For private equity investors who have been monitoring the situation around inflation for the last few months to a year, many have been disappointed to see the slow trajectory with which inflation has been coming down from highs. Currently, inflation in the U.S. sits around 3.7%; while that is certainly better than the 8% and 9% seen earlier this year, it still remains a key point of concern for anyone monitoring the economic situation. Inflation is one of the several economic factors that impact private equity returns, as it can have a material impact on returns as it rises and falls. In this article, we will discuss a few of the reasons why private equity investors care about monitoring inflation and what effect changes in inflation can have on investment performance.
One of the main reasons why private equity investors are concerned with inflation is its profound effect on the value of money, especially over time. As inflation rises, purchasing power decreases. This relative devaluation of money can be dangerous for PE firms, who are still exposed to the same types of costs and liabilities with rising inflation. For example, if a private equity firm invested $100M into a portfolio company with a 20% expected rate of return, this return would not actually be 20% if the calculations were not adjusted for inflation. Instead, inflation of 5% would mean that the private equity firm’s real return would be reduced to 15%. Over time, the value of an investment and thereby returns can be greatly decreased as a result of inflation especially if inflation rises throughout the hold period of an investment.
Inflation can also have an impact on the cost of debt required to finance an investment. Since private equity firms use a significant amount of debt and comparatively very little equity to finance transactions, anything that impacts the cost of debt or the ability to raise debt is a very sensitive consideration when considering the capital structure of a potential investment. Inflation itself does not directly affect the cost of debt or interest; rather, since inflation and interest rates are very closely related, changes in inflation impact changes in interest rates. In today’s environment, since we have been dealing with very high inflation, the Federal Reserve has been raising interest rates in an effort to curb inflation. Through a series of several interest rate hikes, the Fed has been able to calm inflation down to below 4%, but it still remains above the widely accepted, typical 2% level. So, as inflation rises and interest rates also rise in an attempt to slow or decrease inflation, interest payments on debt start increasing as well. This poses a problem for private equity investors attempting to raise debt for new investments or investors exposed to variable interest rates on existing financing arrangements. To make matters worse, high inflation continues to erode away at the value of the investment.
Thinking more directly about inflation’s impact on the portfolio company, high inflation means that the same amount of money can now buy fewer goods and services than it could in the past. Since private equity investments usually have a fair amount of fixed amounts, this means it will just cost more to buy the same necessary goods and services as before, hurting the company as a whole. Furthermore, if the portfolio company’s revenue is not able to increase with or outpace the rate at which inflation is rising, its valuation will ultimately be impacted.
Inflation can also impact a private equity firm’s exit strategy for an investment. Since private equity investments are usually held for a 5-7-year hold period, inflation can influence the timing of exit within or outside of this window. For example, if inflation is high, private equity investors may be more inclined to exit investments higher to lock in returns and avoid the effects of inflation as it deteriorates company value if it continues to rise. Additionally, private firms might choose one type of exit strategy over another depending on the status of inflation. High inflation might make IPOs more attractive as public markets can provide better protection against inflation whereas selling to strategic buyers or secondary buyers (i.e. other private equity firms) may require careful consideration as to how to protect the value of the company from inflation going forward.
There are a few ways to mitigate the impacts of inflation throughout an investment’s hold period. First, diversification is key. Private equity investors try not to invest in only one asset class or asset type in order to limit exposure to certain sectors that may have greater exposure to inflation risk. Another mitigant may be inflation-linked provisions or protections. For example, my firm prioritizes inflation linkage as a key pillar of the investments we make. This means that the company’s contracts or operations are in some way linked to escalations in inflation and/or have shown historical resilience in raising prices or minimizing costs in response to increases in inflation. Lastly, similar to how private equity firms can use financial instruments to hedge against changes in interest rates and foreign exchange rates, they can also hedge with inflation-indexed bonds or other derivatives to mitigate inflation risk.
Overall, inflation must be closely monitored by private equity investors in order to fully understand the impact it may have on investments. Anticipating trends and changes in the inflationary environment is also important, and even if you aren’t always correct in the way things play out, taking a view on inflation risk is a key part of business plan creation. As we have discussed, inflation erodes the value of money over time, affects the cost of debt through its linkage to interest rates, complicates asset valuation if not properly factored into original valuation, influences exit strategies, and requires the use of risk mitigation strategies to minimize its impact. Given the Fed’s recent push to get inflation back to 2%, investors should keep a close eye on rises in interest rates and other indicators that may occur in order to achieve this goal.
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