3 Private Equity Lessons Worth Learning Amid Global Inflation

In late January, the Federal Reserve raised interest rates by 0.25 percentage points, almost 5% since 2022, signifying an aggressive attempt to tame inflation. In 2022, the U.S. Bureau of Labor Statistics reported that inflation had reached 8.6%, a rate that hadn't been seen in 40 years. Although inflation in the U.S. has since cooled to 6.5% in January, private equity firms must continue vigilance to generate differentiated returns.

When dealing with these macroeconomic conditions, understanding the composition of a company's returns is fundamental for boosting performance. Private companies that want to stay afloat need to consider two basic principles: First, how much has the consistency of their asset prices contributed to their returns? And second, how many returns have come from increasing revenue growth or improving margins?

The key to a new and effective value-creation strategy is taking a holistic approach in each case. Tactics such as adding new talent, improving a company's approach to acquiring new customers, or developing industry-specific playbooks will attract opportunities for capturing revenue.

It's not enough to sharpen the company's focus. In trying times like the current ones, practical value creation that comes from understanding the inner workings of a company's value and assets will be primal for survivability. Every link in the value-creation chain needs to line up.

Post-Pandemic Inflation Shows Symptoms of Decline

Global inflation doesn't occur in a vacuum. After the COVID-19 pandemic disrupted global supply chains and the invasion of Ukraine affected the supply of energy, fertilizer, and grain globally, the demand (and costs) for goods and resources soared.

Countries with significant fiscal stimulus plans or countries exposed to foreign stimuli suffered more severe bouts of inflation. In addition, economic research from the Federal Reserve shows that financial incentives boosted consumption without increasing production, causing supply shortages and surges in consumer demand.

So, fiscal support contributed to rising prices, and the relief stimulus checks handed out during the COVID crisis might have just been a temporary bail-out. Still, they were also a giant experiment in terms of economic policy.

Now, we might still be recovering from the halt of the pandemic, but we’re also paying more than ever for fuel, food, and supplies. Simultaneously, this coincides with the current bear market where retirement savers and investors have seen the value of their assets drop significantly.

In current conditions, if we were to solve the pressing global inflation problem, we would face a systemic challenge. The purchasing power of U.S. currency cannot return to its value before COVID-era stimulus plans. Debt cannot be repaid with more debt or more leverage. Rising inflation will continue until supply can keep up with demand.

Pre-Covid Trends and the Flood of COVID-19 Relief

After the 2007–2008 financial crisis, the global economy returned to low inflation, poor capital spending, and a weak productivity growth environment. However, before the pandemic hit more than ten years later, there was pressure to put a large amount of unspent capital into large deals.

During 2020, central banks worldwide made unprecedented moves, injecting as much as 4 trillion into financial assets, substantially outpacing the 2 trillion used for the same reason during the 2008 global financial crisis.

The trillions from COVID-19-related stimulus sparked activity in different sectors across the board, particularly in the health and tech-enabled industries.

According to The New York Times, enormous sums funneled into needs beyond COVID-19, including $662 billion in health spending and biomedical research. Of this amount, legislation allocated $80 billion to pay Medicaid coverage, $54 billion to vaccine and pharmaceutical research development (of which $10 billion went to Moderna and $11 billion to Pfizer), and $6 billion directly to federal agencies to study vaccines and COVID-19.

COVID-19’s Implications for Private Equity

Although the COVID-19 pandemic saw the global economy grind to a halt, the private equity sector fared well relative to other industries.

According to the Bain & Company 2022 Global Private Equity Report, COVID-19 has done little to slow the industry’s momentum. In fact, it has accelerated processes. For example, less traveling and remote work has made teams more efficient in their tasks.

The trillions in monetary stimulus injected into the global economy to counteract the effects of COVID-19-related shutdowns have greatly benefited both public and private investors on a macro basis. For example, in 2020, the federal government disbursed $1.7 trillion in forgivable loans to more than 9 million small businesses with less than 500 employees through the Paycheck Protection Program.

During the height of the COVID-19 pandemic, private equity investors capitalized on the opportunity to purchase and sell businesses due to a record volume of unspent capital available for use. The liquidity burst also ensured that lending to fund buyouts remained accessible and affordable.

The trend of more considerable funds doing bigger deals accelerated in 2021. As per the Bain report, the ten largest deals from that year, which included a $30 billion investment by Blackstone, Carlyle, Hellman & Friedman, and GIC in Medline Industries, made up 18% of all deals that year.

Private Equity Trends to Watch Out for in 2023

Coming off a pandemic hot streak and into a bear market, private equity investors are changing their focus in 2023. Today, it’s not about the buyout anymore. Instead, investors are becoming more sophisticated as markets mature and are adamantly tracking down different types of specialization and diversification that not all buyout funds provide. For example, specialization sees investors overwhelmingly buying out companies in tech-enabled sectors like fintech and Medtech.

Given the fragile state of the global economy, we need tailored solutions for mitigating the inflation surge. For instance, private equities with diverse geography, investment stage, company size, and industry provide the best protection against the outsized effects of inflation because price increases may impact a region or sector in particular.

Diversified companies will be better suited to navigate the interest rate increases anticipated in both the U.S. and Europe, making liquidity harder to obtain. In addition, market-leading companies with differentiated products will enjoy higher-than-average pricing power and the ability to pass costs through to their customers.

Here are three areas impacting inflation worth considering:

Financing

If inflation keeps rising and interest rates continue to increase, increased, higher borrowing costs will, in the absence of effective hedging, will reduce fund returns.

Asset Selection

According to Vistaar, B2B businesses will endure an inflation process better than B2C companies. The latter will be forced to pass more aggressive price increases to customers than B2B, as many consumers currently see rising food prices. Conversely, products and services pricing for B2B companies generally differentiates based on the account size, allowing for greater price flexibility. However, in B2C, it is uncommon to have different prices for the same product.

It’s also important to note that businesses with diverse customer bases, products, and intellectual property will be better positioned to maintain profit margins by passing higher input costs. On the other hand, less differentiated enterprises will be compelled to compete on price, which can pressure their profitability.

Portfolio Company Operations

Effective working capital management could determine success or failure in a high-inflation world. Managers that bring genuine operational value to a portfolio company should benefit from outperformance.

In addition, some equity sectors may provide shelter against rising inflation. Equities usually perform badly during high and rising inflation environments. However, according to Hartford funds, some areas have historically performed better at the sector level, such as the energy sector, which includes oil and gas companies. Such businesses typically produced a real annual return of 9.0% while outperforming inflation 71% of the time.

This correlates with companies in the energy and materials sectors' closer attachment to physical assets and commodities, so their asset values and product prices tend to rise when inflation does.

The infrastructure sector is also a naturally resilient one. Energy, materials, and industrial sectors benefit from the ability to adjust costs easily due to inflation. Demand is typically steady and reliable because it provides essential services such as electricity, heating, high-speed internet, and mobility. Additionally, governments have historically implemented infrastructure-friendly policies during economic frailty, making the asset class less tied to the economic cycle.

According to Harvestportfolios group, higher inflation may also benefit the tech and healthcare industries. This is because the largest companies in the healthcare sector (e.g., CVS, UNH, MCK) own a dominant market share that allows them to pass on the limited cost increases they are subject to.

Globally, healthcare is considered a “superior good,” meaning consumers and institutions will reduce their spending on discretionary goods before reducing their healthcare budgets if prices rise. Also, the speed with which pharmaceutical companies have created vaccines and treatments to combat the COVID-19 epidemic has benefited the whole sector.

Hartfordfunds suggests real-estate investment trusts may also be able to lessen the effects of rising inflation. Historically, they outperformed inflation 67% of the time and produced an average real return of 4.7%. These may provide a partial hedge to inflation via passing price increases in rental contracts and property prices.

According to a Morgan Stanley report, other investments that companies should focus investments on areas that increase productivity gains and lower inflation. These areas include artificial intelligence, autonomous-driving technology trucks, cloud computing, renewable energy, robotics, software innovation, and clean commercial heating and air conditioning improvements that can quickly pay for themselves through efficiency savings.

Actionable Items for Global Inflation. Start Before it's Too Late.

Whatever the industry, having a recession-resistant business model is essential for any company. Not sure where to start? The best hedge may be to focus on successful organizations with track records effectively navigating previous inflationary and deflationary periods.

1. Pay Careful Attention to Your Pricing

According to the Bain 2022 report, companies should rely on disciplined pricing to customers and flexibility. Therefore, identifying cost pressures and pricing opportunities product by product, customer by customer, is critical. Because of this, it’s advisable to come up with concrete, realistic pricing moves for each customer and segment.

2. Revaluate Your Tech Portfolio

Morgan Stanley advises that the focus should be on the `technology takers’ rather than the ‘tech makers’ when rebuilding a portfolio because the former are companies likely to drive increased tech adoption.

3. Focus on Your Businesses' Core Competencies

To survive rising and long-term inflation, businesses should focus primarily on rationalizing their key components, such as brands, segments, customers, product lines, manufacturing locations, and possible supply chain shocks, in other words, sticking to the core areas that provide the best returns.

Private Equity Trends to Expect in 2023

If we have learned something from the economic roller coaster of the past several years, specialization and differentiation have never been more necessary. Rising interest rates and inflation will undoubtedly be a hurdle for some portions of the private equity market. Still, other segments ought to be well-positioned to benefit from the complexity of this market situation.

Here are three private equity trends we expect to continue in 2023:

• Strong managers with real asset selection skills and the capacity to present genuine operational and strategic value-add plans will continue to see guaranteed returns and oversubscribed funds.
  

• Diversification is the most sought-after trait in business models for enduring inflation and high-interest rates, both in products and customer base. Companies across the globe are starting to feel the cost pressures, and hikes expectancy is affecting pricing behavior. As a result, passing price increases on to customers will be necessary for some businesses' survival, and others will perish if incapable of doing so.
  

• Rising capital costs will push companies to invest in future growth instead of corporate buybacks. As a result, businesses may be unable to afford surfing on multiple expansions to satisfy the limited partners as they did a decade ago.

Final Thoughts

Predicting the course of inflation in a macro environment is extremely difficult. Volatility spikes brought on by uncertain geopolitical events, tightening financial conditions, and an underlying rising global inflation will continue to create new challenges.

The leading returns will invariably depend on the practical value creation that benefits a company’s ability to generate revenue and cash flow. Investing in these capabilities during challenging economic conditions will improve a firm’s performance, regardless of the environment.