GPs consider inflation impact in new deal calculations, existing holdings

Investcorp earlier this year invested alongside Trilantic North America in RoadSafe Traffic Systems, which provides services such as pavement marking and management of onsite construction projects for highways, railroads and utilities.

It’s a labor intensive business, so a meaningful part of investors’ due diligence in assessing the deal was making sure talent was available to fill those roles, and the cost of building out a team.

The question, more vital than ever in an environment of rising costs and wages, was: “Does this business have the market position, the culture and the overall compensation to be able to attract quality people over a sustained period of time?” explained Dave Tayeh, head of North American private equity at Investcorp.

The question comes as the US economy shows signs of expanding inflation. The annual inflation rate grew to 2.6 percent for the 12 months ended March 2021, up from an annual rate of 1.4 percent in 2020, according to US Labor Department data published April 13. (The next inflation report is due on May 12.) Industry bellwether Blackstone sees inflation as a “major risk,” president Jon Gray said on Blackstone’s first-quarter earnings call on 22 April.

Prices across sectors are on the rise, and businesses are experiencing wage pressure as they compete for talent amid trillions of dollars in government assistance flowing into the economy. Consumers are flush with cash from government support programs, even as unemployment remains at a level that, for now, convinces many that inflation is not yet here in a meaningful way.

Buyouts spoke with several GPs, who stressed they couldn’t predict whether the economy was entering a prolonged inflationary period, but talked about how they are factoring potential inflation into their existing portfolio, and into future deals.

“Anecdotally, this topic [inflation] is coming out much more than it was … even a month or two ago,” said Mark Sorrell, global co-head of M&A at Goldman Sachs. “It’s clearly a risk and clearly on peoples’ radar.” Sorrell made the comments as part of a panel for the Financial Times’ Global Boardroom digital conference Wednesday.

In private equity, only certain GPs are feeling the effects of rising prices, mostly those concentrated in sectors such as industrials and manufacturing. Raw materials pricing is on the rise, testing companies’ ability to raise their own prices on customers. Pricing power will be a big theme if inflation persists.

“It’s really important to be invested in a business that has pricing power,” said Ethan Vogelhut, head of buyout investments Americas at Schroder Adveq. “If you are facing those input costs rising, you can pass that through to the next user or buyer of that product.”

The ability to raise prices is more vulnerable for GPs invested in companies that sell directly to the consumer, as opposed to B-to-B companies. However, that vulnerability also depends on the kind of products being sold.

“Business-to-consumer investors have to be wary of how much they can continue to push costs up based on inflation and keep products moving,” according to John Stewart, founder and managing partner of MiddleGround Capital. “[Business-to-business] investors typically have pass-through contracts for a good amount of cost items impacted by inflation and therefore can pass along a good amount of these costs to their customers who are typically [business-to-consumer].”

Orlando Bravo, co-founder of Thoma Bravo, contends that enterprise software products will be insulated from inflation impacts as they provide much greater value than their price in the market.

“Many assets now have a nearly perfect inflation hedge,” Bravo said Wednesday on a panel at the Global Boardroom digital conference. “Look at the entire software industry; the value these customers are receiving by buying these products is so far higher than the price being charged that if there’s strong pick-up in inflation, these companies should be very easily able to pass on those pricing increases to their customers without creating a problem for those customers.”

Lost art

For private equity, dealing with inflation is a relatively forgotten art. Fears of rising prices, and consequently rising interest rates, have popped up over the years but have quickly faded.

Private equity, and the American economy, haven’t had to deal with systemic, persistent inflation since at least 1990, when the inflation rate hit 6.1 percent with the prime rate at 7 percent. The economy is far from that level, but rising commodity prices across certain sectors has sparked concern that we could be entering a period of rising inflation.

Private equity professionals say they are concerned about the impact of pent-up economic activity emerging from the pandemic lockdown, combined with trillions of dollars in government assistance and resulting wage pressure. US GDP grew at 6.4 percent in the first quarter, according to the Bureau of Economic Analysis. Goldman Sachs said it sees growth of roughly 10.5 percent in Q2, Yahoo Finance reported in April.

Commodity shortages are also driving up prices as demand grows across sectors, including cars and houses, with consumers flush with government stimulus. This week, the Consumer Price Index rose 0.6 percent, its quickest monthly increase in more than a decade, the New York Times reported.

Biden Administration advisors who have been studying signs of inflation for months say they expect any overheating in the economy to be temporary. Former Treasury Secretary Janet Yellen said this week the Fed may have to raise rates to keep the economy from overheating, but walked back her comments later the same day.

Preppers

For now, as prices rise across sectors, GPs are watching and preparing for an inflationary environment that lasts longer than has been the case in past years.

“For new deals, you need to understand … what happens if pricing increases pretty meaningfully and seeing how that flows through the business model in general and the ability to pass it on [to customers],” Vogelhut said.

Rising costs also are prompting firms to take deep dives into their existing portfolios to try to balance out rising costs, he added.

“You have to do a deeper dive into the cost structure and see: Are there areas where you can save money in terms of purchasing, ways to gain scale? … Look at freight costs and transportation costs to see if there are potential savings,” Vogelhut suggested.

Companies are also feeling pressure to pay more for talent. That is partly due to some workers being able to get 100 percent or more income replacement through unemployment and other forms of government support.

“To be able to attract and/or retain people today, you maybe have to pay a couple more dollars an hour than you did a few years ago,” Investcorp’s Tayeh said. “It’s more important, from our perspective, at a company level to make sure we can attract and retain talented people.”

To navigate this heated market, Blackstone is pursuing high-growth companies “that can grow to offset what could be some multiple pressures” including in tech, life sciences and global logistics, Gray said on the firm’s earnings call. “What we’re trying to do is position ourselves for things that look and feel as least bond-like as possible.”

Another concern is that if the Federal Reserve decides to hike interest rates to try to cool down the economy, private equity’s cost of financing deals would rise. In addition, with higher rates, investments outside of private equity could start to look more attractive to institutional investors. This could potentially slow what has been a bullish private equity fundraising environment over the past decade.

Meanwhile, other alternatives strategies such as infrastructure and oil and gas could see increased interest because they are hedges to inflation, said Peter Martenson, partner at placement agency Eaton Partners.

“Oil and gas [are a] great inflationary hedge … because obviously oil rises with [inflation],” he said. “It’s the same with metal and mining or commodities. In those cases, we’ll see the investors that truly want to get into an inflation hedge directly for their overall portfolio. They’ll invest into those types of areas such as farmland, timberland, infrastructure, etc., because that is for all intents and purposes an inflationary hedge outside of its normal use as a product.”