Inflation’s Impact on Private Equity Transactions

Unless you’ve worked in private equity since the industry’s last tango with inflation, your knowledge of that time is likely limited to what you learned in textbooks or from stories told by partners and managing directors.

Since inflation’s peak at 14.76% in April 1980 — and its subsequent return to a standard rate by the end of that decade — private financing has operated with low interest rates that kept financing costs low and multiples high.

However, that nearly four-decade run could be coming to an unceremonious conclusion. Monthly inflation rates in the U.S. surpassed 7% in December 2021, hit a high of 9.1% the following June, and held steady at 8.2% in September and 7.7% in October.

In Private Funds CFO’s recent survey of private funds managers, 63% of respondents said inflation was among their biggest concerns this year. In a corresponding article, Garett Whiley, managing partner of Silverfleet Capital, said “Inflation, interest rate rises, and quantitative tightening will be the biggest influence on the private equity market in the coming few years,” and predicted declining valuations in the near future.

Inflation is already having an impact, but only time will tell just how significant it will be. With much still to be determined, here’s what our team will be thinking about in the months to come.

Costs on the Rise

The most visible result of an inflationary environment is the Federal Reserve’s (the Fed) increase in loan rates, which is up to 3.88% after a series of rapid and aggressive 0.75-point hikes. The hikes are likely to continue into 2023, though in its most recent statement the Fed hinted at easing the rate of increases to account for the “cumulative” impact of rate hikes so far. Market experts forecast 0.25- or 0.50-point rate hikes in the coming months.

For private equity investors the rate increase directly impacts the cost of debt, pushing borrowing costs higher and diminishing the returns for funds that aren’t properly hedging. The downward pressure on margins has the potential to hit companies hard and ultimately may equally impact valuations. Additionally, because of the business interest expense limitation rules currently in effect, higher interest rates do not necessarily result in lower taxes.

Declining Valuations

Valuations are almost guaranteed to take a hit, a direct result of the aforementioned cost of debt. In private markets, the standard thinking is that when the market’s price-to-earnings (P/E) ratio is added to the rate of inflation, the sum should be in the neighborhood of 12. This ratio is one of the signals of a healthy market and consistent valuations.

Following that logic, P/E is set to fall with inflation on the rise. We can expect valuations to dip to multiples of anywhere from 3x to 5x to adapt to inflation (which is still around 8%), and possibly even lower if the rate is driven higher in the near future.

Higher Hurdles, Fewer Investments

Cost increases and lower valuations have made the pool of attractive investments much smaller. In 2021 the hurdle rate (which is set by the Treasury’s 10-year bond rate and the risk-free rate of return) was 7.56%. It has floated around that number and lower for the past several years, with an overall decreasing trend in low interest rate environments.

As inflation inches higher, so will the hurdle rate — meaning fewer companies will appeal to fund managers.

A Closer Look at Operations

In the past three decades of low inflation, managers have largely left operational thinking to the companies and avoided being bogged down by logistics and price oversight. With inflation rampant, however, those days are over. Investors should start looking closely at cost pressures on new acquisitions and the outlook for the next several years. Is the company able to parse clients by segment and adjust prices on an individual basis? Are input costs slated to increase, and if so at what rate?

These questions must be answered before undertaking new transactions. Investors should be wary of companies that lack operational plans that factor in inflation because down the line they may need to have a heavy hand in operations themselves.

Changes in Asset Selection

The flux created by rising costs and shifting valuations means an equal shift in how private equity selects its investments. Overall, business models with low labor costs and high growth projections will catch investors’ eye because of high margins that are likely to net higher multiples. The biggest impact will likely be felt in tech, where high costs are normal and profitability comes years after initial investment rounds.

While historical performance does not guarantee future performance, infrastructure and residential real estate investments have routinely done well during inflationary periods. This is because their revenue streams and leases correlate positively with inflationary numbers — they see rent increases, higher demand for utilities, and increases in rental occupancy. In the past they have also been shielded from the supply issues that plague other industries and B2C businesses.

Inflation is here — the only question is whether it’s here to stay. While there’s no doubt we’ll know more about the trend as time passes, investors might be smart to start factoring the impacts of inflation into their short- and long-term strategies.