As the pandemic appeared to be receding somewhat in 2021, inflation became the word on everyone’s lips. According to the US Bureau of Labor Statistics, inflation in December was 7 percent over the previous year – the fastest 12-month increase since 1982.
Energy and food costs have been the main contributors, along with the second-hand car and truck market. US wages are also rising at their fastest rate in several years – average hourly wages for those working in the private sector rose to $30.85 in September, according to the BLS.
All this has led Federal Reserve chairman Jerome Powell to confirm that the end of the central bank’s asset purchasing program would be moved forward by a few months in 2022. CEOs will also be watching closely as three expected interest rate hikes are introduced.
For CFOs, it will be critical to keep a close eye on operating costs and profit margins – both with respect to managing existing portfolio assets and to assessing the economic viability of new potential assets.
Speaking to London Business School, Dan Gogel, chairman of private equity firm Clayton, Dubilier & Rice, said that the “rapidity of the increase [in inflation] is still unknown, but the direction is clear and the timing is getting tighter, and that clearly will impact valuations, although of course I hope the impact is minor.”
Covid-19, and its effect on supply chains, has been a major driver of the inflationary trend.
In its Q3 US private equity mid-market report, PitchBook said that many mid-market companies were experiencing “elevated labor, energy, logistics, and raw materials costs. Due diligence processes are focusing on these risks, especially in industries such as industrials and healthcare services.”
To illustrate the impact of rising costs in the industrial sector, companies in the Golub Capital Altman Index, which tracks PE-backed mid-market companies, reported 13.5 percent year-on-year revenue growth in Q3 2021, but only 0.2 percent year-on-year earnings growth.
Other industries, such as the broader technology space, might well be hit by rising raw materials costs, as is being seen in semi-conductors, but there is a sense that higher costs in such markets can be more easily passed on to customers.
Speaking at the Milken Institute Global Conference in October, Orlando Bravo, co-founder and managing partner of Thoma Bravo, said software companies are an almost perfect inflation hedge. If paying an employee more leads to improved productivity, then companies can maintain top-line revenue growth and a healthy EBITDA, especially if operating costs are passed on to the customer.
However, whether a portfolio company’s earnings and productivity can be increased will depend on the industry and the size of the business. It is easier to achieve this in the tech space than it is in, say, hospitality.
“Earnings growth is going to be an interesting metric to evaluate,” says David Larsen, managing director, alternative asset advisory at Duff & Phelps. “The customer is likely to pay more, but do they get more? Say an accounting firm charged $250,000 for an audit last year and they increase the price to $300,000 this year. Even though their revenues rise 20 percent, their costs might also rise by 20 percent or more.
“At the same time, a company CFO might say to their auditor, ‘We’re being squeezed on everything we’re doing so we only want to pay you $200,000.’ So the auditor could end up showing 20 percent growth, no growth, or 20 percent lower growth, depending on how prices are negotiated.”
Costly war for labor
Although the US unemployment rate is low – it fell from above 14 percent in April 2020 to 4.2 percent in November 2021 – workers have been quitting their jobs at the highest rate since the BLS began collecting data in 2000. Nevada recorded a 4.5 percent rate in resignations last September, while the rate recorded in Oregon was 3.9 percent. The phenomenon has been widely referred to as the ‘Great Resignation.’
Not only is talent acquisition costing companies more; so is talent retention.
Craig Ter Boss, partner in the corporate finance group at EisnerAmper, says keeping track of covid-related cost issues and talent acquisition issues, and how these affect revenues and expenses, is something CFOs will need to focus on with their portfolio companies over the next 12 months.
“For example, a high rate of employee turnover leads to the need to monitor the cost of acquiring and keeping talent more closely, especially for firms where the biggest expense is human capital,” he says.
Some investment firms feel that, over the longer term, the US labor market will look quite different and will be characterized by structurally higher wage costs.
André Perold is partner and chief investment officer at HighVista Strategies, a $5 billion, Boston-based investment firm that invests directly in private and public markets to chase inefficiencies across asset classes. “Public or private, you need to understand the cost of labor, the source of labor, the productivity of labor,” he says.
“A firm’s margin could disappear because they can’t source labor at an acceptable cost”
In his view, one of the primary drivers for structurally higher wage costs is the US labor pool growing at a slower rate than the wider population for the first time.
“It is a new phenomenon, not just in the US but globally,” he says. “The combination of older workers remaining in the workforce, and advances in automation and robotics improving worker productivity, could mean that the labor shortage may not become a problem, but we don’t see that yet.”
CFOs will need to monitor labor shortages within portfolio companies – especially younger businesses still in growth mode – and determine the extent to which these shortages are driving costs higher and potentially accelerating cash burn.
Although this will vary case by case, and sector by sector, the overarching question for CFOs in the coming years will be whether they have managed cashflows efficiently and protected the companies’ valuations.
Ter Boss’s point about the war for talent is key. When considering how the inflationary picture could affect US corporate growth this year, CFOs and CIOs appear to be more concerned about bankruptcies being triggered by issues in the labor market, rather than by higher debt costs, as companies in certain industries struggle to hire people.
“A firm’s margin could disappear because they can’t source labor at an acceptable cost,” says Perold. “That to me is the single biggest factor that will impact US corporate growth. If rates go up 1 or 2 percent, I don’t think it’ll matter too much. Some firms will even be net beneficiaries of higher inflation because their assets might be worth more, such as real asset firms (real estate, infrastructure, commodity producers).”
Rising cost of debt
Larsen says that when looking at portfolio assets from a returns perspective and a valuation perspective, it will come down to individual, investment-specific indicators: “If the cost of debt goes up, that will impact cashflows (and as a result, earnings growth). Does that mean that lenders lend less? Possibly. Does it mean the amount of equity to finance deals needs to rise? Again, possibly.
“That in turn changes the internal rate of return characteristics, unless a PE group is only willing to pay less for an investment in order to maintain the fund’s return objectives.”
Private equity CFOs might therefore need to build lower valuations into their financial models before making an acquisition – something Larsen feels is likely to be the case “over the next few years as rates and the cost of debt slowly rise.”
“We haven’t had a recession for over a decade. In that context, with so many unknowns, it is going to come down to how well a PE firm has done its due diligence”
Duff & Phelps
London-based Kreos Capital is a private credit investor, providing debt financing to sponsor-backed high-growth companies across Europe and Israel. It focuses primarily on the technology and healthcare sectors, and provides fixed-rate loans with a three- to five-year maturity. Although inflation cannot be ignored, the bigger risk in the firm’s eyes is an event akin to the 2008 financial crisis hitting the global economy.
“There was a risk of that happening when the pandemic started,” says Parag Gandesha, general partner and COO. “Certain sectors came under massive earnings pressure, but other sectors, like technology, thrived. We do a lot of investment in SaaS businesses, logistics businesses, delivery businesses where technology is driving growth.”
The UK has experienced a sharp rise in inflation, reaching 5.1 percent – the highest it has been in a decade. Like corporate America, much of the British economy is fueled on cheap debt. The Bank of England introduced a modest rate hike to 0.25 percent on December 15, and further increases in 2022 will affect businesses that have enjoyed low rates for an extended period. Those halcyon days could well be over.
Identifying and monitoring the right data
For senior lenders like Kreos Capital, there is an increased focus on data analytics to keep track of various financial metrics.
As Gandesha explains: “We’re increasing the number of data points we use month-on-month on companies we are tracking. We produce certain data points each week for our investment committee as part of our portfolio review process.
“We’re increasing the number of data points we use month-on-month on companies we are tracking”
“We want to know when the next financing rounds are happening, and we track cash burn rate and cash runway with all of our portfolio companies. Risk triggers could be that a company has six months’ cash left and we need to understand what they are doing before extending their cash runway. We want to know well in advance what the cash needs of the business are and how it’s growing.”
Stephen Richmond, partner and CFO at Abris Capital, a European mid-market-focused PE group, confirms that the key financial metrics it is prioritizing are “increases in output prices, trading margins, inventory turnover and working capital requirements, and debt ratios.”
“People will need to take a view on how temporary some effects might be and whether there has been a permanent change in the business model when valuing some companies”
“Some portfolio companies are impacted more than others,” he says. “For example, those that have high energy consumption, or large workforces, or some specific inputs that have increased in price sharply recently. And we are paying more attention to certain costs, on a case-by-case basis.”
For HighVista, the cash burn rate is also an important financial metric when it comes to monitoring its private markets portfolio. This is particularly germane to high-growth companies that it believes can generate a high multiple of invested capital.
“In those cases, we are hoping for a big-payout years down the road, so it’s hard to determine what impact inflation might have on the market,” says Perold. “But what we can look at is financing costs. These are typically younger firms raising money, spending money and growing voraciously, and their need for money could be much higher in an inflationary world than otherwise. Will they be able to raise more equity? And if so, will greater equity dilution lead to a lower MOIC?
“This inflation-related financing concern is one we see directly through the CFO lens we bring to bear on all investments.”
In Gandesha’s view, as interest rates rise in 2022 there could be a slowdown in valuations in the middle and upper end of the buyout space as EBITDA margins and cashflows come under more pressure. This, he says, will require PE sponsors to over-equitize businesses.
There has been evidence of equity cushions rising in the buyout space over the last couple of years. Using Refinitiv LPC data, PitchBook showed that, in Q3 2021, mid-market purchase price multiples reached 12.5x, consisting of a 5.3x debt multiple and a 7.2x equity multiple. By contrast, the average equity multiple in Q3 2019 was 5.9x, with debt remaining largely unchanged at 5.2x.
Abris’s Richmond holds a similar view and sees the potential for both valuations and exit volumes in the buyout space to retrench in 2022. “Trading results are being impacted, but not uniformly,” he says. “People will need to take a view on how temporary some effects might be and whether there has been a permanent change in the business model when valuing some companies. Some buyers may adopt a wait-and-see approach.”
However, some in the industry believe that covid-related uncertainty will affect valuations more than rising interest rates in 2022; and even then, the impact could be short-term.
EisnerAmper’s Ter Boss believes that, based on discussions with PE clients, a pullback in valuations does not appear to be a big concern, with most believing any such move would be likely to be temporary. “That’s not to say there won’t be impacts on valuations and exit deals,” he says. “But factors like inflation, SPAC activity and the war for talent will have more of an influence than the end of the Fed’s asset purchasing program.
“The biggest thing we’re stressing to our clients right now is the need to calibrate and tell a cohesive story about the rationale when the company was bought and valued, through each quarter to the present”
Craig Ter Boss,
“Apart from data, the biggest thing we’re stressing to our clients right now is the need to calibrate and tell a cohesive story about the rationale when the company was bought and valued, through each quarter to the present. Previously, firms could get away with doing this on a year-to-year basis, but the sophistication of LPs and requests from auditors have driven a more frequent reporting process with quarterly updates. While there was some resistance at first, this ultimately has led to increased transparency between firms and investors, which is positive.”
Duff & Phelps’ Larsen adds: “We haven’t had a recession for over a decade. In that context, with so many unknowns, it is going to come down to how well a PE firm has done its due diligence. Have they paid a price for an asset that they feel is appropriate based on the return they are looking for? What will the cost of debt be in three, four or five years if, and when, they plan to exit?
“Nevertheless, I think CFOs will be feeling a little more comfortable following Chairman Powell’s announcement. They know they will need to factor three rate hikes into a portfolio company’s financing in 2022 and their estimated assumptions on what financing can be obtained. It should give CFOs a bit more certainty.