Another major corporate failure in South Africa, this one the result of alleged fraud, has taken everyone by surprise (except, presumably, those in the management of the company who perpetrated the fraud). Especially surprised will have been the lenders to the business who would never have thought there could be anything untoward going on – these were, after all, well-known and respectable business-people.
And that’s the problem. Lenders don’t look critically at the personalities involved and are easily taken in by the hype. After all, what are lenders primarily concerned with – safe lending or putting business on the books and achieving growth targets? We all know the answer to that one when we lend at this level.
It really shouldn’t come as a surprise though. Corporate failures are not that rare, although maybe failures of this size are uncommon.
But is there a thread that runs though these failures that lenders could identify to give them an insight into possible problems before its too late?
Lenders should be aware of the Five Stages of Decline as set out in the book, How the Mighty Fall by Jim Collins. Research carried out by his team following the global credit crunch on failed large global companies resulted in some interesting commonalities from which he developed the five-stage framework.
It’s interesting to note that the first stage of decline is actually when the business is apparently doing well. The seeds of decline are sown when the business is successful and the business becomes insulated from reality by that success.
Stage 1 starts when management become arrogant and regards success as an entitlement (‘We’re great, we can do anything”). They may make some poor judgements but luck and chance will play a part in there being some successful outcomes in spite of that. Management then loses sight of what made the business successful in the first place.
In stage 2, the hubris from stage 1 leads to more scale, more growth, more acclaim – in a word, over-reaching. When management grows beyond its ability to fill key seats with the right people and makes undisciplined leaps into areas where the business cannot be great or driving it to grow faster than it can achieve with excellence, or both, it has set the business up for a fall.
As the title of stage 3 suggests, denial of risk and peril occurs when management sees the warning signs but results are still strong and is are inclined to say that the problems are only temporary – or cyclical – or that fundamentals are still strong etc.
Management starts to blame external factors for setbacks rather than taking responsibility and acting positively. The preference is to brush the problems “under the carpet”.
In stage 4, the decline is now visible to everyone inside and outside the business. There are two possible responses; one is to get back to basics and focus on what brought them the initial success. If that happens, there is a good chance of recovery. The second possible response is to grasp for a “saviour” or “salvation” in the form of a charismatic new CEO or a game-changing acquisition, a bold but untested strategy and so on. Initially, results can improve but it’s only a temporary respite and so management may try something else and, again, a short-lived improvement may be evident.
The longer a business stays in stage 4, the more likely it is that it will fall into stage 5 as the cost of the grand plans starts to eat into financial resources and key people leave, disheartened. Management becomes de-motivated as it has lost the status that it had in the eyes of the investor community and eventually it runs out of ideas.