Navigating challenges in a rising rates and inflationary climate

European private equity firms are taking a more proactive stance in supporting their portfolio companies, and looking for ways to diversify their investment strategies as they contend with economic headwinds, according to speakers at Private Funds CFO Network’s Europe Forum last week in London.

CFOs still see plenty of opportunities to deliver good risk-adjusted returns within private markets, especially in private credit; principally due to the floating rate nature of such products in a high interest rate environment.

The group COO and CFO of a private markets firm that invests in hybrid funds said their firm is tapping into investor demand “by building shorter duration hybrid funds that combine liquid and illiquid assets with a duration profile of six, 12 and 18 months.” They added that while infrastructure is also an area of high demand, the number of projects that could deliver solid performance is still lagging.

Within private equity, the recent period of successive interest rate hikes by central banks, led by US Federal Reserve chair Jerome Powell, is now being felt, as CFOs tackle the impact across all parts of their operations, ie reduced liquidity, less available leverage (via debt financing), higher cost inflation, impacted valuations and reduced deal and exit activity. Not exactly the ideal scenario, which makes it hardly surprising that CFOs already report a challenging fundraising environment, and foresee that continuing over the next 12 months.

PE groups are managing to exit portfolio assets to some extent. According to the CFO of a Scandinavian PE firm, some of the best exits in the firm’s history have been made over the last 15 months, “but the market is very bifurcated.”

During the peak of the covid pandemic, exits were completed that didn’t necessarily tick all the boxes for buyers. This year, by contrast, there have been a couple of instances “where we have brought high quality companies to market and it hasn’t really worked,” the CFO remarked, adding that it is necessary for GPs to be open-minded and take a structured approach.

Deleveraging to strengthen exit appeal

One aspect GPs are focusing on is helping portfolio companies deleverage to optimize and better position them for institutional lending.

“This can be a positive when looking to exit, as it means any potential buyers can potentially avoid having to find their own alternative financing options,” said one CFO attending the event.

As well as improving the credit quality and profile of investee companies, PE funds are working to strengthen management teams, support them in the pursuit of add-on acquisitions, and expand into new geographies, to improve their overall equity profile.

While there is a general sentiment that the current macro conditions remain unfavorable to pursuing exits, deleveraging is considered a good way to better cope with a “higher for longer” rate regime while simultaneously improving the valuations of portfolio companies.

Bringing discipline to valuations

Firms are also strengthening their valuation frameworks, with some choosing to introduce more of an AI, data-driven approach to apply more discipline to, and rigorous analysis of, portfolio company performance. The endeavor brings the investment team and IT team together as management firms look for ways to use AI tools that can detect patterns in liquid markets and apply them to private equity to improve outcomes.

Those that strengthened their valuation frameworks during covid by getting weekly valuation updates are reaping the benefits in today’s more challenging macro climate. By determining what the outcomes might be to a set of parameters – such as, ‘What would happen to a company’s valuation if interest rates rise by two percent?’ or, ‘What will the multiple contraction be?’ – the deal team is better able to pace its investment activity.

This additional work on valuations is allowing CFOs to be a little more nuanced at a time when LPs are asking more and more questions on valuation methodologies.

Discounted cash flows are generally regarded today as a useful reference point, but are not core to the decision-making process as CFOs are increasingly relying on additional valuation data points.

Focusing in on cashflows

Cashflow monitoring has always been part of the reporting process. In today’s economic climate, however, “you need to discipline investment teams” suggested one CFO, to ensure they are discussing this during their monthly reporting updates with investee management teams.

PE sponsors are spending more time and money supporting portfolio companies and finding the optimal path to performance, with firm CFOs participating more on this front over the last 12 months.

Strategies include using monthly monitoring templates on performance to determine how cashflows, material costs and leverage levels are fluctuating. Some CFOs are appointing a member of operations team who sits on the audit committee to help guide PortCo management teams on contingency planning, should there be unforeseen spikes in the cost of materials that leads to a liquidity squeeze, for example.

“We are trying to develop integrated management information systems with our PortCos to have direct access to their financial positions, both from a balance sheet and operational cash flow standpoint,” said one CFO. The aim is to strengthen their efforts on short-term cash flow forecasting over six, nine and 12-month timeframes.

There are also efforts to support portfolio companies on the pricing of their products and services.

“I don’t think we’ve done as much as we should. People say that window is closed. I don’t think so. You can still push but you need to be more selective,” said the CFO of a Swedish PE group.

A degree of patience is also recommended; for example, gradually increasing prices over a two-year period, rather than a harsh sudden increase, which could end up being detrimental to the end customer, and ultimately the stakeholders.

Selecting the right deals, at the right prices, has arguably become harder over the last 12 months: which companies are best positioned today to survive over the long term, and flourish if and when rates fall?

As one CFO emphasized when discussing the deal landscape: “In challenging times the quality of the management team is vital.”