It’s a Bird… It’s a Plane… It’s an Alternative Lender (Q4-12)
Dec 30th, 2012
The following was excerpted from Third Eye Capital Management Inc.’s Q4 2012 Annual Investor Letter.
Business schools and popular theory have inculcated managers to believe that all companies, like living organisms, have a life cycle that is very predictable. They grow, mature, decline, and eventually die. Living organisms can be described in biological terms, through physics and chemistry, but companies are much more complex systems that evolve less sequentially and cumulatively than theory claims. The duration of each stage of the life cycle is relatively definite for any particular living organism, while duration is virtually impossible to specify for companies. Companies need not die, and in fact could stagnate and decline and then revive and prosper again. Companies can renew themselves continuously, and it is at this juxtaposition of decline and revival where credit investors can capture outsized risk-adjusted returns even in an environment of low yield.
At the decline stage, companies experience deteriorating profit and loss of market share. As they suffer from the declining performance, they also face external problems such as the emergence of new competitors, fierce rivalry, and falling prices. In addition, internal issues like overstaffing, increasing expenses, and exhausted innovation dulls their motivation to stay in the industry. All of this could provoke the demise of the firms unless they are determined to fight for their survival through transformative changes. The process of change always starts with some form of survival anxiety. Management will need to relinquish the status quo, unlearn the things that worked in the past but no longer apply, and commit itself to new and effective organizational learning.
The revival stage is typically one of diversification and expansion of scope. The focus is on innovation rather than imitation of the strategies of competitors. It requires strong leadership and also increased investment, to finance capex, R&D, or acquisition. Cost-cutting and product rationalization during the decline stage may have stabilized operations and reduced losses, but retained earnings have been exhausted and companies will need to rely on external sources of capital. Equity is permanent and at this stage can be intrusive and extremely expensive. Traditional bank debt would likely not be available in sufficient amounts given poor recent history through the decline stage and the risks and uncertainties of transformative change efforts. Ideally, companies in this stage are able to attract credit from alternative investors that are accustomed to managing such complex and heterogeneous risks. For companies’ owners, immediate access to and availability of capital becomes more important than its cost, which is temporary and in absolute terms much less than the costs of other options, including the opportunity costs of abandoning the change effort or liquidating assets.
Transformative change is a daunting task and many companies fail because the path to revival is obstructed by established behavior patterns, processes, and cultural norms. Leadership at these companies must not be paralyzed by the risks but rather encourage risk-taking and non-traditional ideas, actions, and activities. Take the example of Marvel Entertainment. It emerged from bankruptcy in 1999 with a heavy debt burden, limited cash, and a corporate culture resistant to change. The cultural orthodoxy at Marvel was to own every form of exploitation of the company’s library of popular superhero characters like Spiderman, the Incredible Hulk, and the X Men. A new chief executive adopted a licensing model for movies, television shows, and video games, and for consumer products such as clothing, school supplies, toys, and even pool tables. He used the proceeds to retire high-yield debt and then with the help of an asset-based debt facility secured by the strength of the character library, the chief executive launched a movie studio which eventually generated blockbuster hits such as Iron Man, The Incredible Hulk, Thor, and The Avengers. Marvel was sold to Disney in 2009 for over $4 Billion, a nearly 60-fold increase in value from when the transformative change effort began.
Marvel is an extraordinary example of how companies can successfully transition from decline to revival and eventually prosperity. Companies move from one stage to another because they are misaligned with the needs of their environment and must adapt in order to survive. Marvel never declared victory or rested on its laurels while undergoing transformative change. It used the credibility of short-term wins to tackle bigger problems, and anchored changes in the company’s culture by showing how new approaches, behaviors and attitudes led to improved performance.
One of these new approaches was looking at alternative sources of financing. Companies undergoing a similar transition must find investors that are champions of the change effort and are willing to structure their investment to promote the revival. This is a heroic task for traditional lenders, still suffering from the after effects of the financial crisis, but alternative lenders, like Marvel’s superheroes, are accustomed to battling all types of risks and providing rescue when others cannot.