As part of Finance Monthly’s brand new fortnightly economy and finance round-up analysis, Rhys Herbert, Senior Economist at Lloyds Bank, looks at some of the big issues being discussed this month.

June’s surprise drop in inflation to 2.6% – its first decline since last October – confounded economists.

The consensus forecast, and our own, was that inflation would remain unchanged at 2.9%.

The size of the miss raises the question: why did we get it so wrong? More to the point, is it possible that May’s 2.9% outturn marked the peak?

The first question is easier to answer. The fall (and miss) was largely concentrated in the prices of energy, food and recreational goods (notably toys and computers).

The latter alone deducted 0.1% from June’s inflation rate. To some extent, this was expected as it was outsized price gains in this category that was responsible for the sharp jump in inflation in May.

Over the quarter as a whole, inflation was pretty much bang in line with the Bank of England’s May forecast.

So, could consumer price inflation have peaked? It’s possible if the economy and labour market were to deteriorate sharply from here. But we doubt it.

Cost pressures continue

Retailers continue to face significant cost pressures - primarily resulting from the fall in the pound.

Over the coming months, this pressure is likely to continue. Many firms are only now starting to feel the full force of the fall in sterling, as currency hedging strategies put in place ahead of last June’s sharp drop expire.

Furthermore, changes in business rates, the rise in the National Living Wage and the introduction of the Apprenticeship Levy are also pushing up costs.

We expect these forces to boost inflation over the coming months.

A rise above 3% would require the BoE Governor to write an open letter to the Chancellor explaining the reasons for the overshoot and the measures the Bank intends to take to bring it back down.

Autumn overshoot

Mark Carney shouldn’t put his pen away just yet, as we predict the 3% threshold will still be breached in the autumn.

Thereafter, inflation should ease back a little as some of the base effects from rising import prices and other cost increases dissipate.

That said, we, and the Bank of England, predict inflation will remain above the government’s 2% target for at least another two years.

As we have noted before, the extent of the overshoot will depend on how wage growth – or more particularly unit labour costs – respond against a backdrop of weak productivity and a tightening labour market.

If wage growth and unit labour costs start to accelerate more sharply, the inflation overshoot would be far larger and more enduring.

Population pessimism

The recent release of updated UK population projections gives us the opportunity to examine an important longer-term issue, the implications of demographic trends.

While the broad themes are familiar – the population is rising and ageing – the numbers are nevertheless striking.

They also highlight the justifiable concern around the long-term sustainability of UK economic growth and the likely wider pressures on society and the public finances.

According to the Office for National Statistics (ONS), the UK population reached a record high of 64.6mn in 2016. It is projected to rise to 70mn by 2026 and to 74mn by 2039, driven by a combination of natural growth and migration.

If the rise were due to an anticipated increase in the number of young and those of working age, it would be good news. But it isn’t.

By 2036, the number of people aged 65 years or above is projected to rise from 18% to 23.9% of the total population.

Increasingly aged

In other words, around 75% of the rise in the UK’s population over the next twenty years will be driven by those reaching or exceeding retirement age.

As a result, the old age dependency ratio (OADR), which is the ratio between the number of people aged 65 and over and those aged between 15 and 64, looks set to rise sharply.

The higher the OADR, the greater the potential burden on the working population. Last year, the OADR was estimated at 28%. By 2036, it is projected to rise to 41%.

The anticipated rise in the OADR is all the more striking as the ONS’s projections allow for continued growth in net migration – which is mostly by those of working age.

Prior to the EU referendum, there seemed little reason to question this, but last year, things changed.

Immigration impact

Net migration posted its biggest annual fall for more than twenty-five years in 2016 – dropping from 334k to 249k. This reflected, in roughly equal measure, lower immigration and higher emigration.

While we would caution about reading too much into one year’s data, the direct and indirect consequences of the EU referendum result is likely to have had at least some bearing on this.

It appears to support anecdotal evidence that uncertainty over Brexit and the fall in the pound are both discouraging new immigrants and prompting some existing foreign workers to leave.

This is a particular issue for some key sectors, such as retail, healthcare and construction.

If net immigration stalls, population growth over the coming twenty years is likely to be far lower than the ONS projects.

But this may be small comfort if, at the same time, it leads to an even sharper rise in the UK’s OADR, with all the adverse implications this would bring.

Private equity firms have slowly started to push loans that have restrictions on which investors the debt can be sold to, limiting the amount of bargaining that can take place. Stephen Hazelton, Founder and CEO of Street Diligence, explores with Finance Monthly the long-term impact eroding this protection for investors will have.

Despite the rapidly moving trend toward covenant-lite leveraged finance transactions, which are expected to continue well into 2017-18, many investors are concerned about the ongoing impact of the lack of maintenance covenants, historically demanded by lenders to riskier companies.

With private equity firms starting to push loans with aggressive covenant language that essentially restricts lenders’ bargaining power in times of distress, Stephen Hazelton, Founder and CEO of Street Diligence, a leading provider of fixed income analytics on bonds and bank loans, explores the long-term impact of these eroding lender protections.

The landscape for loan issuance and direct lending of late has shifted in significant and impactful ways for, both, corporate debt issuers and lenders. The implications are not only material but long term, in that covenant terms and conditions negotiated today will have an impact in good times and in bad.

How Did We Get Here? Let’s first explore the market shift and the reasons behind it. The financial crisis of nearly a decade ago resulted in a fundamental shift in the regulatory environment. Credit investing and bank lending at the bulge bracket, global banks became challenging, resulting in a capital flow into less regulated investment vehicles, including business development corporations (BDCs) and private direct lending investment vehicles. With so much capital shifting to these vehicles, and the subsequent blurring of lines between large-cap syndicated loans and traditional middle market direct lending, the increased competition has led to new entrants and a flood of capital chasing deals. The result meant more leverage for corporate issuers and their private equity sponsors to negotiate and drive better terms.

Deal Term Implications. The resulting landscape has meant a deterioration in negative covenant protections and the loosening of other key terms and conditions. This has led to more flexibility for financial engineering at the CFO’s office of these loan issuers, better “base case” return scenarios for private equity sponsors and, conversely, declining return expectations for bank loan investors, direct lenders and their own investors.

Loosening Covenant Protections. Broadly speaking, the changing covenant terms in this market boost issuers and their sponsors by eroding lender returns in the event an issuer executes on its plan and doesn’t come close to an event of default. Additionally, in the event all doesn’t go to plan and the issuer struggles, deteriorating recovery rates for lenders can be expected under these looser conditions. Let’s have a look at a few key trends.

Mandatory Prepayments: Lenders typically recover a small portion of the loan annually in the form of a prepayment, which depending on various factors can mean up to 10-15% of the face value is repaid prior to maturity. This repayment hedge in favor of the lender has been declining of late, meaning a smaller cumulative prepayment amount. This hurts lenders, as it removes one of their monitoring tools to force struggling issuers to the negotiating table and benefits issuers in the form of more advantageous cash flows.

Excess Cash Flow (ECF) Sweep: The ECF Sweep provision mandates that excess cash flow, as defined by the deal documents, must be apportioned, in part, to early repayment of the loan obligation. Typically, the ECF sweep requires 50% of excess cash flow be repaid to lenders in advance of maturity. Additionally, in most cases, as an issuer deleverages its balance sheet, the ECF sweep requirements also decline from 50% to 25% and, in some cases to zero. This market is pushing ECF sweep requirements down on a percentage basis in addition to softening the requirements for the stepdown over time. Consequently, with relatively minor improvements in credit profiles, issuers are retaining more cash if they so choose.

Equity Cure: When issuers are operating under stress or distress, the equity cure provision provides private equity sponsors with a “get out of jail” card to use in an effort to avoid an event of default. When used, the equity cure allows a sponsor to provide a cash infusion to the issuer. Critically, this infusion can be treated as EBITDA for the purposes of calculating the issuer’s maintenance covenants, namely their financial covenants. The violation, or threat, of a violation of a financial covenant is a common impetus for a lender renegotiation, so a solid equity cure provision can be valuable in times of stress. Equity cures typically provide for an annual limit and a lifetime limit, the latter of which is increasing from the standard 3 to 4 times, which can be an acute advantage to an issuer in trouble.

EBITDA Definition: Not all EBITDA definitions are created equal. In fact, each issuer generally customizes their definition for the purposes of calculating covenant thresholds and maintenance tests. Herein lies an opportunity for the issuer to insert soft add-backs to their EBITDA equation and soften the depending covenant restrictions. We are seeing increasingly aggressive add-backs, particularly as they relate to future costs savings, business optimization expenses and other pro-forma line items. The add-back caps (as a percent of total EBITDA) that lenders use as levers to combat this are trending in favor of the issuer.

Deal terms are ever-changing, sometimes in subtle ways, but the trend in this market is clearly in favor of the issuer and their sponsor-led private equity deals. As an issuer, the climate is ripe for new issuance and refinancings through a competitive underwriting process.

Angela Knight, the former head of Energy UK, talks to ELN about whether she believes the government will go forward with the price cap.

This week, IBM Security and Ponemon Institute released the annual Cost of a Data Breach report.

This year’s report found that the UK experienced a decrease in the cost of a data breach, from £2.53 million in 2016, to £2.48 million in 2017. The average cost per lost or stolen record in the UK is estimated at £98.

Key points from the study include:

• Incident Response Leads to Significant Cost Savings: For the third year in a row, the study found that having an Incident Response team in place significantly reduced the cost of a data breach, saving $19.30 USD per lost or stolen record.
• Containment Speed Is Critical: The cost of a data breach was nearly $1 million lower on average for organizations that were able to contain a data breach in less than thirty days compared to those that took longer than 30 days.
• Room for Improvement: On average, organizations took more than 6 months to identify a breach, and more than 66 additional days to contain a breach once discovered.
• By Industry, Healthcare Breaches Most Costly: For the 7^th year in a row, healthcare has topped the list as the most expensive industry for data breaches. Healthcare data breaches cost organizations $380 per record, more than 2.5 times the global average across industries ($141 per record.)
• Top Factors Increasing Cost of a Breach: The involvement of third-parties in a data breach was the top contributing factor that led to an increase in the cost of a data breach, increasing the cost $17 per record.
• Top Factors Reducing Cost of a Breach: Incident response, encryption and education were the factors shown to have the most impact on reducing the cost of a data breach. Having an incident response team in place resulted in $19 reduction in cost per lost or stolen record, followed by extensive use of encryption ($16 reduction per record) and employee training ($12.50 reduction per record).

IBM has also created a “Cost of a Data Breach Calculator,” which can use below.

(Source: IBM)

Mark Hixon is a Partner at global advisory firm Transform Performance International with over 25 years’ experience advising Fortune 500 companies on their cost management solutions. Here he provides Finance Monthly with 7 ways to manage costs and what considerations to make.

Not long ago, British Airways suffered a huge and unprecedented system failure. Flights were grounded, and the plans of thousands of passengers were at best disrupted and at worst ruined. The scenes at Heathrow and Gatwick were predictably chaotic, and there were suggestions that had the airline not outsourced its IT work, the incident might have been avoided. This, and other recent events, have brought the negative impacts of cost reduction to the fore once again--but it’s unfair.

Cost reduction, when done properly, merely serves as an improvement to a business. It should never be used as an excuse to defend process failures. Of course, there are times when organisations change their service standards and the impact needs to be understood, but these changes should never manifest as process failures. When this is the case, it almost certainly stems from failing to consider the consequences of not funding certain levels of service.

Many organisations embark upon cost reduction or cost management programmes but almost as many fail to deliver the required benefits. Some organisations even find themselves worse off. For nearly 20 years at Transform Performance International, we have worked with clients to improve their existing cost management programmes, and have a found a pattern of recurring errors, all of which can be prevented.

1. Senior executives are not aligned to the requirements and only provide tacit support. Cost reduction is always popular when undertaken in other people’s business functions but less palatable when it’s done in your own area.

Solution: Use an analytical approach to set targets. In recent years there has been a great deal of intellectual debate as to how to set targets. We successfully developed an analytical approach to segmenting the cost base and setting targets based on activity classifications. This is a non-confrontational way of defining targets.

2. There is weak sponsorship at the executive level. This is characterised by certain executive members or senior managers paying lip service to the programme and the targets but spending their time protecting their own areas of the business.

Solution: Each person on the leadership team should be set a target and these targets should be embedded into their objectives: ‘failure to hit the target = failure to achieve their bonus’. Businesses should also set end-to-end process targets that require collaboration.

3. A ‘one-size-fits-all’ approach is used to make parts of a business take similar approaches to deliver savings. Most cost reduction programmes start with the premise that a consistent approach is required across all areas of the business, however some business areas are more suited to ‘process improvement’ type approaches whereas others require a service level driven approach.

Solution: Define a programme of work that considers how savings may be achieved within the various business areas and then apply the tools and techniques appropriate to each area.

4. The scope and scale of change is not agreed at the executive level so improvement options are rejected or undermined. Cost management programmes often begin with good intentions but as soon as ideas are placed on the table for consideration they are knocked back.

Solution: Hold an executive workshop where a range of ideas are put forward and apply what you learn to frame the overall programme of work.

5. The dynamics of the cost base are not understood.When targets are set, the real implications of the targets are often misunderstood. This is because the true dynamics of the cost base are not understood.

Solution Segment the cost base and analyse it to find out how much of it is addressable, how much is fixed and how much is variable. Fixed or variable analysis should provide data on how costs vary with volume as well as time.

6. The root causes of cost are not addressed. When cost-saving ideas are put forward, there is often very little consideration as to what is drivingthe cost within a business.

Solution: Use an activity-based approach to collect data that enables the root causes of cost to be collected. By collecting the data in a structured manner you will be able to see how much of the cost base is affected by each specific root cause. 

7. The consequences of failing to fund a particular level of service are not well understood. Quite often, businesses suggest reducing levels of service but they do not analyse the risks of failing to support current levels of service. These risks can impact revenue, the ability of the business to maintain a going concern and potentially the end customer.

Solution: All ideas and suggestions should be assessed in terms of their impact on customer service and the overall risk they pose. Some cost management techniques, such as zero-based budgeting, have this type of risk assessment embedded within the methodology: i.e., every service level is characterised not only by the resource and cost requirement, but also in terms of the consequences of not funding it.

The life of the Pacific Salmon is an uphill battle. After years spent at sea, every mature salmon must return to the place where it was born to spawn, and make the arduous journey upstream to get there. Here Alessandro Evangelisti, Finance & Supply Chain Evangelist at Oracle explains to Finance Monthly that in business, the value stream perspective can be beneficial, but weak links are a risk.

As impressive as the physical challenge it faces is the salmon’s innate understanding of exactly how much energy it needs to clear each obstacle along the way while saving enough to finish the journey.

The modern business’ aspirations are not quite as singular as those of a spawning salmon, but there is a lesson to be learned here: efficiencies are found in processes, not in outcomes, and they add up to major gains in the long run.

If a salmon used all its energy at each obstacle, the upstream journey would be too tiring and fewer fish would make it. Similarly, a company that devotes resources to inefficient processes will see its bottom line shrink and jeopardise its future success.

Navigating the value stream

Companies have traditionally built their cost-allocating approach around their products and specific outcomes. However, this driver-based expenditure only allows them to redistribute costs between processes, giving them little hope of uncovering new efficiencies.

This is the same thinking that scares companies into divesting themselves of new product lines even if they show genuine promise, or of holding back on R&D and innovation.

A better approach is to for companies to organise themselves around value streams, which allows them to follow the flow of expenditure throughout their processes and uncover new opportunities for savings.

This is not easy an easy shift. Many CFOs have made their career out of traditional cost allocation, and shaking things up will be as culturally challenging as it is a logistically difficult.

For inspiration, finance leaders can look to supply chain and operations managers, who have adopted value-stream costing because it forces them to focus on productivity, which is key to their success.

Turning to telecoms, Orange France has taken a value-stream approach to managing supplier invoices and preparing financial profitability reports, which has allowed it to spot and clear bottlenecks in these processes. As a result, Orange’s finance, procurement and operations teams have never worked together more closely and deliver better results for customers, all at lower cost.

Three steps for a smooth j upstream journey

The transition to value stream-based costing cannot happen overnight, nor should it. The whole company first needs to be aligned in its approach, and data needs to flow freely between departments if costing is to remain consistent.

What follows are three steps to guide businesses along the way:

Step 1: Know your customers

Knowing what constitutes value for customers puts businesses in the best position to work backwards and develop processes that deliver on peoples’ expectations. From marketing, to warehousing and shipping to manufacturing, each leg of the value stream will be developed with the same focus.

Step 2: Always address the weakest link

Any chain of processes is only as strong as its weakest link. By spotting bottlenecks early in the game, companies can then build systems designed to avoid these. To gain the necessary visibility, businesses require a granular view of their data and of how processes are working together.

This approach has helped some supply chain organisations achieve 20% gains in year-on year productivity.

Step 3: Go digital

It’s no secret digital processes are easier and faster to manage. They can also be automated to help the entire business work faster. With new data from IoT sensors and increasingly automated processes at their disposal, value stream managers have more information than ever to help them overcome any obstacle.

Value begins and ends with finance

In essence, value stream mapping is a form of supply chain segmentation applied to the entire business. As the organisation’s “data impresario” the CFO sits at the centre of its value stream approach.

CFOs therefore need to a close-up view of process data from each line of business. Equally, they need a system that ensures consistent data across every value stream – the disparate systems many companies still use make it almost impossible to scrutinise processes side-by-side. Value stream costing is ultimately about teasing new efficiencies out from processes across the businesses, so a complex system that only allows for a piece-meal approach to change defeats the purpose.

Thinking back to the Pacific Salmon’s uphill battle, the difference between life and death can be a matter of centimetres and relies on how much energy a fish has stored to clear each obstacle (in addition to some luck). In a large business, even the simplest tweak to a manufacturing bottleneck can elevate a product from cost-centre to game-changer. Organisations simply need the strategies, people and infrastructure to spot and clear these hurdles on their way to growth.

A new survey, sponsored by The Brexit Tracker, has calculated that Brexit planning has already cost UK businesses, £667.2m so far in executive man hours and this figure is set to rise to £813m after Article 50 is triggered.

The survey, conducted in January, polled 168 Board Directors of UK companies with a turnover of £10m - £150m to discover the impact and cost of Brexit planning. The associated costs were a conservative calculation based on current working hours spent on Brexit planning, accounting for one individual per organisation and factoring in that 68% of organisations have at least two staff involved.

Ben Martin, founder of The Brexit Tracker said, “Our research suggests that 40% of firms have already started planning for Brexit and with 70% CEOs and CFOs being tasked with that planning you can see how already it’s becoming an expensive business.”

However, despite anticipated costs, the survey found UK businesses were predominantly positive about Brexit and leaving the EU. While many are in ‘wait and see’ mode almost twice as many respondents are positive about the benefits Brexit has had on their industry sector than are negative (39% v 21%).

37% of respondents felt there would be a positive impact on business following the triggering of Article 50 while 30% thought there would be a negative impact. But optimism rises again to 42% v 34% when considering the impact of leaving the EU in 2019.

But the survey showed that Brexit was having a negative impact on general business planning and investment. Three quarters of organisations stated the level of uncertainty impacted their ability to invest. The biggest area facing one third of organisations is developing new markets (34%) and this is most notable in Construction (58%), Professional Services (47%) and Business Service (45%). Investment in technology and recruitment were the other main areas facing uncertainty.

Ben Martin explains the thinking behind The Brexit Tracker: “Our research highlighted that although76% of respondents understand the general implications of Brexit that falls to 67% when looking at how Brexit impacts their own business. Clearly there is a knowledge gap.

“The Brexit Tracker analyses 390 economic indicators pertinent to the sector and the firm’s particular circumstance. Stakeholders can understand likely implications for their business and compare their views with those of their peers. Our tool enables expensive resource to be smartly invested in strategic planning, not squandered in trying to make sense of a myriad of factors that may or may not be relevant to the business.”

(Source: The Brexit Tracker)