Five Questions with Catalyst Investors’ Brian Rich on preparing for a downturn

It’s been 10 years since the last recession and Brian Rich, managing partner of growth equity firm Catalyst Investors and secretary of the NVCA’s Executive Committee, has some advice for venture-backed and growth firms about recession-proofing their businesses. Rich doesn’t think it’s the responsibility of firms to predict the next recession, but he does think they should bullet-proof their companies and prepare them to weather the storm whenever it comes.

How did you prepare Catalyst’s 17 portfolio companies?

We did a liquidity analysis of every single one of our companies to see if, when an economic downturn happens, how badly would the company be affected. We have some companies that will be more affected than others. In some cases, we raised more equity capital, some cases we increased the bank facilities so we had larger revolvers to draw down on. No [it’s not bad to increase the debt] as long as they can amortize. The death knell is running out of liquidity. You just don’t want to run out of money.

What’s the worse-case scenario for a VC-backed company?

When I look around my office at the investment staff, the majority of them haven’t seen a recession. They were in high school [for the last one]. You have to have lived through it to know how horrible it was, 2008 was horrible. If you are a VC-backed company, 90 percent of them are Ebitda negative. If they run out of money, they go broke. Or get forced into situations that are really bad. Like having to sell themselves for a fraction of what they’re worth or having to do down rounds, which are really, really painful.

Should companies take more money if they can?

I tell my CEOs this: You are at a cocktail party and they are offering hors d’oeuvres. Founder CEOs usually worry about taking too much money. I tell them to take a few extra orders. Take more money so you have plenty of room in case things don’t work out as you had planned. If you take way too much money that’s a problem, too. If you take so much money then those investors expect a return, and the business doesn’t justify it, that’s no good. I’m advocating for stress-testing your model. This is what a downside case looks like. Make sure you raise enough money to see you through because in a recession, if you are forced to raise money, that’s going to be difficult.

With PE portfolio companies it’s all about liquidity. In the last recession, there were a number of PE-backed companies that couldn’t pay back their debt and the high yield default rate went up dramatically. They thought they could re-negotiate the loans and they couldn’t. The lenders foreclosed. So, number one, make sure you are well within your covenants. Number two, make sure that you have plenty of leeway in your amortization schedule.

What can you learn from looking at comparisons?

We all theorize what would happen in a recession, but you can learn a lot from history. Examine the closest equivalent to the business from previous recessions and assess what happens to demand. Consider what happens to the company, its valuation and its Ebitda margins, if growth slows materially or even goes backwards…Some businesses get more adversely affected [in a recession] than others. We have a company offering speech therapy to kids. In a recession, they wouldn’t get affected much. You have to really look at the business, look at what happened to it during last recession or that space. You have to think about what will happen to their revenue growth projection during a recession

What about adding customers?

Make sure the business model works in good times and bad. If you can’t add a customer profitably today, it will be that much harder to acquire a customer when that customer is anxious and worried about the macro environment. Growth at any cost is not good growth. You can get away with it sometimes, while the capital markets are strong, but definitely you cannot when things get tight.

Once you are in a bad way — you’ve got two quarters of cash left and you’ve stopped growing and maybe you’ve shrunk — at that point you have to bite the bullet. The mistake people make is not doing a down round. That’s a mistake. My answer is suck it up and take your lumps. Raise that down round.

CORRECTION: A prior version of this story said that PE firms thought they could “renovate” the loans. That is wrong. PE firms thought they could “re-negotiate” the loans. Also, death nail changed to death knell. The story has been changed.