Boards of directors play a critical role in ensuring that management is well prepared for a wide range of potential shocks. In the fourth episode of our series on board perspectives around the most important issues facing organizations, the Inside the Strategy Room podcast looks at the role that boards play in building resilient companies. Frithjof Lund, who heads our board services work, leads a discussion with Gordon Orr, a nonexecutive member of several companies’ boards and a McKinsey senior partner emeritus, and Martin Hirt, the global co-leader of McKinsey’s Strategy & Corporate Finance Practice. This is an edited transcript of the discussion.
Frithjof Lund: If there has ever been a year when corporate resilience was tested, it was 2020. Martin, you have led a lot of our research on resilient companies. What does resilience mean in this context?
Martin Hirt: Broadly speaking, resilience refers to a company’s ability to weather a crisis well. That means being prepared to deal with an unforeseen event such as an accident or, more commonly now, a major global health or economic crisis.
Gordon Orr: I don’t think resilience is only about unforeseen events. As boards, we would not criticize ourselves for failing to anticipate a pandemic in 2020, but for not having included in our portfolio of potential risks something that would have the kind of business impact that COVID-19 has had and developed the key actions to take.
Martin Hirt: I would concur: resilience is about preparing for both unforeseen and predictable crises. Companies aware of how various types of events would affect their economics are generally better prepared. That is what drove our research. We looked at how organizations fared during previous economic crises and defined resilient companies as those in the top 10 percent of shareholder return outperformance through and after the crisis. We tried to understand at a very granular level what these companies did that differed from others and how those actions played out over time.
Gordon Orr: The share price metric is clearly critical, but assessing how well a board or management perform during a crisis has to encompass externalities, not only preparedness and actions taken midcrisis. During this crisis, share price changes of the companies on whose boards I sit have ranged from a 50 percent decline to an increase of 200 percent, and the biggest difference has been the nature of demand. An airline flying out of Hong Kong is now more than a year into demand at 1 percent of historic levels, whereas a manufacturer of PCs has seen the highest demand for its products in years. The resilience challenge at the computer manufacturer has been about ensuring the supply chain works, whereas for the airline it was more about balance-sheet resilience.
Martin Hirt: So it makes sense to differentiate between the actions companies take before a crisis strikes to prepare themselves where the timing is uncertain, and the actions they take once these externalities hit.
Gordon Orr: I agree. Shareholders tend to see the board’s annual enterprise risk assessments as tick-the-box exercises to meet stock exchange requirements. But if they are done well, they are foundational elements of being prepared, because you discuss the range of risks the organization faces and how those risks play into the financials. The overarching takeaway from that process is often, “Do we have enough capacity in the balance sheet to deal with the shock?” At crisis time, it is too late to start paying attention to the balance sheet. You have to have been thinking about that in advance.
Shareholders tend to see the board’s annual enterprise risk assessments as tick-the-box exercises to meet stock exchange requirements. But if they are done well, they are foundational elements of being prepared.Gordon Orr
Martin Hirt: There is an additional layer of how the board engages with management so the needed actions are taken. In about 2006, we worked with a large Australian real-estate company whose board had asked us to help them think through how their economics, balance sheet, P&L, and cash flow could be affected by certain events. After the financial crisis, in about 2010, they told us they only implemented half of the recommendations. They said, “In hindsight, we wish we had done everything because what we did do saved us.”
Gordon Orr: Well, the development of the risk map and plan is not done in isolation of management. In fact, management and the risk team do the heavy lifting and we, as the board, stress-test. A particular challenge we had this year is that it wasn’t just the COVID-19 crisis—we also had a geopolitical and social stability crisis. Over the past four or five years, companies have been facing increasing levels of geopolitical risk, particularly in the technology space, and some of those issues have intersected with COVID-19 around market access and security of supply. Multiple dimensions are amplifying the effects of the pandemic and each other, and increasing the chance of something that might have been incremental turning into a major discontinuity.
Frithjof Lund: At what point and how should a board intervene to ensure the company is developing resilience?
Gordon Orr: That generally is first debated in depth in the audit and risk committee, working with the finance team and the strategy team. That is then synthesized and elevated to the full board for discussion to stress-test and challenge. In crises, the dynamic between the chair and the CEO becomes incredibly important because they talk several times a week and then inform the board, shareholders, and potentially get the board together to make decisions. Do we reach out to the governments for support? Do we need to communicate with investors? Do we need to resize a business significantly? As a board member, this is the moment when you show up. This is what a high-quality board member prepares for because these are difficult decisions you have to make quickly.
Martin Hirt: One important resilience factor we have seen, especially in this pandemic, is how quickly companies shifted their operating model at the top—how they collaborate, how they make decisions and at what pace, and how they support those processes with war rooms or teams providing a synthesized version of external information, structured into scenarios so decisions can be taken confidently. In your experience, what role does the board play in triggering those operating-model changes, Gordon?
Gordon Orr: The judgment between acting too fast or hanging on in the hope that things turn around is tough. The board’s role, at a first level, is to be a counterweight to what management proposes: Why are you saying “A” when the opposite of “A” is equally valid? Secondly, the board has to stand back and take a strategic perspective because management is likely doing firefighting at this point. The board should ask, “Will things ever get back to the way they were before? What does the post-COVID world look like? Will the business model we used ever come back?”
Martin Hirt: One of the big insights we had from working with hundreds of corporations during this crisis is that, especially when uncertainty is extremely high, not just focusing on firefighting (although firefighting is important) and not just focusing on the long term but focusing on key decisions along the entire timeline is crucial. I found, for example, that many teams struggled to decide whether to accept stimulus, because many companies that had been quick to accept government support during the financial crisis started regretting it within months because it came with big strings attached and getting out of it was not easy. That is one example of a decision that has to be taken in two or four weeks’ time but has potentially multiyear implications.
Other critical decisions, of course, are related to employee health and safety. Then come the decisions about resource reallocation. One interesting insight from our research was that before and at the start of the last crisis, resilient companies divested 50 percent faster than their peers. They were willing to accept lower asset prices in order to create liquidity or make new acquisitions that repositioned them ahead of trends in order to come out of the crisis in a better position.
Frithjof Lund: You have talked about what boards should do, but what are the big pitfalls boards should avoid? Some boards, for example, made fairly high demands for information updates in the early stages of this crisis.
Gordon Orr: It has been very helpful for boards to get more information. The board and management need to have a common understanding of the most important information and at the right level of detail. For me, that means a dozen key performance metrics that tell you the input volumes and demand and how the company is addressing externalities, and getting that information weekly. It is already going to management so just add a few more people to the distribution list. And yes, recognize that when we get back to normal, returning to the monthly rhythm of information sharing will be fine.
Martin Hirt: The information sharing is an interesting one. It builds on the points we discussed earlier about the way boards and management teams look at key decisions during a crisis and the timeframes they consider. One of the differentiators we see is how well management teams use scenarios. It starts with the number of scenarios. If you have three or five, I would say you are operating in one scenario. You need to have an even number [so you do not naturally gravitate to the middle scenario], and structure the information in such a way that management and board directors don’t have to start every conversation with a lot of context setting but are operating in the same frame. Updating those scenarios with the latest information, on the basis of a set of assumptions understood by everybody, is foundational. Once boards and management teams are on the same page, decisions can be taken very swiftly.
If there is information asymmetry—which scenario are we operating in and what does it mean?—it causes misunderstandings. In a crisis, there is a huge premium on decision speed and accuracy. In the military, the team that prepares the information and feeds it in a consistent way is called a plan-ahead team. It is different from the crisis management team, which is taking actions, executing decisions, reacting tactically in the field. The plan-ahead team sits next to the decision maker and its only function is to take information from all sources of intelligence and work it into these scenarios.
We have learned a lot about how these teams work best. For example, you should structure them around issues so when a decision comes at you—Do we take government stimulus? Do we ramp down our process-intensive operations that will require a long ramp-up time later?—it flows to that team and around these decisions the scenarios are applied. You have a structure that feeds decision-ready information to the board and the management team.
Gordon Orr: On the teams point, effective boards now are working as teams, and it helps if the large majority of board members have been together for a while, with an understanding of the business, the industry, management, the level of trust in each other that the synthesis coming up to the full board is of high quality. The orchestration by the chairman as the team leader becomes very important, particularly as you shift to virtual meetings. Members who joined the board recently and lack the experience of going through multiple balance-sheet cycles with management become a challenge for that team dynamic.
Martin Hirt: In order to be an effective team, people have to be trained. How does the board’s operating model change during a crisis, Gordon? What type of capability building and preparation have you seen be effective?
Gordon Orr: Skill building and training is another one of those things investors think boards do to tick the box. But boards do it because they want to get better. When you look at digital, for example, the board needs to be smart enough to challenge management. There are various ways of addressing that, such as an expert talking to the board. It could shape the decision on where we hold board meetings. If we want to understand the Indian market better, the board can spend time there as a group. It would be a red flag to investors if boards were not conducting a regular program of skill development.
Frithjof Lund: In terms of the chair’s role and the new dynamic between management and the board, how much of that do you think will persist beyond the crisis?
Gordon Orr: The role of the chairman has become much more time consuming and that may stay in the form of outreach to investors, governments, and other stakeholder groups. Many countries are piling more and more responsibilities on the board, which is becoming a challenge. Environmental, social, and corporate governance [ESG] is an enormous new topic in terms of board time. Cybersecurity is another. Being a board member is not a full-time job but it is getting closer to that, particularly in Europe. You are asking people to show up for 12 board meetings a year, plus committees, and to do this for a fraction of the compensation they received before.
The question is, will the insights that the board and management gained about the operating model during a crisis be institutionally preserved, or will they have to be relearned?Martin Hirt
Martin Hirt: I would add an individual component. Now that boards and management teams have worked together through the crisis, there is a level of bonding and understanding each other. But management teams and boards change. The question is, will the insights that the board and management gained about the operating model during a crisis and how to shift to it quickly be institutionally preserved or will they have to be relearned?
Frithjof Lund: If we look ahead, what are the top things boards should ensure are in place to handle future crises?
Gordon Orr: If there is one thing to remember from our conversation, it is the importance of preparation across a broad set of potential risks. Second is to lean in to decision making. Taking them sooner is generally better. And because of geopolitical risk, avoid the small and risky investments: initiatives that could create value but are potentially highly risky, where you could get a disproportionate negative impact on the business in return for relatively small gains.
Martin Hirt: As we think about future crises, we should not forget that we are still in this one. There is still a lot of uncertainty. We have seen in China that when the virus is domestically under control, economic activity jumps back, uncertainty drops, and economic growth returns to previous levels, if not higher. It is also relatively clear that the recovery will happen sometime in late 2021 or first quarter of 2022 for most countries that have been ahead of the game in ordering vaccines. Where the uncertainty remains high is how long the stimulus will continue. After the financial crisis, some governments cut off the stimulus too quickly, which stifled their economies. If that happens now, we could see a wave of bankruptcies and financial difficulties coming toward us.
But what I would stress from a board perspective is that the trends that have been accelerated through this crisis are almost certain to stay. The question is, are you acting on the writing on the wall? Traditionally, one of the most difficult things for corporations is reallocating capital and resources toward new initiatives. Helping the management team accelerate that process is absolutely critical right now.
Frithjof Lund: Aside from the stimulus ending too quickly, what sources of potential future crises should boards have on their radar?
Gordon Orr: Geopolitics is not going away. ESG and the potential inability of businesses to keep up with the expectations of society and investors could cause major discontinuities. And third are the massively greater levels of government intervention in business and potentially the return of active industrial policies by governments in many sectors.
Martin Hirt: There is a longer-term issue we all have to reckon with, which is that stimulus has been given out at astonishing rates. Some may say, “When it comes to central bank accounting, you can just cancel the whole thing out.” That may not be realistic for some governments. So how we deal with the bill from this crisis is a potential future crisis.