Responding to strategic uncertainty: arks, sharks and whales,
by Jonathan Wood.
Success in 2017 means recognising and adapting to a prolonged period of strategic uncertainty. Most companies will seek to account for strategic uncertainty by reconfiguring their businesses in one of three ways: limiting risk, seizing opportunity or positioning for future growth.
Arks pursue a defensive strategy focusing on core businesses and markets. This involves a combination of shedding non-performing assets, reducing debt, cutting costs (especially headcount) and delaying expansion until risks recede. It is not always a voluntary position: external shocks such as the collapse in commodity prices have caught companies ‘swimming naked’. Tighter regulation – especially large penalties – has the potential to plunder balance sheets. Strategy failures, including blocked M&A amid rising nationalism or unsustainable debt burdens, have been key drivers of corporate retrenchment. Arks are often casualties of the increasingly complex and competitive global business environment, but – if successful – are poised to rebound on the back of improving external variables.
The decline in mineral prices since 2011 and collapse in oil prices in late 2014 forced commodity producers and traders to batten down the hatches. Major miners have spun off a raft of ‘non-core’ assets faced with a global supply glut in many commodities and slowing growth in China, which in 2014 accounted for over 50% of global consumption of iron ore, copper, and coal. High-cost or high-risk projects were shelved as international oil companies sought to strengthen their balance sheets, defend dividends and adapt to low price equilibrium – particularly through multi-year, multi-billion dollar asset disposals. According to the International Energy Agency (IEA), oil industry capital expenditure declined by around one-quarter in 2015 – about USD 130bn – and was expected to decline up to another 20% in 2016.
Commodities found their floor in 2016, as anticipated, but remain well below the peaks achieved during the so-called ‘super cycle’. In 2017, this will necessitate further streamlining, not least because many producers are only part way through multi-year austerity drives. However, falling investment will tighten markets, allowing better-capitalised Arks to float on a tide of rising prices.
Commodity producers are not the only players hammered by strategic uncertainty. Retailers, in particular, have faced substantial business model disruption as consumption across a wide range of market segments, from fashion to food, shifts online. Indeed, ‘e-tailer’ research suggests that online sales in the top four global markets – US, China, UK and Germany – will double by 2018 to around USD 1 trillion. As a strategic response, and under sustained pressure from super-efficient online bazaars, many retailers are ‘evolving’ from physical to purely virtual storefronts by disposing of costly real estate.
In addition to the disruptive force of the online economy, some retailers are curbing their global ambitions due to changing economic and operational circumstances. China – the most attractive emerging consumer market in the world – remains notoriously difficult for foreign retailers to crack, particularly given state promotion of national champions. Turkey, meanwhile, a consumer market dominated by domestic conglomerates at the best of times, has experienced rising political and security risks owing to nationalist policymaking.
Sharks, by contrast, will take on more risk in pursuit of opportunity, whether in new activities or new markets. Low (or negative) interest rates, in particular, have increased the appeal and reduced the costs of hunting yield. Economic reforms and lifting sanctions have opened up new territories, including Cuba, Iran and Myanmar, for companies with risk appetite and suitable risk management practices. Finally, growing middle classes continue to present the opportunity for risk-adjusted returns that beat anything on offer in the core economies.
Financial services, in particular, face significant strategic risks in 2017 and beyond. These include strategic policy risks such as Brexit, the rise of emerging market financial centres, rising regulatory and compliance costs, and technological disruption. One bright spot might be some relaxation of US financial sector regulation in 2017 and beyond. As a result, some are moving to capture profitable first-mover advantages in frontier markets or disruptive businesses, such as mobile payments or financial technology. Indeed, the global value of transactions conducted via mobile devices is expected to increase by 50% in 2017, including via emerging payment systems that use peer-to-peer and blockchain technologies to reduce transaction costs (and disrupt the lucrative USD 80bn settlement market). Such technologies could revolutionise remittances, for example, which reached an estimated USD 440bn worldwide in 2016, according to the World Bank.
Sharks in 2017 will continue to position themselves to snap up opportunities in jurisdictions unlocked by dramatic shifts in US and global sanctions policy. Iran aims to double FDI in 2017, Myanmar can reasonably expect a significant boost in trade and investment following the termination of remaining US sanctions, and the end of the US’s 50-year economic embargo on Cuba is approaching, if not imminent.
However, each of these jurisdictions remains complex for investors, due to a combination of government intervention, underdeveloped institutions, adverse regulation, infrastructure deficiencies, lingering reputational risks, residual sanctions – the list goes on. In Iran, for example, the proliferation of trade delegations and memorandums of understanding have yet to result in major Western contracts, due to lingering geopolitical and sanctions risk. Needless to say, engaging in these and similar markets continues to demand selectivity, patience, and fierce due diligence.
Whales will try to get too big and too diverse to sink in anticipation of a prolonged period of strategic uncertainty. Taking advantage of cash stockpiles (around USD 6 trillion at the outset of 2016) and historically cheap financing, this strategy focuses on M&A to create diverse, integrated businesses that can dominate select markets or sectors. It is also driven by heightened international competition as foreign (read: Asian) companies and state-owned enterprises globalise, and rising costs imposed by regulation of markets from healthcare to energy.
Whales want to compete and operate globally as new markets emerge on the back of rising incomes or better technology. Although being a whale pays some immediate dividends in terms of revenue, market share and efficiency, it is fundamentally a long-term strategy increasing resilience to risk and competition while targeting underlying trends in consumption, demographics and technology.
The 2015 wave of M&A – reaching over USD 5 trillion globally – extended into 2016, especially towards the end of the year: deals in October 2016 alone surpassed USD 500bn. Consolidation was particularly notable in the technology, media, pharmaceutical and agribusiness sectors, due to both fierce competition and vulnerability to disruption from technological or environmental change. For example, a series of pending mega-mergers in agribusiness would concentrate over half of global market share in three companies.
In the technology industry, specifically, consolidation also reflects the relative immaturity of the digital economy, in which first-movers in search, social media, mobile, marketing and cloud have carved out lucrative global fiefdoms through network effects and economies of scale. Acquisitions often consist of simply buying established networks and their juicy user data, as when Microsoft acquired LinkedIn for USD 26bn. Legacy telecoms companies are now trying to buy their way into fast-growing streaming services as the next evolution of mass media.
As ever, the main threats to corporate whales are the sharpening harpoons of economic nationalists and competition regulators. Worldwide, governments have increasingly opposed mergers fearing job losses, revenue losses (through tax base erosion) or threats to national security. Around eight in ten countries currently impose foreign ownership restrictions in at least one sector, with transport and media more restricted than financial serves or extractives. Investment liberalisation remains largely bilateral rather than universal. The broad geopolitical trend towards nationalism has supported increased scrutiny of deals in certain sectors or involving certain countries.
More recently, populist pressures in Western countries are also tacking against consolidation, as regulators scrutinise concentration across multiple sectors. In the US, both left and right have opposed recent proposed mergers, often yearning for the ‘trust-busting’ days of arch-populist president Theodore Roosevelt (1901-09), who broke up Standard Oil’s energy monopoly. One way or the other, the next US administration is likely to be more hostile to the whale strategy.
The EU’s competition authority, meanwhile, shifted in 2016 further towards an activist stance on both competition and tax avoidance, in response to growing popular and political pressure. High-profile investigations and record penalties in the tech sector, in particular, were also an indictment of the dominant position of US companies in the European market, linked to long-standing concerns over data privacy. Recent investigations – whether involving US or Chinese acquisitions – are part of the broad policy defence of ‘European standards’ that has complicated trade negotiations.
Analogously, anti-trust regulators have also been used to prosecute corruption cases in China, in part to secure a more favourable competitive landscape for domestic players as part of an over-arching economic strategy. Indeed, the trend towards ‘weaponising’ regulation to shape the investment climate is occurring across both developed and emerging economies. As one result, the volume of withdrawn or blocked deals – estimated at over USD 1.1 trillion since the beginning of 2015 – has increased in tandem with appetite for conglomeration. Just as populism is eroding public support for free trade, nationalism is cutting into government support of foreign investment.
The foundations of the post-Cold War era are increasingly unstable. The rising tide of Western populism and competitive nationalism threatens to wash away key assumptions underpinning multinational business models, including economic liberalisation, regulatory convergence, and political stability. Key variables in the outlook for 2017, from US trade policy to European elections to China’s leadership transition, are still undetermined but likely to be decisive.
We will need to adapt to this less predictable landscape by becoming variously more resilient, more flexible, and more diverse. In practice, this is likely to mean an overhaul of the basic elements in the risk management toolbox: threat assessment and monitoring, horizon scanning, peer benchmarking, operational auditing, scenario design, and government relations. Many methods were designed for less complex times defined by narrower ranges of possibility. They were also typically tooled for foreign activities, under the valid assumption that home markets – whether in Western countries or major emerging markets – were broadly benign and predictable.
Going forward, a wider range of plausible scenarios, coupled to a more diverse and diffuse range of threats, will make risk prioritisation more difficult. Processes, methods and reporting developed for operations abroad may need to be deployed at home. Strategic roles up to the C-suite are beginning to take greater interest in and accountability for risk management, not least as planning horizons shrink to accommodate greater uncertainty. Ark, shark or whale, we are all in the same boat. BACK