How Has Inflation Affected the UK Private Equity Industry?
Discussing the woes, the burdens, and what investors can do to manage private equity investments during times of inflation
Unless you've been living in the woods, with nothing but a stack of whittling wood and an SAS survival guide, far away from the gloomy free press, it’s been impossible to avoid grim headlines around the cost of living crisis, driven by surging food and energy prices. At 2022's peak, inflation reached levels not seen since 1980, the year that Diana Ross released Upside Down. And to crowbar this reference in, what a fitting song title for turbulent economic times.
Inflation and Morale
Recently, Andrew Bailey, Governor of the Bank of England, shined a light at the end of a long and dark tunnel, by announcing to the Commons Treasury Committee that UK inflation could drop considerably along with global energy prices. Nothing too ground-breaking there, but we'll take what we can get.
Given the unpredictability in global markets, and despite Andrew Bailey’s tentative optimism, it is likely that interest rate policies of central banks will be under close scrutiny this year. Balancing price rises, without adversely affecting economic growth or employment figures, is a key priority, but critics of the B of E have pulled no punches in expressing their frustration at the speed of base rate changes to stem the UK's inflation figures. Poor Andrew Bailey must be wondering whether the universe is playing an elaborate joke on him, having taken the reins just in time for a global pandemic—then enduring the sterling crisis, political instability, and Liz and Kwasi's mini-budget—only for press and public alike to vilify him for his perceived inaction.
It’s refreshing to hear a positive perspective around UK inflation, but as financial professionals (and financial amateurs for that matter) watch this break in the clouds, their positivity is subdued. Everyone seems to be wondering, “What is the impact of this inflation likely to be on our public and private equity investments?”
The Debt Burden
The good news during periods of high inflation is that—in some instances—inflation can raise asset values and cash flows held by portfolio companies, thereby enhancing returns for investors. The bad news is that as central banks increase interest rates, companies find their debt more expensive to service.
But in private equity, the water is a little murkier.
As rates increase, leveraged buyouts become more costly, and this can impede private equity transactions. Smaller portfolio companies with long supply chains are also likely to suffer, as will those with less established brands and those without patents. Such businesses can find it harder to pass these costs along to consumers.
Further, interest rate increases drive the discount rate used to value future cash flows. For private equity investments, the value of future cash flows are worth less in the present when the discount rate goes up, but different types of private equity investments can be impacted in different ways.
For venture capital investments, the future cash flows can be further away in the future. For real estate investments, the cash flows start immediately. Businesses whose value is derived by more distant future cash flows can take a more punitive hit to their valuation when the discount rate increases. Hence, valuations for venture investments are typically more vulnerable to a rising rate environment.
In the technology sector, where revenue growth has trumped profitability over recent years, future cash flows are particularly unpredictable. Not only does this impact valuations across the industry, it also means that early stage businesses may struggle to attract and retain market leading talent. Smaller growth companies have historically relied on stock options to attract employees, but in a difficult economic environment these can become less attractive. Established technology firms can rely less on these options and have more firepower to increase salaries, putting them in an even stronger position to succeed.
Active Management
A great first step for addressing these challenges is to take a more active approach when assessing investment ideas or portfolio companies. By monitoring and assessing company performance, managers can get a head-start isolating those that are most likely to suffer from rising costs and shrinking profitability.
Firms with pricing power will be particularly attractive, since they will be more easily able to pass any supplier cost increases onto their own customers. Managers can also take a more active approach here and get involved with helping portfolio companies with cost control; this is accomplished by using the manager’s expertise to negotiate better terms with said suppliers, and by helping these companies to find efficiencies elsewhere.
Diversification is key, across strategy, sectors, and regions. Investors in emerging markets, for instance, may have less ready access to financial instruments like inflation-linked bonds or derivatives to use for hedging purposes. Also, inflationary pressures in emerging markets tend to be more extreme due to higher population growth, volatile commodity prices, and increased political turmoil. For those unfamiliar with the third cause listed (perhaps it’s the same wood-whittling group aforementioned), note that the House of Commons in 2022 would not even remotely be described as a paragon of political stability.
Inflation by Sector
Certain sectors can more easily pass increased costs onto their customers. Commodities prices, for instance, are often directly linked to inflation, so firms involved in these sectors can often weather the storm more easily. Real estate businesses, particularly those involved in rental properties, are able to increase rental prices to keep up with inflation. Conversely, construction and retail businesses can suffer as the cost of raw materials go up, and they are less able to automatically pass these increases on.
It's important to note that this is not a blanket rule. Some firms, even in more difficult sectors or regions, may be able to endure and even thrive within a challenging inflationary environment. Larger firms, with high pricing power, can do especially well, particularly as many of their smaller scale industry peers are likely to find life difficult. Further, managers with a high level of expertise in portfolio companies or company sectors, along with deep and high quality relationships across the industry, may be better placed to identify valuable investment opportunities.
Whilst investment in certain sectors and countries might swing the odds in favour of certain managers, private equity can still be thought of as a high risk—but potentially high return —strategy. And, as we are reminded ad nauseam, past performance will certainly not guarantee future success, regardless of whether an investment is public or private.
Understand Your Investments
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Information provided by SEI through its affiliates and subsidiaries. This information is for educational purposes only and should not be considered investment advice. The strategies discussed herein are complex and are not suitable for all investors. Please note the “Upside Down” song is not owned by SEI and nor does SEI hold any liability for any errors or omissions. The song has been included for educational purposes only.
Charts included herein are for illustrative purpose only. Information provided by SEI through its affiliates and subsidiaries. This information is for educational purposes only and should not be considered investment advice. The strategies discussed herein are complex and are not suitable for all investors.
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