Paths to Improved Business Growth When the Federal Reserve’s Policies are Ineffective

The United States is entering a period of unprecedented economic uncertainty regarding the effectiveness of Federal Reserve (FED) monetary policies. The asset management and expansion practices of S&P 500 companies have already changed and substantially reduced the effectiveness of lowering interest rates to stimulate economic growth. Practitioners of all sized companies are reassessing their expectations that the Federal Reserve can effectively stimulate growth and planning accordingly.

Overview

The National Bureau of Economic Research (NBER) reported that the recession officially ended in June 2009.[1] Yet the annual rate of economic growth remains below a long term average of 3.0 percent. While it may be tempting to think that all businesses have shared equally in the pains of a slow recovery, it is not an accurate view. Many practitioners believe that big businesses are growing faster than ever because they can leverage their large scale to grow faster in markets outside the United States. However, such globalization patterns do not increase GDP. In the past monetary policies could be counted on to stimulate economic growth for all businesses. As shown in this article that is no longer the case.

In 2016 the FED’s Chair Janet Yellen presented a paper at a Federal Reserve Bank of Kansas City symposium in Jackson Hole, Wyoming, entitled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.”[2] The Chair stressed that the proven way the FED had stimulated economic recovery and growth from past recessions was to reduce its lending rate to member banks (i.e. discount rate). Specifically, the discount rate, which is the rate that the FED charges member bank to borrow funds in the short run to maintain required reserves, dropped an average of 4.3 percent for the last three recession recovery cycles. Similar rate changes exist for the federal funds rate which is the rate that banks charge each other for short-term loans to maintain required reserves.

If the United States economy had gone into recession in March 2017 when the discount rate was 1.50 percent and the FED followed their previous recovery rate policies, the discount rate would have been lowered to -2.8 percent. With inflation at two percent the real or adjusted discount rate would have been -4.8 percent. There are no precedents to predict what rational economic behaviors would have been for banks, businesses, and households.

In addition, the FED acknowledges that uncertainties exist on multiple levels, which include how to increase the current discount rate of 1.75 percent to 5.0 percent or higher, how many asset purchases would be needed to maintain the unemployment rate at or near 5.0 percent in a future recession, how phasing out interest rates on bank reserves and asset purchases would affect bond markets and bank liquidity, and how fiscal policies and shocks from worsening economic conditions in other countries would affect the effectiveness of U.S. monetary policies. How should practitioners plan for these uncertainties?

This article postulates that the ineffectiveness of the FED’s expansion policies requires businesses to adapt their business tactics and strategies. At the heart of the matter large businesses have already adapted to the Global Information Age by focusing on Intangibles and Goodwill asset investments which are not bank financed. While the FED and its member banks still assume that lower interest rates will increase business investments, practitioners can no longer rely on physical capital expansions to stimulate economic growth. Small and mid-size businesses are encouraged to understand what large companies, such as the S&P 500 companies, have done and adapt their Global Information Age investment and expansion strategies to increase their growth. More than a dozen suggested actions and strategies are discussed below.

Why the FED’s Monetary Policies are Ineffective

In 2017 it is easy to focus on the uncertainty facing businesses and the national economy from the Trump Administration’s proposed fiscal policies. These policies include reducing taxes, increasing government spending for infrastructure projects, eliminating regulations, and replaces the Affordable Care Act. In a period of such fiscal change the only certainty is that market conditions will not remain the same. In such a period monetary policies can be seen by practitioners as a way to provide economic stability and stimulate economic growth. In 2016 Larry Summers determined that monetary policies contributed to secular stagnation growth in the United States.[3]

Historically, the FED’s most effective tool has been its ability to reduce the discount rate to engage a change cycle that ends up stimulating economic growth. Unfortunately in 2017 the FED does not have this monetary policy tool available to stimulate the U.S. economy. Figure 1 provides a view of an annualized federal discount rate for the last 20 years.[4]

The discount rate averaged 4.0 percent from 1990 to 2017 and since 2008 the average has been 0.78 percent. The FED historically pushed the discount rates up during periods of economic growth and then decreased the rate to stimulate the economy out of recessionary economic conditions. The FED did this in 2001 and in 2008. In the 2001 recession the FED was able to move the rate from 6.00 percent to 1.33 percent and promote economic recovery. In 2008 the FED moved the rate from 6.25 to 0.50. While reasonable people can disagree about the length and extent of the recovery since the Global Financial Crisis (GFC) there is little doubt that the current discount rate of 1.75 percent cannot be effectively lowered.

With historically low FED discount rates since 2009 many economists and practitioners ask why bank financed physical capital expansion has not stimulated economic growth? Two reasons are postulated in this paper: (1) banks did not know if household savings would rise with low interest rates, and (2) large businesses have changed their asset management investment profiles and their priorities for bank financing.

Since 2008 banks interest rates offered to household savers has remained within 0.5 percent of the FED’s discount rate. With low interest rates households have not historically increased their savings account balances. Traditionally, banks do not increase their loans without additional savings because such actions reduce their liquidity ratios. In retrospect the period from 2009 to 2015 turned out to be historically different. Savings account amounts increased with low interest rates. Banks discovered that they no longer needed to raise interest rates to increase savings amounts from an ageing demographic base in the Global Information Age. Banks used the unexpected additional deposits to buy back stock, pay dividends, increase cash balances, and acquire other institutions.

With regard to bank/business lending for physical capital expansions a schism occurred in 2008-2010. In this period businesses went to their banks to access credit lines to sustain the downturn and were denied access. Business/bank relationships have been tenuous since then. Do you remember the case where McDonald’s went to its bank and was told no additional credit was available for a proposed investment in their restaurants? The Great Recession can be characterized as the period when businesses lost trust with bank financing. Since then businesses have financed capital project expansions using their own cash, long-term debt, and equity financing. Compustat data for the S&P 500 companies from 2008-2015 shows that Goodwill and Intangible assets have risen to 17 percent of corporate assets while Plant and Equipment has remained close to 1.3 percent.[5] With bank financing tied to physical capital expansions the connections between banks, businesses asset management, and economic growth are broken.

A Business Actions List for consideration in 2018-2019

While the previous section focused on how the actions of the S&P 500 companies and the FED led to stagnant U.S. economic growth, this section suggests what small, mid-size, and large companies can do to offset the downside of ineffective monetary policies and improve business growth when monetary policies are ineffective.

Small corporations should carefully examine alternatives to bank financing of future expansions. Corporations deemed small business (in general, net after-tax income of $2.5 M or less) should carefully review all financial advantages afforded by the Small Business Administration (SBA). The SBA is a focal point of the Trump Administration, and it will receive greater funding and visibility. There are numerous programs including, but not limited to: (1) SBA 7(a) loans; (2) SBA 504 loans; (3) Certified Development Company loans; (4) CapLines loans; and (5) Export Working Capital loans. Further, and not directly related to the SBA, are other government financing methods to both small and large corporations. These include, but not limited to: (1) Industrial Revenue Bonds; and (2) business and industry loans through the U.S. Department of Agriculture which can be broadly defined.

Practitioners of all medium and small sized businesses should also assess how to better leverage bank relationships as S&P 500 companies have since 2009. Specifically, large corporations have connected the availability of increased cash in banks to cheaper long-term debt financing. Why should not all businesses follow this trend?

Practitioners should also be concerned that increases in cash positions by large businesses and banks signal that an economic downturn is increasingly likely. So time may be limited. Recessions are cyclical. The duration between the last five recessions was six to nine years. The current recession clock started in July 2009 according to the NBER. In 2017 the United States economy is well within the duration range. While there is no certain date for the next recession, uncertainty is rising. In 2018-2019 the recession clock will pass above the duration range.

If a recession occurs and the FED maintains low discount rates, end strategies for small and mid-sized companies must include acquisitions by large companies. The following list of actions is appropriate for small to mid-size business managers to consider and discuss as paths to improved business growth and increased acquisition value:

  • Increase Total Corporate Goodwill Value

Increase return on equity (ROE) to 15 percent or higher. Using the DuPont System, practitioners can determine what processes the business does well and which need improvement. The DuPont equation is:

ROE = (net income / sales) * (sales / assets) * (assets / equity)

or said differently:

ROE = net profit margin * asset turnover * equity multiplier.

  • Increase Intangibles

Insure that any copyrights or patents are filed and up to date. Review, and if necessary, enhance legal protections to preserve and safeguard projected account receivables.

  • Hedge Commodities

Companies should consider hedging commodities to assure raw material prices and adequate supplies.

  • Work harder on Customer Satisfaction

It is imperative that smaller companies gain customers since they translate into increased Goodwill. Strategically prepare for this now by rethinking and reconnecting with those factors that drive customers to your company.

  • Push Innovation and Product/Service Extensions to engage in Global Supply Chains

Examine core business competencies and conceptualize how to extend utilizing current output with only minor changes. Are there any industries that can successfully use your products and services as interim outputs?

  • Enhance Strategic Business Models

Examine the possibilities of entering new markets with new products and services through alliances or mergers and acquisitions on a global level. It is a very good time to acquire these extensions, but at prices that reflect the potential for U.S. and global economic downturns.

  • Expand Long-Term Debt Financing Positions in 2018-2019

As S&P 500 companies have done seek available bank funding to finance long-term debt.

  • Return Off-shore Monies to U.S. Banks

Renegotiate banking relationships with better credit terms and investment opportunities for off-shore monies returning to the United States. Small to medium sized businesses can determine the benefits from lower corporate tax rates and allocate available funds to high priority capital projects in the United States. In a shifting trade deficit, practitioners can expect more on-shore opportunities, specifically in holding accounts.

  • Increase accumulated Cash Positions

Make plans to accumulate more cash for a recessionary cushion. Practitioners should revisit tactics to determine how to improve short-term revenue collection and credit targets and enhance cost spending controls. In effect practitioners should seek to lower their exposure to a problematic national downturn. Revisit cash management with banks based on new controls and accounts payable management processes.

  • Leverage Equity Positions

Seek equity positions to increase owned shares. Buy back as much stock as possible when overvalued equities reset. With a refocused cash management position this increased liquidity should give poised practitioners a chance to foster growth during a financially weak period.

  • Expect increases in the value of U.S. Currency against other National Currencies

Bet against the U.S. currency to take advantage of poor monetary transmitters. The FED cannot reduce interest rates to reduce the value of the U.S. dollar relative to other currencies. Furthermore, the FED’s tools cannot reverse potential effects of a changed domestic policy from a shifting federal government agenda.

  • Consider strategic Job Relocations

Relocate jobs to rust-belt states to take advantage of shifting tax and perspective identifies. In a recessionary crisis, the supply of labor will present practitioners with renewed opportunities in capital and labor markets. Market opportunities will differ by state.

  • Analyze 2018-2019 Industry Opportunities

Reassess defense, healthcare, and infrastructure construction industries. The FED will not be able to stimulate the economy, but fiscal spending priorities are likely to stimulate higher growth sectors/industries that practitioners can penetrate by partnering with established business entities.

Considerations and discussions of these actions are important first steps. Practitioners will choose different paths to meet their specific situations. Regardless of the paths taken the effectiveness of the actions should be judged on improved future business growth rates and future acquisition values.

Conclusion

A shifting domestic agenda presents practitioners with a realistic and rapidly approaching economic scenario. The U.S. economy faces serious existential questions regarding risk and volatility against a poorly positioned FED and continued ineffective monetary policies to stimulate economic growth. Trade, immigration, and geo-political decisions, the U.S. currency, and the recession clock combine to present practitioners with an increasing level of downside risk. Practitioners who take advantage of pre-recession financing opportunities, recognize the risks ahead, map out the consequences of key monetary and fiscal policy actions, and solidify their equity-based positions and liquidity through cash management are more likely to succeed in this economic environment. In a real sense, it is better to adapt strategies and act today than be dependent on the Federal Reserve tomorrow.

 

[1] CNN Money, accessed July 10, 2017 on http://money.cnn.com/2010/09/20/news/economy/recession_over/index.htm

[2] Yellen, J (2016), The Federal Reserve Bank of Kansas City Designing Resilient Monetary Policy Frameworks for the Future Symposium: “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”, accessed January 15, 2017 from https://www.federalreserve.gov/newsevents/speech/yellen20160826a.pdf

[3] Summers, L., Secular Stagnation and Monetary Policy”, Federal Reserve Bank of St. Louis Review, 98(2), Second Quarter 2016, pp. 93-110.

[4] ”FRED Discount Rates INTRDSTUSM 193N.” Chart. St. Louis Federal Reserve Bank, accessed April 20, 2017, https://fred.stlouisfed.org/series/INTDSRUSM193N

[5] Compustat, S&P Capital IQ, North America, Fundamentals Annual, accessed on June 15, 2017.

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What Can Managers Learn from Silicon Valley Venture Capitalists?

Successful organizations are often those that continuously learn and innovate. While this impetus for learning and innovation may come from familiar sources, less familiar origins of insight may provide the stimulus for creativity[1] and the identification of new breakthrough product-markets.[2] While venture capitalists (VCs) play a vital role in the development of new firms and even new industries, their insights are primarily provided to those companies directly financed by them. This article reviews the primary roles of venture capitalists and relays key management advice from Silicon Valley VCs normally reserved for their portfolio firms in order to share new insights that may spur innovation among managers of firms beyond Silicon Valley.

Venture Capital 101

The roles of venture capitalists are, of course, multifaceted. In brief, venture capital is a type of private equity focused on financing the growth of high potential new ventures of a variety of industries at various stages of their growth. To accomplish this VCs create a venture capital fund, for which they convince institutional investors, limited partners (LPs), to commit significant capital for the purpose of taking ownership stakes in high potential private companies. Acting as agents for their limited partner investors,[3] VCs set the parameters of the fund (e.g. stage and industry focus of the fund’s portfolio companies), and then identify high potential private firms to invest in after conducting extensive due diligence. Their job is not over at this point as they guide, support, and cajole the firms they invest in to pursue optimal strategies to potentially lead or create industries rather than simply developing new companies. In order to return their LP’s capital and an adequate return on that capital, VCs must guide a sufficient number of their fund’s portfolio firms to significant growth and a successful liquidity event (exit) through an acquisition or an IPO. Please see Figure 1 for a graphical representation of the VC business model.

Figure 1:

Venture Capital Business Model

So what can managers who are not directly part of this venture capital centric entrepreneurial ecosystem learn from these purveyors of capital and guidance? To provide current advice from practicing venture capitalists, I conducted a short survey of some of the Silicon Valley VCs who regularly provide insight for a related ongoing quarterly research study of venture capitalists’ confidence.[4] In the survey for this study, I asked each VC to offer one or two pieces of advice to business managers that they have found to be effective in guiding their portfolio firms. I also asked if I could cite them. Each agreed. The VC responses were placed in context of relevant underlying theory in entrepreneurship and innovation to validate the commentary as durable wisdom for business professionals. In the following please find a review of their responses along with my analysis.

Venture Capitalists’ Advice for Managers

Highlight Leadership Rather Than Management to Spur Innovation

Bill Reichert of Garage Technology Ventures offered “two recommendations for business leaders who want to drive innovation and growth in their companies.” First, Mr. Reichert insisted to:

…ban the title ‘manager’ and the word ‘management’ from your vocabulary. You don’t want ‘managers’ in your organization. You want leaders, up and down the organization. Managers seek stability, which is best attained by avoiding anything that rocks the boat. Managers suppress conflict, ‘Shut up and do what I tell you to do.’ Leaders seek out opportunities to innovate and make things better. Leaders invite diverse and differing perspectives, knowing that better solutions come from the clash of competing ideas. Disagreement and conflict are not bad, if channeled toward achieving shared goals. ‘Managing innovation’ is an oxymoron.

Underpinning Mr. Reichert’s argument, Ireland et al.[5] concludes that entrepreneurial leaders can foster an entrepreneurial mindset in their organizations by protecting innovations that threaten the current business model, making sense of new opportunities, and questioning the dominant logic of the organization.[6] And Blatt asserts the importance of cognitive conflict (the debate of ideas) in enhancing performance among cohesive teams.[7]

Supporting the aforementioned primacy of leadership, Dag Syrrist of Vision Capital observed “…governance and near-termism are restricting large companies more than small companies, especially public ones.” Mr. Syrrist continued, saying:

…generally, senior executives in larger companies have less time and freedom to try and do new things versus the same position in smaller firms…In my experience senior executives in large companies have a laundry list of innovative and valuable things they think would and could make a huge difference in all sorts of ways that would directly impact even near-term key performance indicators (KPIs), but they do not have time or free budget to do anything outside their overburdened near-term to do list… So my number one advice to managers at mid to large size firms, is get bosses that will let them spend x% of time and budget on new things. I worked with a $40B company that had two SVP’s called ‘pathfinders’—they clearly got this idea, and freed them from day-to-day crap. It’s hard to do because Wall Street and EPS drive all aspects of all large public companies in the end, and there are very few Steve Jobs or Mark Zuckerbergs out there.

Focus on a Meaningful Outcome and Chart the Milestones to Achieve It

Tim Draper of DFJ, shared, “My advice to managers is to make sure everyone is pulling in one direction; all motivations should center around a single goal. That goal should be clear and exciting. Financial incentives should align with the outcome you aspire to.” Jeb Miller of Icon Ventures stressed, “Have a strong conviction in your long-term vision. Startups can make adjustments along the way, but you need to have conviction in your long-term vision in order to convince others (employees, investors, customers) to join you for the ride.”

Bob Bozeman of Eastlake Ventures also emphasized focus on something that is “worthwhile.” Mr. Bozeman elaborated on this notion, saying:

You can only stay focused on one thing—make it something worthwhile. Often people pick goals that are opportunistic to get a fast win. Worthwhile things are not always easy but they are worth the focus and breaking down into an executable plan that can make life worthwhile too. When the long-term goal has a high worthwhile factor then the short-term steps (sometimes called work) are bearable.

Mr. Bozeman explained further “Connect short-term to long-term and vice versa. To some people the BIG picture is everything and to others tactical is everything. People that keep long-term goals in mind while getting things done effectively create the momentum that leads to success.”

Ensure a Company-wide Culture of Customer and Sales Orientation

The second point that Mr. Reichert underscored is:

Everyone sells. Nurture a culture in which selling is appreciated as one of the highest arts of entrepreneurship, right alongside innovation. Too many cultures disparage selling as an unfortunate necessary evil, and sales people are too often held in low esteem. Everyone in the company should have an orientation toward creating value for customers. Everyone should understand how to sell and love to sell the company’s product or service.

To amplify this effect, Bob Bozeman of Eastlake Ventures suggested “TEAMING.” He specified “Don’t be a loner—connect to the team that coordinates to get hard things done more effectively. This is the people factor in business and connects individual contributors to achieving the required momentum and being part of the overall success.” Underlying this point, Blatt maintains that developing a communal schema and clear contracting practices can help reduce affective conflict and support team cohesion and performance.[8]

Consider Startups’ Priorities, Opportunities, and Pitfalls

Kurt Keilhacker of Elementum Ventures indicated “One of my own phrases I cite to my first-time CEOs is ‘The CEO ultimately owns three responsibilities: The recruitment of the right people at the right stage, the securing of the right capital at the right price, and the advancing of the right strategy at the right market.’” Dag Syrrist of Vision Capital added that:

…Smaller companies can compete with larger ones simply by virtue of being able to do things; they are not limited to only those things that can move big needles in a big way. So, one way to think of this is that in startups the hard part is to decide what NOT to do. Because the future is unknown and there is no predictable revenue or near term growth the challenge most small companies have is doing too many things, thinking it’s a hedge against being wrong when in fact what it does is dilute each effort often into nothing. So we invented the idea ‘to pivot’ which is just another way of saying we were wrong. As the business grows this changes as the business is better understood, and it’s more about execution and cranking the production. This makes it obvious what to do, less time and money to do ‘new’ things, and as the company gets really big there is nothing left in terms of free time, budget or imagination.

Cash Efficiency

Shomit Ghose of Onset Ventures stated:

The two most important words for startup managers? Cash efficiency. Cash efficiency must always be a primary consideration for entrepreneurs in the startup fray. Companies without a relentless focus on cash efficiency are doomed to fall among the 90% of startups who fail. So once funds are raised, spend every dollar as if it’s your last. Focus your spending in two key areas: customer validation and building your management team. If you can use your funding to demonstrate market need as shown by paying customers and revenue growth, then you can look forward to continued up-rounds, over-subscribed financings, eventually leading to a tidy exit via M&A or an IPO.

Jeb Miller added “Spend cash prudently. The best returns for all parties are usually generated by capital efficient business models that spend wisely.”

Conclusion

While all the advice from venture capitalists may not be applicable to every organization’s day-to-day operations, their insights may provide unique perspectives that could give business leaders, from startups to public corporations, an edge in strategically guiding their firms through an increasingly dynamic and competitive landscape. The key themes emphasized by the responding venture capitalists include a focus on leadership, culture, and finance. Table 1 highlights dimensions of each of those themes.

Table 1:

Silicon Valley Venture Capitalists’ Advice for Managers

Ironically, the primary advice from venture capitalists to managers is to lead rather than to manage and to recruit leaders throughout the organization. Leadership begins with setting a clear and exciting vision and maintaining focus on that vision and using it to inspire colleagues and recruit the right team of leaders. Once that team is in place, encourage debate to get to the best solution and spur innovation. Ensure company-wide focus on a meaningful goal and connect short-term milestones to achieving this long-term goal while budgeting time and capital for continued opportunity scanning and experimentation. Meanwhile, build a culture that affirms a strong customer orientation and honors selling and cash efficiency.

Venture capitalists are revered for their ability to guide new CEOs in developing fast-growth businesses that disrupt industry incumbents and take or create market share in the process. In this Darwinian environment,[9] VCs rely on the leadership of the CEOs they support to communicate an inspiring vision and build a team and organizational capabilities every day to achieve it. Managers of established organizations may benefit from considering the priorities that Silicon Valley venture capitalists demand to achieve uncommon results, particularly as the rate of technological change and global competition increasingly impacts firms of all sizes and industries.

 

[1] Baer, M. (2010). The strength-of-weak-ties perspective on creativity: A comprehensive examination and extension. Journal of Applied Psychology, 95: 592-601.

[2] Christensen, Clayton M.; Johnson, Mark W.; Rigby, Darrell K. (1992). Foundations for Growth: How to identify and build disruptive new businesses. MIT Sloan Management Review, Spring 2002, Vol. 43 Issue 3: 22-31.

[3] Denis, D. J. (2004). Entrepreneurial Finance: An Overview of the Issues and Evidence. Journal of Corporate Finance, 10: 301 – 326.

[4] Cannice, Mark V (2004 – 2017, quarterly). Silicon Valley Venture Capitalist Confidence Index Research Reports. ProQuest and EBSCO, Volumes 1 – 13, quarterly: 1-5.

[5] Ireland, R.D., Hitt, M.A., and D. Sirmon (2003). A Model of Strategic Entrepreneurship: The Construct and its Dimensions. Journal of Management, Vol 29 (6): 963–989.

[6] Ibid.

[7] Blatt, R. (2009). Tough Love: How Communal Schemas and Contracting Practices Build Relational Capital in Entrepreneurial Teams. Academy of Management Review, Vol. 34 (3): 533 – 551.

[8] Blatt, R. (2009). Tough Love: How Communal Schemas and Contracting Practices Build Relational Capital in Entrepreneurial Teams. Academy of Management Review, Vol. 34 (3): 533 – 551.

[9] Cannice, M. and Bell, A. (2010). Metaphors used by Venture Capitalists: Darwinism, Architecture and Myth. Venture Capital: An International Journal of Entrepreneurial Finance, Vol. 12: 1 – 20.

 

 

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