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Inflation Leads Private Equity Execs, Lenders to Confront a New Reality

The knock-on effects of the coronavirus pandemic are creating an inflationary environment not seen in decades. Here’s how middle-market investors are approaching it.

Inflation Leads Private Equity Execs, Lenders to Confront a New Reality

Inflation is defining the market for the first time in more than 30 years. The consumer price index increased by roughly 7% in 2021, the largest jump since 1982. Faced with higher input costs, middle-market businesses and their private equity sponsors are having to adjust their expectations for growth and profitability, and in some cases, rethink their approach to M&A.

“Businesses are experiencing rising costs from several different angles in their operations,” says James Fellows, CIO at First Eagle Alternative Credit. “It’s a combination of the supply chain, and higher energy and labor costs.”

Although it’s tempting to attribute the current inflationary environment to the pandemic, much of it stems from trade hostilities between the U.S. and China as U.S. importers absorb higher costs related to the 20% tariff on Chinese goods.

This is a preview of a story that originally appeared in Middle Market DealMaker’s Spring 2022 issue. Read the full story in the archive.

This section of the report was illustrated by John Krause & Ken Orvidas

COVID-19 hasn’t helped. Its knock-on effects caused the global supply chain to seize up, while stimulus measures around the world increased people’s purchasing power without increasing production. At the same time, companies that are transporting parts, components and other products from a backlog of container ships are now having to pay hefty overtime rates to do so.

In response to these rising costs, companies are looking for ways to close the gaps in their balance sheets.

Meahgan O’Grady, director of business development at Palladium Equity Partners, says that many attempted to pass through only partial price increases to the end consumer in early 2020. However, prolonged supply chain issues are now compounded by labor shortages, inflation and impending interest rate hikes, prompting some businesses to increase prices multiple times in a relatively short period.

“In general, customers understand the pressures and have been accepting,” O’Grady says.

Related content: Inflation Opens an Opportunity for Mid-Market Companies to Partner with Private Equity

However, Michael Ewald, managing director and global head of private credit at Bain Capital Credit, says that costs aren’t always being passed on in the current environment. Some manufacturers are accepting lower profitability in the interim or cutting expenses where they can.

Adapting to the New Reality

With inflationary pressures in just about every sector, many companies are now tamping down their growth forecasts and focusing on profitability. At the same time, expectations around deal pricing are beginning to change.

“What’s different now…is what private equity firms are willing to pay for companies given the headwinds of extended inflation,” Ewald says. “Their focus hasn’t changed, but their price expectations have.”

What’s different now … is what private equity firms are willing to pay for companies given the headwinds of extended inflation.

Michael Ewald

Head of Private Credit, Bain Capital Credit

The most sought-after businesses today aren’t necessarily the same ones that investors flocked to over the past two years. “Smarter” private equity firms are now searching for companies that have pricing power rather than those whose performance was boosted by the pandemic as investors look toward a post-COVID reality, says Max Wolff, managing partner at venture lender Leste Clearway Capital.

One concern for his firm when evaluating prospective borrowers is whether they’re planning to raise prices for customers. Another factor is the nature of a company’s debt. Wolff suggests investors will make a point of acquiring companies without short-term debt, as shorter maturities will reset interest rates sooner.

For private equity firms, exits might take longer than usual. Ewald notes that investors could potentially increase their hold periods. He notes that sponsors might have certain price expectations for their exits, which could take longer to realize in an inflationary environment.

In general, lenders are treading carefully as they account for the impact of rising prices throughout the economy, and have started to change the way that they quantify inflation risk and manage the potential for downside and losses.

What’s Ahead

A number of economists have predicted that growth in the consumer price index should moderate to around 3% over the course of 2022. Yet that number will ultimately hinge on a return to normalcy for supply chains and energy prices. It’s also possible that the Federal Reserve’s much-anticipated interest rate hike could temper inflation, according to Palladium’s O’Grady. However, she cautions that the effects may not be apparent immediately.

“A rise in interest rates will take time to trickle down to the root causes of the inflation. Furthermore, the rates will likely rise slowly to allow for the economy to digest them,” she says. “I’d say we’ll have a good idea of how much or how little the rise in rates is helping with inflation by the end of the summer.”

A rise in interest rates will take time to trickle down to the root causes of the inflation.

Meahgan O’Grady

Director of Business Development, Palladium Equity Partners

Fellows says that the current inflationary scenario could persist for at least a couple of years. Ewald says that portfolio companies are expecting freight issues to last until the end of this year or sometime in 2023 based on forward contracts. Still, the effectiveness of a rate hike, or even a series of them, isn’t guaranteed. Meanwhile, Russia’s recent invasion of Ukraine casts further uncertainty on the market and rising costs.

Related content: What the Russia-Ukraine Conflict Means for Global M&A

Despite the specter of continuing inflation, many agree that private equity sponsors are in a strong position to help their portfolio companies achieve some level of profitability, even in a challenging market. Investors can also apply lessons from across the portfolio, using the knowledge gleaned from a host of companies to create solutions for others, according to Joseph Lazewski, senior credit officer at NXT Capital.

If history is any guide, middle-market companies could be in for a difficult period, and they’ll need all the help they can get.

“When you look at the great inflation of the 1970s along with what was needed to stop it and what occurred when the Fed tried to stop it, it’s evident that was a sober time for the markets in general,” Fellows says. “Hopefully the Fed doesn’t lose control, and we find ourselves in a similar scenario, because there’s a lot more leverage in the system today.”

Carl Winfield is a New York-based writer covering finance and sustainability.