Colin McLean: Caution will prevail as era of cheap money ends

Despite rising costs and uncertain customer demand, what big businesses most fear is disruption - new rivals coming out of nowhere, grabbing customers and undermining profit margins.  Now, the end of cheap money means that many loss-making start-ups will be forced out.  Life will be easier for longer established and better financed businesses. What will this mean for innovation, growth and inflation?

Innovators typically benefit from cheap finance, often via private equity.  Investments in new businesses usually involve a few years of losses before hopefully scaling-up to a dominant business model.

Long established incumbent providers lose market share to these entrants, at the same time as being forced to reinvent their own business and cut prices.  In recent years that has been a major headwind for bigger businesses, less agile than the younger entrants and only able to respond slowly by cutting costs and adopting new technology.

A stockmarket shakeout has cut investor appetite for risk. The backers of early stage businesses realise that some of their investments may never pay off. Suddenly cheap money has gone and the financing environment now favours proven businesses.

As a result, valuations of many of the disruptors are falling sharply, with little appetite from their owners for further losses. Effectively, the cost of capital for start-ups has risen, having previously been almost zero when private equity and banks were awash with money.  Failures lie ahead. Every exit from a business sector brings some loss of jobs and opportunity, but will bring relief to the survivors.

Consumers and organisations buying goods and services face less choice. Some offerings are simply uneconomic, whether online fast fashion with cheap returns or consumer credit at point of sale that encourages spending.

Neo-banks, with their brightly coloured debit cards that appeal to millennials, may be forced to raise charges, and cut back on free services. And we may find that only one or two online buyers of second-hand cars are needed, not many. 

Economic reality will prevail after a period in which unsustainable business models offered unprofitable services.  For consumers, subsidised pricing was a halcyon period: for established businesses it was a nightmare. It couldn’t last. 

Bank problems are just one early sign of a growing liquidity squeeze. We can expect a rise in real interest costs that accompanies a higher cost of credit and falling inflation.

This may see investors and other providers of finance put more value on cash generative, profitable businesses. Easy money has propped-up poor business models for years; actual failure takes time.

It may take a year or two for the lossmakers to close. But money pressures are already weakening their ability to compete. As losses mount, many early stage growth businesses have cut back on marketing and other costs to extend their cash runway. Cutting the rate at which they lose money simply prolongs the inevitable.

Before weak companies actually fail as cash runs out, it is likely business models will change, compromising their growth.

Many companies have burned cash to attract customers or subsidise essentially uncommercial service offerings. Liquidity tightening will force this to be recognised, and encourage customers back to more traditional incumbents.

Some e-commerce businesses will calculate that the cost of product returns means much of their activity is loss making. Supermarkets can tweak their customer offerings – say, by reducing rewards – but new businesses often have little customer loyalty to rely on.

Key to survival is how companies can cope with a liquidity squeeze; it may prove a favourable background for genuine cash-generative growth.

Over the next 12 months, the Bank of England interest rate is likely to move in the opposite direction to the real borrowing costs of many businesses. This will drive change in industries used to borrowing for working capital or investment. Organic growth and cash generation will matter more, and equity may need to come from retained profits.

Caution will prevail.It means an economy with slower adoption of innovation, with change controlled by the pace that big businesses can adapt.

Colin McLean is a director of SVM Asset Management