15 Sep 2021
Inflation and the private equity dilemma
Higher rates of inflation in 2021 have caused some head-scratching among fund managers. But there may be little to fear.
- Inflation in the eurozone hit 3% in August, its highest rate in a decade, with US price rises reaching a 13-year high of 5.4% and the Bank of England warning that inflation could reach 4% by the end of the year
- Central banks appear to be in no rush to lift interest rates, with the US Federal Reserve not tipped to take action until late 2022, and the Bank of England expected to follow suit
- Inflation may see private equity managers re-evaluate a number of sectors and the value of businesses within them, which may lead to greater caution and a wider scope of sectors
After 29 years in private equity, Alex Cooper-Evans understands the fears of inflation and rising interest rates that are now being expressed by many fund managers – but he insists it is nowhere near time to panic.
“I can see why people are very concerned about inflation and interest rates, but this is not the first time I’ve heard people say returns are going to come down, and it’s going to be much, much harder for private equity to make money and all of those things,” says Cooper-Evans, a partner and investment committee member at Epiris, a high-performing London-based fund manager.
“In fact, I have heard that for 29 years, so I don’t really buy it. Yes, it’s going to be a test, but it’s not the only test out there and I think higher interest rates would actually create some real opportunities.”
While high-profile investors such as Blackstone’s COO Jon Gray have named inflation as the number one risk facing the private equity sector, Cooper-Evans insists that portfolio companies with good labour relations and the ability to pass price rises on to customers should still be able to take higher inflation in their stride.
“A company that has the right sort of market position and the right sort of relationship with its customers and its workers can manage its prices and profit margins even if labour costs are going up,” he says.
“There is a real risk of a correction for high-growth businesses because higher interest rates will reduce the value today of their future cash flows. That may translate into markedly lower valuations, particularly for the kinds of high-growth sectors that have been booming in M&A terms over recent years.”
The opportunities would come for investment strategies like that of Epiris, which concentrates on firms that “have become capital constrained and management constrained and need some fresh thinking and fresh capital”.
Cooper-Evans adds: “Some firms take on a lot of debt when interest rates are low, then when the interest rate cycle turns, they are in trouble and generally need a recapitalisation. That can be a great opportunity for someone like us to step in and provide that extra capital and support.”
Rising rates?
Neil Parker, FX Markets Strategist at Natwest Markets, says investment managers should certainly be bracing for both the dangers and opportunities of higher inflation as shortages in materials and labour drive up prices amid the post-Covid recovery.
Inflation in the eurozone overshot expectations to hit 3% in August, its highest rate in a decade, with US price rises reaching a 13-year high of 5.4% and the Bank of England tipping inflation to reach 4% by the end of the year.
But central banks are in no rush to lift interest rates, Parker says, with the US Federal Reserve “potentially raising rates in the back end of 2022, once, maybe twice, with further hikes to come in 2023”. The European Central Bank is likely to be the last to raise rates, he says, with the Bank of England expected to act somewhere in between.
Parker believes that central bankers are being complacent in insisting that the inflationary pressures and labour shortages are largely transitory.
“Core inflation is running at a three-decade high, and I don’t feel that any central bank has properly explained why that’s happened, or why it has overshot their expectations,” he says.
“Instead, they’re trying to maintain their planned level of monetary stimulus by saying it’s all temporary. They might or might not be right but, unless you can raise your level of labour force participation, you’ve got a much larger and longer-term problem with your domestic inflation inputs, particularly wages, which of course have been exacerbated in the UK by Brexit. Labour has the potential to have a more significant and lasting effect on pricing than raw materials.”
“Some firms take on a lot of debt when interest rates are low, then when the interest rate cycle turns, they generally need a recapitalisation. That can be a great opportunity for someone like us to step in and provide that extra capital and support”
Alex Cooper-Evans, partner, Epiris
Parker believes that private equity managers “are going to have to be far more diligent in looking at balance sheets and looking at earnings [and other] projections to see whether businesses really stand up to scrutiny as worth the money that’s being demanded for them”.
He explains: “I think inflation will potentially lead to private equity managers re-evaluating a lot of sectors, and the worth of businesses within those sectors, and they might end up taking a hit on some businesses.
“They’re going to have to be a lot more cautious, not only on what price they’re going to pay but also on their exit strategies, pushing more towards the longer end of how long they’d want to hold.
“And they’re going to have to be more skillful in their interpretations and look at a broader array of sectors beyond the darlings of recent times, like retail and consumer-facing services, which have been easier to analyse.”
Finding value
While private equity strategies that rely on high leverage would be squeezed by higher interest rates, there should be less strain at firms such as Foresight, which invests in smaller businesses across many sectors.
Matt Smith, a private equity partner at Foresight, says “we have a long-standing view that small companies really shouldn’t be heavily leveraged.
“Our focus on responding to inflation is at the operational level within portfolio companies: can we demonstrate the pricing power that comes from great products or services, and stay ahead and hold our margins? I think that’s the game, rather than overly worrying about levels of leverage.
“We’ve got hospitality, recruitment, a lot of technology businesses and a bunch of support services companies, so we really are sector agnostic and that’s across about 120 portfolio companies.”
Smith says it makes sense for central banks to “let inflation run a bit longer than they otherwise would because we need to inflate away some of the enormous debt that has been built up around the world. Five years at 4% or 5% would put a huge dent in those debt levels.
“That means we have to be talking to our portfolio companies right now about inflation, because many of their CEOs will not have operated in an inflationary environment.”
He adds that the world is already starting to see costs rise, especially for labour, but combined with a reluctance to increase product or service prices.
Even a more stubborn rise in inflation than central bankers are anticipating may not be a disaster, Smith insists.
“As long as the company can demonstrate that it has proper pricing power and good gross profit margins, and there’s demand for its product, then we’re comfortable continuing to invest across all kinds of sectors.”
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