As the global markets emerge from the pandemic and into a period of high inflation, private funds professionals are under pressure to drill down into the impact of rising prices on portfolio company valuations. In the face of rising fuel prices, labor shortages and supply chain constraints, working out how different businesses will be impacted is not an easy task.
Attul Karir, a financial services partner at PwC, says that, to assess the impact of anything on valuations, two things must be considered: the impact on cashflow and the impact on risk.
“From a cashflow perspective, you can break that down further into the impact on revenues, cost and capex,” Karir says. “In terms of revenues, the impact is going to be felt more by those businesses that can’t reprice their products or services. On the cost side, the question is how high is the cost base and what flexibility does the business have to lock in raw input costs. Given the trends we are seeing in international trade, input costs will also be impacted by changes in tariffs.
“Then you need to look at how far in advance a business needs to commit to capital expenditure programs, because businesses in capital-intensive sectors such as infrastructure, energy, utilities and manufacturing need to commit to those far in advance, and therefore have little flexibility to roll back. Ideally, you would like to be able to break up your capex program in a period of high inflation and take a more cautious approach.”
While it is difficult to point to any parts of the economy that will be immune from inflationary impact, it is little surprise that sectors like technology, software and business services have emerged as a popular option for investors in recent times.
“Given the trends we are seeing in international trade, input costs will also be impacted by changes in tariffs”
“On the risk side, broadly speaking the businesses that will be least impacted by the high inflation environment will be those with stable income streams and minimal debt burdens,” says Karir. “That’s not dissimilar to the discussions we had around covid, where the sectors that remained more robust in terms of valuations were those that had lower debt burdens, stable income streams and more flexibility around cost structures.”
Andrew Robinson, a corporate finance partner who leads Deloitte’s specialist valuation group, says it is important to remember that there will be winners as well as losers, and valuations will not necessarily just track downwards as a result of inflation.
“Inflation introduces additional risk into forecasting the future, which is fundamental to valuations,” says Robinson. “That will lead to lower valuations for some companies. However, certain businesses will be better off – and potentially valued higher than before – in an inflationary environment. That’s because they will be able to make higher revenues, either through contractual or regulatory mechanisms, or consumer demand, but their costs may not inflate as much.
“One thing that is really important when looking at valuations is to try and work out what aspects of the business will be impacted by inflation, whether that is revenues, costs or capex. Those will all react differently and if you are able to pass on the impact on your cost base, then the chances are you will be a net beneficiary.”
One of the challenges for valuations professionals looking at the current spike in inflation is determining how long such an environment might last. With the outbreak of war in Ukraine and the length of the supply chain issues that have hung over from covid restrictions – both unexpected in inflationary forecasts – fund managers and valuers are trying to second-guess what comes next.
Leon Sinclair, global head of private equity and debt services at S&P Global Market Intelligence, says: “Whether you are a GP or a valuation practitioner, you are trying to establish where inflation levels out, and in what timeframe it does so. Most economic forecasters don’t expect inflation at 8 or 9 percent for multiple years, but where it levels out is really very important. The earlier this starts to become clear, the earlier the markets will find consensus.
“An important question on the topic of valuations is also how severe a recession has to be to bring inflation back to target levels in major economies and how do we stave off stagflation. A bout of stagflation will be significantly more concerning than the discussion on elevated inflation.”
Karir adds: “Part of the challenge is that it feels like short-term inflation expectations are more elevated than long-term ones. It seems to me that this could be more of a near-term phenomenon, and clearly it is uncertain how long it will persist. This is highly dynamic and therefore investors and valuers will need to monitor this closely going forward, with a particular focus on announcements from the leading central banks.”
Robinson says such uncertainty also calls on funds professionals to do a lot more work when looking into the way each portfolio company might react. “We are dealing with a period of high inflation and we don’t know how long it will last. Therefore, you have to do more work as a valuer, a private equity investor or a CFO to truly understand the impact that inflation will have on your investee companies. A superficial analysis is not going to get there. Every single sector and every single asset type is going to be affected in different ways.
“You need to make sure there is a consistency of viewpoint between the impact of inflation on the cashflow you’re going to generate from the business and what your cost of capital is going to be and therefore your target returns. That will be different for all investors, but you have to have a clear view on that issue, supported by evidence, when making an assessment of the value of a position. Investors in funds are already asking those questions of their fund managers.”
“Every single sector and every single asset type is going to be affected in different ways”
Taking a closer look
Sinclair says the high levels of inflation today are not fundamentally changing the way professionals approach valuations, just calling for additional scrutiny. “Ultimately the intrinsic valuation drivers of a business being able to generate sufficient levels of free cashflow to the enterprise are unchanged,” he says. “It’s the business’s ability to grow the top line, its level of operating margin, unit economics and investment rates needed to deliver the required growth.
“So, it’s not that the approaches change, but interrogation of these intrinsic drivers is heightened in times when these factors are put at risk by any event or confluence of events that the asset class is facing. What’s important is to have a thoughtful framework to play these assumptions out and to tie them back to real-world factors impacting the business.”
David Fowler, global head of private equity at Sanne Group, says that, from an accountancy perspective, there will now be even more focus from auditors on the detail of valuations, and particularly how inventory and deferred tax liabilities are reported at portfolio company level and the liquidity of highly leveraged businesses.
“We have seen a demand in more detailed and granular reporting in recent years, as managers and investors look to access their data and make quick evidence-based decisions off the back of this; however, this trend started before inflation started to rise and is not a result of the current environment. I don’t see the frequency of reporting changing at the moment but certainly the informal communication between managers and their LPs will increase, and there will be more focus on the impact of the current conditions on individual investments. Demand for real-time data will continue to increase, although not necessarily because of the current environment.”
Fowler adds that fund managers may shift their value creation strategies somewhat in response to the inflationary environment. “In recent years, a significant proportion of private equity valuations have been driven up by multiples, helped along by a wave of low interest rates. With interest rates rising, those multiples are starting to fall and we are starting to see managers focusing much more heavily on revenue growth and margin improvement. We will now see private equity managers taking much more interest in businesses where they can add growth and operational efficiency through technology rather than labour.
“The first obvious direct effect of inflation is the impact on interest rates, which means increased borrowing costs for private equity funds, which in turn can have knock-on effects for valuations and returns. There will be more focus on hedging to manage that interest rate risk going forward, for both managers and their LPs.”
Hurdle rates could also creep back up for fund managers as the risk-free rate of return rises due to inflation, Fowler adds.
Sinclair says he is already seeing the impacts of inflation feeding into the negotiations between existing investors and portfolio companies on new funding rounds. “Flat rounds are now occurring for businesses that are performing materially better than expected at the last round and are fairly well-placed to ride out the storm. Significant down rounds are occurring for businesses that have performed well into Q2 but have a significant cash-burn that will have to remain relatively intensive for the business to execute its plan and get to meaningful scale.
“This is especially true of business models dependent on high long-term growth projections. For example, technology businesses that are capital intensive and often unprofitable until they are at huge scale will see valuations contract as the discounted value of long-term profits is compressed.”
In such an unfamiliar inflationary environment, it seems likely that such questions will be front of mind for private funds professionals for some time to come.