Market rationalization and exit risk in global supply chain management
Global | Publication | March 2021
What does this briefing cover?
- Explains why the capacity to contract, and to rationalize or exit markets selectively, in each case effectively and quickly (market rationalization and exit risk) is critical to global supply chain management.
- Highlights those factors which can cause major loss and damage in relation to market rationalization and exit risk, (many of which will probably not have been considered by a business during market entry phase).
- Considers how best to:
- Plan for market rationalization and exit risk in global supply chains during the establishment and operational phases.
- Ensure all relevant issues and risks feature in the decision-making process before the critical announcements and decisions giving rise to liability are made.
- Implement any decision to mitigate risk, liability and damage.
- Examines the potential implications of market rationalization and exit for other stakeholders alongside the affected business.
- What is a typical set-up scenario?
- What’s changed that is leading to a need for rationalization?
- What might need to change?
- Are there unforeseen risks and unbudgeted costs for brand owners?
- How to plan for market rationalization and exit
- What factors are relevant to market rationalization and exit decision-making?
- What are the key implementation activities for brand owners?
- What are the implications for other stakeholders?
What is a typical set-up scenario?
Most international supply chains are set up solely with growth and expansion in mind. Decisions are made after careful planning, and are supported by ongoing resource commitments to deliver the desired outcome. Jurisdictions are chosen based on factors such as market potential, logistical efficiency and low manufacturing costs. Relationships are focused on an envisaged mutually beneficial long-term association. Market entry and deal consummation is warmly celebrated, and often widely publicized. The aura is palpably positive and friendly, and is comparable to a wedding ceremony in situations where joint venture partners are involved.
From a legal perspective, the focus is on getting the deal done, and putting in place all of the necessary structures and arrangements to enter the market. Navigating foreign investment requirements, establishing international payment and shipment arrangements, organizing the appropriate structure, optimizing the tax implications and putting the necessary people in place are seen as the priorities. Once a decision is made there is often a haste to get the first product to market, or local product manufactured and shipped, or local service provided. There is usually significant capital investment involved, including by any local joint venture partners.
Internal and external lawyers try to strike a balance between safeguarding future interests on the one hand, and not taking the shine off the deal or prejudicing any business or governmental relationships or customer anticipation, on the other. As a result, it can sometimes be like trying to negotiate a pre-nuptial agreement at the wedding ceremony. In consequence, most international trade and supply chain agreements tend to focus on the basics when it comes to adverse outcomes – there is a dispute resolution framework and some general force majeure protection. The end outcome is comparable to a no-fault divorce system – the relationship is ended without unnecessary rancor or attribution, but the big arguments about property settlement still need to occur.
What’s changed that is leading to a need for rationalization?
International market expansion and supply chain management has, to date, essentially occurred in an era when globalization has prevailed, the world has seemed increasingly connected and borderless and the primary objectives have been growth-oriented.
However, many of the fundamental assumptions underlying the establishment and operation of global supply chains no longer hold true, or are under threat. The dramatic and immediate economic impact of the COVID-19 pandemic on global businesses brought some of these assumptions into sharp focus, but for some time it has been clear that:
- Technology is not an adjunct to, but the essence of, a global supply chain.
- Governments have been adopting a more nationalistic approach to international trade.
- Consumers are more comprehensively informed and are genuinely valuing and prioritizing non-financial factors in their purchasing decisions.
- Modern slavery, anti-corruption, data privacy and environmental legislation has become commonplace.
- Businesses are now acutely aware how global connectivity can exacerbate the impact of the negative. Local problems can become global problems in the time it takes to tweet or share a Facebook post.
What are the lessons learned from COVID-19?
The COVID-19 pandemic has accelerated, or at least brought into sharper focus, the underlying changes (for example, those described above) that will cause profound and long-lasting economic damage in some sectors, in an instant rendering some markets unviable and paralyzing global networks and supply chains that had a weak link in technology or logistics.
The lessons learned are simple:
- Most relevant factors that will necessitate change have already occurred, and the only question is when a business or stakeholder will be impacted.
- Not all of the implications of change are obvious or predictable.
- Governments are not necessarily neutral observers if change impacts a local market.
- The right time to plan for change is before a crisis.
- It is sensible to expect the impact of change to be increasingly profound and immediate, rather than incremental and gradual.
What might need to change?
Reliability and flexibility will become more critical in distribution and supply chains, as whole countries and markets may need to be circumvented. Distribution within markets may need to be rationalized, and potentially whole markets exited. Many distribution networks were established at a time when having a local business partner wholesaling or retailing goods or services was the only way to achieve quality local market penetration.
These days the internet has largely destroyed the theory on which such independent networks were built – that is, that without motivated local business owners it was not possible to provide a rich customer offering yet still have the requisite geographic reach. In a highly competitive global market all margins need to be justified, and those with the most efficient supply chains win.
Case study: Automotive sector
Some markets are undergoing fundamental change. For example, the automotive sector is faced with multiple challenges and opportunities, such as:
- New global entrants to an already hyper-competitive market.
- Energy transition issues.
- Autonomous vehicles.
- Drone transportation.
- Dramatic changes in consumer purchasing preferences.
Accordingly, perhaps greater control is required over global supply chains, or retail pricing, in which case vertical integration through lower tier suppliers makes sense.
On the other hand, divestment of some parts of the supply chain may make better sense in the context of future flexibility of sourcing.
Past profits are not necessarily a good guide to future risk, including future market rationalization or exit risk. This has a number of implications for mergers, acquisitions and investments, including that due diligence in merger and acquisition of supply chain targets needs to consider new risks in supply chain structure and flexibility.
Often decisions will need to be made very quickly, and to the detriment of various parties involved – business partners, suppliers, service providers, local employees and customers. If the impact is significant there is the potential of political, regulatory, trade union and activist involvement. The potential complications of market rationalization and market exit are often under-estimated, and rarely limited to financial matters.
The fundamental point is that the future is not all about global expansion and growth. Contraction and rationalization, or at least the capacity to do so selectively, effectively and quickly, is just as important.
Are there unforeseen risks and unbudgeted costs for brand owners?
The core problem with market rationalization or exit is that it often delivers the two things that business likes least – unforeseen risks and unbudgeted costs.
Case study: Consumer goods manufacturing
In the face of dramatically reduced global demand, a major US-based consumer goods manufacturer had to close manufacturing plants in several international markets, cease supply of products to some markets, and significantly narrow its global product range. It saw those decisions as logical business decisions for a global business to make, and anticipated few problems.
It dramatically under-estimated the reaction. Among the issues it then faced were:
- Major and ongoing media and political backlash.
- Political and legislative efforts to prevent the business from exit.
- Regulatory intervention on multiple fronts – corporate governance and solvency, consumer protection, foreign investment, and taxation.
- Worker revolt and major trade union action.
- Pressure on local market employees, including threats of criminal prosecution and possible incarceration.
- Major class action by local distribution partners, funded by aggressive litigation funding, and fuelled by coordinated political and media communications activities.
- Investigations in unrelated areas, such as environmental compliance, occupational health and safety, funding of worker superannuation entitlements, and entitlement to government incentives.
- Dramatic and immediate further reduction in consumer demand well below anticipated levels as a consequence of media-fuelled negative consumer reaction to the decision.
Interestingly, and notwithstanding the broadly identical implications in multiple countries, the reaction was not universal. The political, legislative and regulatory framework led to substantially higher difficulty and cost in some countries than others. There was also little correlation between ease of market entry, and ease of rationalization or exit, for a particular country.
How to plan for market rationalization and exit
Each industry and business will be different as to detail, but in broad terms the following steps should be taken to ensure a global organization is best prepared for any market rationalization or exit decision:
- Assess markets for rationalization and exit risk, either as part of the market entry decision process, or during normal operations.
- Appreciate that some countries have a different approach to commerce than might be the case in, say, the US or UK. Some countries do not operate as free market economies, and “buyer beware” or “freedom of contract” are not universal global principles. It is valuable to understand the types of risks and potential liabilities, to avoid unforeseen consequences and properly estimate the potential risks and costs associated with any decision.
- Ensure trading and business partner documentation is fit for purpose. It is important to ensure, where possible, that there is a contractual framework that supports any desired business decisions. This is likely to mean more specific attention to the explicit duration of agreements and relationships, including (where possible):
- Express termination provisions.
- Thoughtfully designed dispute resolution mechanisms.
- Appropriate post-termination or rationalization provisions.
- Carefully considered force majeure clauses.
What factors are relevant to market rationalization and exit decision-making?
Decisions of this nature often need to be made quickly, and sometimes without prior warning. This may be because of continuous disclosure obligations of publicly-listed companies, or simply to avoid market implications. Giving warning could provide opportunities for competitors, allow unhelpful speculation or enable others to control the messaging.
The following factors are important to consider in the context of any decision on market rationalization or exit:
- Ensure all relevant issues and risks are factored into the decision-making process before the critical announcements and decisions giving rise to liability are made. Not only must decision-makers be able to show that they were fully informed when making such an important decision, but it will rarely be possible to back-track from such an important decision if the costs were higher than anticipated. Decision-maker regret – “if I had known that consequence, I would not have made the decision” – often has serious consequences, including in relation to the career path of the decision-maker.
- Be clear who is making the decision, and who is not. This can be particularly important for local executives, who may well be at risk if they are personally involved in making any decision. This risk is heightened if they have been making any “business as usual” statements, or taking any “business as usual” decisions shortly prior to any decision.
- Be clear when the actual decision is made, and announce it immediately. This is likely to be relevant to many subsequent matters, including any litigation. It is common for plaintiffs to allege that decisions were made well before they were announced in order to claim damages from statements or conduct preceding the announcement.
- Implement any decision to mitigate risk, liability and damage. Often how things are done is at least as important as what is done. Affected parties should be treated with respect, and decisions should be communicated with empathy for the impact on affected parties.
What are the key implementation activities for brand owners?
Market rationalization and exit decisions are typically whole-of-business decisions taken by senior management, and only after consideration of a wide range of economic, financial and legal factors. Risk is only one part of this process. However, the COVID-19 pandemic has seen an increased focus on key business priorities.
Many global consumer markets were established in different times, and contribution to global profit had never then been more important than the number of flags on a global map. The following activities may be worth considering as part of the broader risk assessment and management process, or as a standalone activity.
Creation of a global Market Exit Index
Many global businesses are engaging in various network-mapping exercises in response to risks such as modern slavery and corruption. A business could develop an index of each market in which it operates on a graded scale that assesses the likelihood, nature and extent of risks of rationalization or exit from a market. If a market scores highly, further work could be done on specific risk assessment and quantification, and implementation of a risk management program for that market.
Financiers may wish to develop a similar index or customer matrix that they can use to assess lending risk, either globally, or in relation to specific markets.
Market exit and rationalization – training and review of documentation
By definition, unforeseen circumstances and unbudgeted expenditure can be cured by better planning and implementation. Businesses could consider developing a whole-of-business training program that creates general awareness of the key issues, and provide management with access to specialist competency in order to ensure quality decision-making and implementation.
Training often fits well with a review of template documentation. Scenarios can be workshopped, and current documentation and processes assessed for effectiveness.
Specific market risk assessment
Some global businesses have markets that are already in decline, or are under-performing for a variety of reasons. Where some form of market rationalization or exit is on the agenda, there will likely be value in understanding and properly quantifying the consequences of any decision before a decision is made.
In some countries this exercise is relatively straight forward, whereas in others it is more complicated. Much also depends on the nature of the business, and the potential reaction of the various international and local stakeholders who may be impacted by the decision.
What are the implications for other stakeholders?
There can be profound implications for parties impacted by a brand owner’s decision to rationalize or exit a market, particularly if the decision is (as is often the case) perceived to be unexpected:
- Loss of a core product or brand can devastate local joint venture partners, dealers, distributors, licensees and franchisees involved in the wholesale or retail of the items in the local market. Suppliers of ingredients or services can be similarly impacted.
- Financiers may find their local business customer unable to meet commitments, particularly if recent significant capital expenditure has been incurred in expectation of continuity.
- Regulators and consumers may have concerns about whether product warranties can be honored, and any necessary product recalls properly implemented.
- Local management may be concerned about personal liability.
- Employees will naturally be concerned about potential job losses and associated workplace relations matters, including ongoing funding of superannuation/pensions.
- Consumers may feel they have lost value in any recent purchase they have made, or fear lack of future access to service and support.
- A recent buyer, seller or investor can see the value of its investment impacted.
Usually there is little by way of preparation that parties impacted by the decisions of a brand owner can do prior to the decision. Local business partners should factor the risk into the commercial and investment decisions they make, and ensure that they are protected in any transaction of relationship documentation. It is also possible to include the scenario in any business continuity planning they may conduct.
However, the typical activity will be to assess the implications of the decision once made, and assess and quantify any legal or other claims a party may have. Such an exercise is by necessity tailor-made to the situation, but can include:
- Assessing whether the decision can be changed, amended or deferred.
- Considering whether the conduct is lawful, having regard to the contractual position, and prohibitions on unlawful conduct (such as misleading or deceptive conduct or unconscionable conduct). This will usually involve assessing contractual and statutory rights, including any claims to damages and how best to secure damages or compensation.
- Determining the impact of the decision, how to best mitigate the impact and how to communicate the implications of the decision to financiers, investors and staff.
- Deciding on what action to take in future, either in relation to that brand, or the business generally. This may include making decisions on whether to diversify the business, the availability of substitute brands or products, whether to join class action litigation and whether there is merit in involving regulators and politicians.