Making Sense of Evergreen Leader Optimism Going into 2023

Dear Friend of Tugboat Institute®, 

As we step into a new year, I carry with me interesting insights from our recent Tugboat Institute Member Pulse Survey from early December. These members span 20+ industries across the United States, Canada, and Mexico. 

Contrary to what others are saying in the media and elsewhere, most of our members surveyed do not think we are heading into a major recession, or even a hard landing. Overall, over 60% of our members are expecting 2023 to be a growth year and nearly 20% think it will be flat. 45% of our members view the current economic environment as good to very good and 51% view it as ok–not good but not bad. Few view the current economic environment as very bad. 

The difference between their cautious optimism and what we are seeing and hearing on the national stage may, in fact, reflect the differences between Evergreen® companies and public, PE-owned and VC-backed companies that dominate the media and capital markets. Let me explain.

Inflation, supply chain uncertainty, and labor shortages are just a few of the issues that have presented challenges to most businesses in the past year or more. These pressures are certainly real, for Evergreen companies as for all others, and I do not mean to downplay any turbulence or headwinds they are currently causing you. However, I think that a look at the difference between the way Evergreen companies operate and, for example, the way private equity (PE)-owned and venture capital (VC)-backed companies operate might explain this relative optimism in the face of today’s challenges.

PE firms are highly competitive, with over a trillion dollars in dry-powder as an industry. To win the deal, they must pull every lever they can in their modeling, post-acquisition planning, and use of leverage to maximize their offer price while still earning a PE-level return for their investors. This leads to substantial amounts of debt relative to equity in their purchase prices, often 2:1 and even 3:1. In a low interest environment, more leverage is a great way to boost equity returns even higher. To further maximize every dollar of equity return, PE firms often stretch for the lowest possible interest rates, even during our recent period of historically low rates, which means variable interest loans.

After closing the deal, the typical PE playbook is to raise prices and cut costs as much as possible to generate cash to service the debt, typically through layoffs and elimination of any spending that does not feed immediately back into the bottom line. They will also move to squeeze suppliers on costs and payment terms, cut long-term investments, cut charitable giving, reduce product and packaging quality, sell off real estate, sell off divisions, reduce benefits, replace expensive, tenured managers with young go-getters, etc. 

But what happens when the economy unexpectedly slows? Post the massive COVID-related stimulus, and with interest rates rapidly spiking up as the Fed belatedly fights high inflation, conditions can change very quickly, as we have seen in the second half of this year. For these companies, there is a further cash crunch as revenues soften, costs rise, and the earlier pursuit of super-low variable interest rates becomes a time-bomb, significantly raising the amount of cash flow directed to debt service as rates reset. It’s ugly. 

I bet many PE-backed CEOs felt forced to take actions in 2022 that they despised, including moves against their employees, customers, suppliers, and communities. They undoubtedly viewed every move as necessary to preserve their jobs and the companies they lead so that ultimately, a small number of PE owners can continue to financially benefit, along with the pension funds that provide half their funds. How would it feel to be an employee in those PE-backed firms? Remember Doug Tatum’s analysis that over 20% of all jobs in America are working for firms with PE ownership, thus living under this tough playbook. 

A VC-backed company faces a different set of challenges today, but they are daunting as well. Instead of the debt that funds so many PE buyouts, the VC playbook for over two decades has depended on willing and generous investors funding continued losses in the pursuit of get-big-fast (GBF) and market leadership. While the VC industry pre-Netscape IPO was remarkably capital efficient (recall that the three trillion-dollar winners of Amazon, Google, and Microsoft hardly needed any equity capital pre-IPO), that was no longer necessary as money flooded VC firms. With the exceptionally low interest rate environment and excessive liquidity from quantitative easing created by the US Federal Reserve after the Great Recession, the return on fixed income portfolios dropped to almost nothing, and institutional investors had to move to riskier assets, like VC and PE, to find higher returns than the stock market to achieve their return goals or obligations. VC promised, and for a time delivered, these increased returns, enjoying the tailwind of a public market with overinflated asset values in tech, software, and crypto due to those same near-zero interest rates, and therefore attracted even more money from all sorts of sources. 

Today, with valuations of unprofitable tech companies getting destroyed and the FAANG stocks down by half since the end of 2021, VC and later-stage speculative investors (Tiger Global, Softbank, for example) have pulled back their investments, as public companies quickly become worth less than private ones. The mantra now in the VC circles is get to profits, since funding risk has gone exponential and an unprofitable firm cannot count on raising new rounds at anywhere near the current paper valuation, if at all. Layoffs abound in both private and public technology firms as they try to find a profit discipline. Through this process, they are also destroying their once fun, lavish, and friendly cultures. It is going to be really tough to change a culture from playful and undisciplined, with prolific spending and questionable employee effectiveness, productivity, and accountability, to a culture where every dollar matters, there is tremendous Esprit de Corps, and Pragmatic Innovation reigns. Most of the private GBF companies won’t make the shift successfully. 

In contrast, Evergreen companies are not beholden to outside investors. They are typically debt-averse, and if they do carry debt, it is in a reasonable amount, and often backed by hard assets, not the goodwill of outside investors. Evergreen companies grow steadily over time and from their own profits. While this may mean slower growth at times, if you compound their growth rates over decades, it leads to large, meaningful, well-run businesses. Evergreen companies are grounded in a foundation of actual, real value, delivered to employees and customers, and profitability. This equates to far greater stability than their PE and VC backed competitors. Evergreens are better positioned than anyone to weather downturns and therefore, to survive and thrive into the recovery. 

I certainly do not mean to suggest that Evergreen companies are not facing headwinds in today’s economy, nor do I intend to diminish the reality of the struggles you are facing in your company. Simply, as I listen to your feedback and hear the cautious optimism that stands out against the backdrop of a much more pessimistic message from the collective non-Evergreen community, I see strength in our difference. 

Because of the decisions you made not to fall for the sirens’ song and pressure of raising outside money, overleveraging, selling out to PE, or going public, during the past decade (or even further back to the beginning of the 40-year march in declining interest rates), your foundation is strong today. You have an incredible competitive advantage, existing for a deeper purpose, growing slowly and steadily from your own fuel, investing in the future when others are on defense, taking care of your people, and protecting your values and independence. 

For over a decade, it felt like money was plentiful and cheap; between low interest rates, excessive government liquidity, and an abundance of aggressive investors, it was. Therefore, companies who were willing to take massive investments and grow as fast as possible to get as big as possible as soon as possible appeared to be winning. Today, the winds have shifted, and I believe they are blowing in our favor. It may not be intuitive to most to be optimistic at this moment, but if we think about the difference between an Evergreen company and its competitors, it does make sense why you are. 

Wishing you the very best in 2023 and deeply grateful to you, your teams, and your families for being the quiet, stable backbone of our economy.

Warmly,

Dave Whorton

CEO & Founder, Tugboat Institute