Private equity as an industry has never had to confront a sustained inflationary environment, the last of which occurred around the early 1980s, right when private equity was emerging in the financial world.
As the economy increasingly shows signs of overheating, private equity GPs and LPs don’t have a lot of models to reference when thinking about how to navigate a sustained era of high prices, and the consequential higher interest rates the Federal Reserve could use to try to tamp down the red-hot market.
GPs are looking for ways to shore up their own portfolios as costs rise across sectors for raw materials and pressure increases to raise wages to attract talent into open positions. Private equity dealmakers are approaching new transactions with an eye toward operating in a sustained market of rising prices, and the potential for higher interest rates a few years down the line.
In a sense, the industry is preparing for what could be a new reality if inflation proves persistent and sustained. And it’s doing so without much historical guidance, sources tell Buyouts. “There is not a generation of investment professionals working today that was working during the last inflationary crisis,” says a fund of funds LP who remarks their GPs have not been too concerned with potential inflation.
“Our data does not even go back to the last time there was real inflation, which was in the early 80s. There were only a couple dozen firms. But it’s not what private equity as an industry did [at that time], it’s what happened to individual companies. How do companies respond in different sectors in inflationary times? From a private equity standpoint, the picture gets even murkier. Software [as an investment target, for example] wasn’t even really around the last time there was inflation. It’s not totally clear how software will respond to an inflationary environment.”
Without hard evidence to reference on best practices during persistent inflation, the industry must use proxy examples over the past decade that can help shape the way forward, according to Jason Thomas, managing director and head of global research at Carlyle Group.
“The scenarios I look back to are not 1965 to 1979… we can look back to the way that inflation risk became a phenomenon in the last 10 years,” Thomas says. “Go back to the Taper Tantrum in 2013, go before that, in 2010 and 2011, the amount of people suggesting Fed policy was too accommodative and we were risking a massive surge in inflation. This was cause for concern for many investors.”
Inflation concerns also arose after the 2016 elections, when spending proposals from President Donald Trump precipitated a surge in inflation fears in the market. Says Thomas: “We don’t need to go back to actual inflation… we’ve had many experiences in the last decade where there were a lot of people concerned about inflation. How did we manage through that?”
“Our data does not even go back to the last time there was real inflation, which was in the early 80s. There were only a couple dozen firms. But it’s not what private equity as an industry did [at that time], it’s what happened to individual companies”
Fund of funds LP
And, on a macro level, since the economic crisis of 2008 there has been fierce debate between economic hawks and doves about how much of a threat inflation poses, and if the artificially low interest rates engineered by the Fed for the past ten years have done more harm than good. On the flip side, Europe has been struggling with a different economic nemesis, deflation, as has Japan for decades. For many, inflation is simply a sign of a healthy, growing economy – a sick patient putting on a few pounds because of recovery.
A few key aspects of private equity have emerged that GPs believe will help them withstand any economic cycle, including inflation. One is firms’ focus on investing in market leaders or helping turbocharge a growing company’s ability to become a market leader. And another is firms’ competitive advantage to find top talent for open positions, even in a period, like now, when hiring has become challenging.
The relative advantage of private equity, and private markets in general, is the longer-term outlook of the asset class. It is important for GPs to pursue themes they believe in that will ultimately develop through various cycles.
“This is a long-term asset class, and we have a long-term lens,” says Adam Howarth, managing director and head of portfolio management Americas at Partners Group. “It might be inflation one year, it might be a change in the administration in Washington another year, it may be some sort of geopolitical conflict another year. So there’s always something.”
Buyouts spoke with several GPs, who stressed they could not 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, [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 in May.
Certain GPs are feeling the effects of rising prices, mostly those concentrated in sectors like industrials and manufacturing. Raw materials pricing is on the rise, testing companies’ ability to raise their own prices on customers. Pricing power has become a major focus for those firms that have already seen rising input costs at the portfolio company level.
Partners Group, for example, does scenario testing as part of its underwriting deals, both on the macro and micro levels. The firm looks at scenarios like rising input costs and the impact that would have on returns and higher labor costs and how that would affect things.
Perhaps especially relevant in today’s market, the firm focuses on the pricing power of a business it wants to buy, which is the business’s ability to raise prices without impacting demand for its product. “Pricing power is something you can do if you’re a leader in the space,” Howarth says. “We’re very focused on investing in market leaders who are often the leader by many multiples, so therefore they have the pricing power to offset some of these rising costs.”
Reflation versus sustained inflation
While some see inflation as a major risk today, a certain amount seems inevitable as the deflationary effects of covid-19 unwind and the economy picks up momentum, writes Michael Baruch of affiliate title Private Equity International.
In a blog post in late May, Commonfund Capital director Ryan Driscoll examined the confluence of pandemic recovery inflationary pressure with forecasted sustained long-run inflation as a result of the Federal Reserve’s pumping trillions of dollars into the economy.
The current debate about whether the spike we are seeing in inflation is “transitory” should be reframed as “reflation versus sustained inflation,” according to Driscoll. “Just like many other economic data points (ISM, confidence, employment) the recent inflation measures represent a resurgence from the mid-pandemic lows and a positive sign of economic recovery. We believe it is also short term and should not be misconstrued as the long-run intention of the Federal Reserve’s actions.”
Traditional measures of inflation may no longer be appropriate given how lifestyles have changed to adapt to covid, Driscoll added. “Headline inflation data is likely not capturing what the consumer is experiencing,” he wrote. “The basket of goods used for CPI suffers from lack of substitution and does not represent all production and consumption in the economy.”
Accelerated labor costs (wage inflation), particularly in inelastic low-skilled labor, could present economic hardship for businesses trying to recover, Driscoll also noted.
Commonfund believes the Fed will continue to focus on the employment half of its dual mandate (rather than price stability). Driscoll’s post explained: “As chairman Powell noted in his last press conference, ‘Payroll employment is 8.4 million below its pre-pandemic level, and this figure understates the shortfall in employment as participation in the labor market remains notably below pre-pandemic levels.’”
The ability to raise prices to keep up with the rising costs of raw materials, transportation and other areas of the supply chain is key to adapting in an inflationary environment, several GPs told Buyouts in recent interviews. “Inflation in some cases can be a benefit, if you’re selling something in such short supply people will pay up for it, your revenues have gone up, and profits have gone up,” Carlyle’s Thomas says.
“It’s really important to be invested in a business that has pricing power,” says 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.”
But the ability to raise prices on customers often becomes more complex depending on the sector in which the company operates. Business-to-business has more fluidity, while direct-to-consumer companies may find it tougher to raise prices.
“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].”
Rising prices are one indicator that the environment is different from some of the inflation scares of past years. Indeed, the economy is emerging from an unprecedented lockdown with a corresponding rush of demand for products and services across sectors.
Demand is flooding into the market at a time when manufacturers, who cut production fearing a recession last year, find themselves short of supply. The protectionist trade policies of the Trump administration, which were already driving up prices in some categories and disrupting the global supply chain, have only helped fuel rising prices.
US GDP growth in the first quarter of 2021, according to the Bureau of Economic Analysis
Stoking the overheating even more have been a few unfortunate one-off situations, such as the hack of the Colonial Pipeline that stopped the flow of gasoline to much of the East Coast for a period of days, driving up gas prices.
The charged economic environment is reflected in the data, which is being closely watched by market professionals as well as the White House. The Consumer Price Index rose 5 percent for the 12 months ending in May, which was the fastest 12-month increase since 2008, according to the US Labor Department data published June 10. Industry bellwether Blackstone sees inflation as a “major risk,” president Jon Gray said on Blackstone’s first-quarter earnings call on April 22.
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.
Along with rising prices, companies are experiencing wage pressure as they compete for talent against trillions 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.
“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,” says Investcorp’s Dave Tayeh, head of North American Private Equity. “It’s more important, from our perspective, at a company level, to make sure we can attract and retain talented people.”
The question of wages and talent retention loomed large in Investcorp’s acquisition, alongside Trilantic North America, of RoadSafe Traffic Systems, which provides services such as pavement marking and management of onsite construction projects for highways, railroads and utilities.
RoadSafe is 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 needed on the streets, literally, 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?” Tayeh says.
Growing out of it
To counter this sort of overheated environment, many firms focus on a key concept: growth. GPs look for growing companies, with indispensable products, that expand out of any economic cycle.
Blackstone, for example, 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.”
An example of this sort of growth and pricing power are companies that provide software essential to the operations and security of businesses, Orlando Bravo, co-founder of Thoma Bravo, said during an industry conference in May.
“Many assets now have a nearly perfect inflation hedge. 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,” Bravo said.
A focus on growth is part of the key themes Partners Group uses to map out its investment strategy. The themes include priorities around automation, digitalization and productivity. This focus does not necessarily have to include companies that are growing but are not yet profitable or cash-flow positive.
“Sometimes that plays in … the software focus, but it can also be bringing some of those themes and concepts to more traditional businesses that are not yet embracing them,” Howarth says.
The idea of future cashflows and profitability in growth companies with sky-high valuations is one of the major risk factors in viewing them as a counter to inflation, says Carlyle’s Thomas. Such companies could be especially vulnerable to rising interest rates, he says.
“Inflation is about duration of cash flow. The sooner that cash flow comes to you, the less exposed you are to inflation risk,” Thomas says. “The further in the future those cash flows arrive, the more risk there is. To the extent one really fears we’re entering a new environment of inflation, the more you have to think about exposure not to things that look like bonds, but anything where the bulk of the cashflows are really very deep in the
LPs have more choices than ever
Flexibility has been the buzzword for many limited partners in the past few years.
LPs who back private equity firms look for the ability to passively invest in funds, directly investing through co-investments and move in and out of illiquid pools through secondaries.
This sort of flexibility could prove to be a great boon to LPs if the economy overheats into a period of persistent inflation. Such optionality will give LPs who have constructed their portfolios in this way the ability to target investments they feel will best match the market.
“LPs have more choices than ever. They are increasingly able to target their exposure into things they like and things they think will do well over a given environment,” says Brian Gildea, head of investments at Hamilton Lane. “LPs are able to look at a company and say, ‘I like this company’s characteristics; it fits into my portfolio and my view of the world.’”
That sort of flexibility will allow LPs to consider the best way to build portfolios in an inflationary environment, Gildea says. Like GPs, LPs don’t have a lot of reference points to consider when thinking about how to move forward through an inflationary period. It’s hard to say how sustained inflation could impact private equity fundraising. However, the fundamentals of what drives investors to the asset class – strong performance by businesses regardless of cycle and relatively uncorrelated to public markets – would remain.
For now, GPs have been communicating with potential new investors about their thoughts on inflation and how their portfolios will fare through various cycles, sources say. Several LPs said their GPs have not raised red flags yet about inflation impacting performance. “We haven’t seen it affect the performance of our companies just yet,” says a fund-of-funds LP, adding that the firm doesn’t try to predict cycles: “We don’t invest that way. We try to find the best things we can and dollar-cost average by vintage year … and let the chips fall where they may.”
Private markets investing is only one part of an investor’s portfolio, and perhaps not even the allocation that would be adjusted in a time of persistent inflation, Gildea says. Shifts within private markets are possible, as some LPs have shown interest in inflation-linked investments like infrastructure, oil and gas and agriculture, sources said.
“Investors are talking more and thinking more about strategies like commodities or infrastructure or real estate,” Gildea says. “It’s not clear how all these things will play out in inflation, there’s not a lot of historical data. Our view is that interest in private markets is driven by performance relative to the public markets, diversification and participating in a broader segment of the capital markets with less volatility.”
‘Volatility brings great opportunity’
Investors at Private Equity International’s Women in Private Markets Networking Day were upbeat about encroaching inflationary market trends, writes PEI’s Carmela Mendoza
“Volatility brings great opportunity. We shouldn’t be afraid of inflation or volatility because it does create opportunities,” Denise Le Gal, chair of the UK’s Brunel Pension Partnership, told Private Equity International’s Women in Private Markets Networking Day, a virtual conference held in Mid-May.
Specifically, private debt funds, for example, are attractive because they are “floaters and they reset, so it’s a good way to ratchet up if you are having inflation creep,” Le Gal said.
She also singled out opportunities in distressed assets. “Once [government schemes] start unrolling in Europe, there are some companies that will survive, but others are practically zombies that have been kept going for the wrong reasons. There are winners and losers – we just hope we’ll be aligned with the winners,” Le Gal said.
Brunel Pension Partnership manages roughly £30 billion ($42.4 billion) on behalf of member funds, including Buckinghamshire, Devon, Environment Agency and Somerset. It has committed to funds including those managed by Intermediate Capital Group and Capital Dynamics, according to PEI data.
Le Gal added that growth in the tech sector may not continue to be as “exponential” as before and may result in a “rotational shift towards industrials. We are seeing that already – it’s not necessarily mainstream, but it’s certainly happening,” she said.
Similarly, Lorna Robertson, head of funds at London-based fund of funds manager Connection Capital, said the prospect of rising inflation and interest rates will filter down to grassroots funds and investments that LPs are involved with.
That means pressure on long-term borrowing, inflated asset pricing and potentially an increase in the number of defaults, Robertson added. “Some of it will be good, and one thing is for sure: it will create opportunities. As we know there is nothing worse than a benign, boring environment with low rates, low inflation, no growth. None of us want that.”
For her part, Sarah Farrell, Allstate Investments’ head of private equity in Europe and Asia, said she does not anticipate a reallocation in the insurer’s roughly $94 billion investment portfolio that covers private equity, real estate, public markets, opportunistic, and agriculture. However, Farrell said Allstate is “very mindful of the implications of the current environment as well as very high asset pricing.”
While tech-enabled businesses – those that are high-growth, high margin and with high cashflow conversion – are benefiting from the market environment, Farrell noted that it all comes down to being “very careful” around GP relationships.
“If you are allocating to that particular space, you have got to be careful that you are working with a partner who can still continue to add value at very high prices,” she said.