Inflation in Middle-Market Private Equity

Annual inflation rate in the US slowed to 8.3% in April from a 41-year high of 8.5% in March, but less than market forecasts of 8.1%. Energy prices increased 30.3%, below 32% in March namely gasoline (43.6% vs 48%) while fuel oil increased more (80.5% vs 70.1%). On the other hand, food prices jumped 9.4%, the most since April 1981 and prices also rose faster for shelter (5.1% vs 5%) and new vehicles (13.2% vs 12.5%). On a monthly basis, consumer prices were up 0.3%, slightly more than expectations of 0.2% but below a 16-year high of 1.2% in March. The index for gasoline fell 6.1%, offsetting increases in the indexes for natural gas (3.1%) and electricity (0.7%). Despite the slowdown in April which suggests that inflation has probably peaked, the inflation is unlikely to fall to pre-pandemic levels any time soon and will remain above the Fed's 2% target for a long time as supply disruptions persist and energy and food prices remain elevated.

Inflation has been one of the important thoughts as PE firms invest in companies in an inflationary environment. Year over year, consumer prices have remained above 5% and since the last half of 2021 the price index has reached 7% and, in some markets, far past that. There is a light at the end of the tunnel as forecasts indicate that inflation has peaked and will trend downward over the next 12 months according to the U.S. Bureau of Labor Statistics. In a broader sense, the current U.S. economy has been struggling from global supply chain disruptions due to the pandemic and other worldwide struggles resulting in labor shortages as well as supply shortages in many in-demand materials. With this widespread supply chain issue in company’s minds, due diligence processes focused on risks including rising prices in labor, energy, and raw materials which is also top-of-mind for PE firms as these investors look to invest in companies with costs rising and margins diminishing within certain industries. Furthermore, there is the risk of decreasing valuation within Private Equity portfolio companies because of lower EBITDA due to the inflationary environment. Firms are encountering new challenges with investments/valuations and exits because of the decreasing EBITDA potential within the middle market. In a firm's current portfolio, holding periods could be longer than historical holds because of the lack of ROI upon exit leading to hopeful change in the economy which may come later than expected.

Within Private Equity, deal-making in inflationary environments vary by industry. Healthcare and the industrial sector have seen decreasing earnings in Q4 2021, between 4%-6% due to inflation and other pandemic-caused issues. Though the collective YoY revenue is a growth for both sectors mentioned, the decrease in earnings for Q4 2021 shows the rise in costs in labor and raw materials. With the decrease in earnings, companies have slowed production in order to keep costs down and be cognizant of the recovering economy. PE firms investing in middle-market companies are especially mindful of the high-growth investments where inflation may take away from the potential earnings and growth potential at this time where the economy is uncertain, and the price of goods are heightened. Private Equity firms manage the existing portfolio, invest in new portfolio companies, and exit existing portfolio companies. In these phases of portfolio management, there is a constant reminder to execute on the value creation plan and navigate economic changes where upon exit, there is the highest valuation possible. With the current inflationary environment, portfolio management has their challenges because the value creation plan is either put on hold or takes longer to execute in order to yield the highest return upon exit. Though firms have their challenges within the portfolio, each company has their own set of challenges as well. Portfolio companies that have customers that pay for services or products have the option to increase the costs of goods or services to their customers. Another option for these companies is to find ways to save on the cost of goods or suppliers to keep revenue high and costs low.

With current and prospective investments within the middle-market, the importance of the due diligence processes heightens in order to combat some of the current pricing of goods within particular industries. During that process, current vendor contracts and vendor efficiency need to be made a priority in order to forecast and model future costs and create growth in earnings. Leveraging different value creation services and market research will bring potential growth to companies and sustain that growth throughout inflationary periods.

By:  Ryan Peterson, Treya Partners Business Development Manager