit acquisitions of new assets at bargain prices.

Second, find the right people

Top investors are talent-focused. Even before finalizing a deal, they emphasize finding managers who have led successful transformations in the past. When building your transformation strategy, include team members who have a history of enabling change and who won’t be constrained by the status quo. Winners will have a transformation mindset and capabilities that support rapid adaptation. They will teach employees new skills and simplify processes.

Third, bring them together

During a crisis, proper organization is paramount. That is why effective investors often set up dedicated transformation offices. The office is led by a chief transformation officer (CTO) and supported by leaders from both operations and finance, with an optimal team size of about five to seven full-time employees. The team’s role is not to run the business day-to-day. Rather, they address transformation opportunities, building and executing a turnaround plan.

The role of these transformation offices extends beyond execution. Successful ones act as “nerve centres” – operating at a higher speed than the rest of the organization to monitor risks and clarify decision accountabilities. This allows them to maintain a sharp focus on leading economic and financial indicators, so they can see threats on the horizon and make decisions quickly when they arise.

Fourth, create incentives

Investors typically establish incentives that are aligned to turnaround objectives. Relying on existing corporate incentive plans is often insufficient to achieve these goals. In particular, incentives should exist at all levels of the organization – not just at the top – and be commensurate in scale with the desired outcomes.

Fifth, plan for reality

Leading investors build and rigorously maintain in-depth monthly operating forecasts, typically for at least three years, that provide a pro forma financial model and associated credit statistics. Downside operating assumptions, including lower prices, higher costs and longer collection periods, are included, providing a clear-eyed view of the worst-case scenario. In case of a downturn, these forecasts act as a decision-making dashboard. Managers should build a similar decision-making tool to understand and act on the nature of their firm’s sensitivity to the risk of a downturn.

Sixth, reassess your balance sheet

In difficult economic times, lenders tend to tighten credit. For this reason, investors should prioritize the cash position, fixed obligation maturity schedule, liquidity requirements and covenants of their assets.

Before a downturn strikes, management must develop its banking relationships, demonstrating to lenders a superior understanding of their company’s covenant sensitivities under varying macroeconomic conditions. In tough times, we have seen high-performing firms begin each day with a “morning cash/balance sheet meeting” at which management reviews cash positions and discusses immediate and short-term cash needs. Continually courting multiple options for fresh financing from new and existing sources is also crucial.

Seventh, establish clear goals and governance

Based on the forecast, investors set simple, top-down financial performance goals, such as increasing margins or releasing working capital. Targets then cascade clearly to profit-and-loss (P&L) owners throughout the organization. Often, investor boards and chief executives, in conjunction with the CTO, become intimately involved with bottom-up planning. Tracking initiatives individually using specialized software provides an early warning system that flags deviations from the plan to the executive team. Executives must ensure that the prioritization of and involvement in the turnaround work is clearly visible to the rest of the organization.

Eighth, focus on working capital

In selecting top-down financial performance targets, investors emphasize working capital improvements due to the rich opportunities they often present. Change without measurement is difficult, and thus tracking and benchmarking metrics of working capital – days inventory outstanding, days sales outstanding and days payable outstanding – in a “working capital control tower” is critical. Indeed, we often see working capital reductions of 20 per cent to 40 per cent uncovered from a shift in governance, with no investor intervention necessary.

Ninth, cut carefully and attend to digital

Rarely is every business unit, customer segment, channel, geography and product unprofitable. Instead, poor company performance is usually the consequence of specific initiatives that underperform. Many businesses undertaking a turnaround wrongly make sweeping cuts as a knee-jerk reaction. Doing so not only fails to fully address underlying issues, it also handicaps high-performing efforts. Investors, on the other hand, work hard to uncover the true value of a business, identifying what needs to change to unlock it. It is fair to say that the next downturn will be different and affected by additional headwinds that will require new moves in the playbook.

One new imperative is the need to act with digital discipline – in today’s landscape, companies that lag on digital maturity could be more severely punished by a downturn than they were in 2008, when digital and analytics remained relatively nascent. In the next downturn, companies caught in the middle of a digital transition could be left playing catch-up, crippled by a weak balance sheet and an unfavourable economic climate, while digitally mature competitors scoop up their market share. Identifying the highest-impact digital initiatives and making investments to develop and deploy them early will ensure organizations can cut judiciously when they need to, without placing themselves at the mercy of competitors.

Management need not wait for a downturn nor an activist investor as impetus to improve business performance. Playing offence rather than defence is part of the play to emerge as a winner. Prepared carefully, even when the music stops, there is a way to keep dancing.

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